Real Estate Metrics
The metrics below are used quite frequently in real estate:
Net Asset Value
Net Asset Value (“NAV”) is the difference between the fair value of the assets and liabilities. If the figures on companies’ balance sheet reflected the true fair values (as opposed to historical figures or figures bound by accounting standards), then the equity would be equal to the NAV. It basically indicates what would be the cash that investors will receive if all assets were sold today in a free market and all the liabilities were paid on the same day.
NAV is specifically useful in real estate because of the stable and (relatively) predictable nature of the investment, and the fact that most of the income that is generated from the investment is distributed. So, it’s a little bit different from technology companies that the retained cash will be used to put the genius of the management into work and created value that is tenfold the original price. It’s true that competent management in a real estate company can create value, but the growth is more gradual. As mentioned in other posts, REITs (both private and public) are required to pay 90% of the taxable income as dividends to investors in order to maintain their REIT status (tax exempt). Also, they are not usually heavily leveraged, meaning that although protected in the downturns, they won’t benefit as much in the upturns. These are all the desirable characteristics of a stable and dividend-paying investment.
As it relates to private funds, the NAV is determined by management as per the governing documents and reported to investors at their pro-rata share.
For public REITs, although conceptually the value of shares should equal to the NAV per share, other factors are in play. The shares of the public REITs are liquid and can be purchased in small increments. In addition, the public REITs are managed by professional management. These factors contribute to shares being overpriced as compared to NAV/share. There are also some opposing factors that drag down the prices, the most important of which is the fees that the management team charges. In addition, the general direction of the market also determines whether a public REIT share is overvalued or undervalued. Historically, public REITs have been overvalued.
So, one can determine the NAV per share and compare it with the price per share. Note that NAV/share is not the only metric and there are other factors in play. For example, if the company is dealing with a serious environmental investigation, or is highly leveraged in a rising-rate environment, then such factors (rightfully) will drag the value of the shares down.
Net Operating Income (“NOI”)
NOI is an important metric in the valuation of real estate properties. The calculation is as per the below:
REVENUE:
Potential Base Rent
Less: Absorption and Turnover Vacancy
Less: Free Rent
= Scheduled Base Rent
+ Other tenant revenue (percentage rent, recoveries)
= Total Tenant Revenue
+ Other income (Parking, Locker, Vending Machines, Antenna)
= Potential Gross Rent
Less: General Vacancy and Credit Loss
= Effective Gross Rent
OPERATING EXPENSES:
Property taxes
Repair & Maintenance
Property management fee
CAM (Common Area Expenses)
Other operating expenses
NOI = REVENUE - OPERATIONG EXPENSES
Note that interest, asset management fee, general and administrative expenses, depreciation, realized and unrealized gains, and foreign exchange gains/losses are not included in NOI.
How NOI is used in the valuation of a property?
If we know what is the capitalization rate (see below), then the value of the property is NOI/Cap Rate.
Usually, the stabilized NOI is used, which reflects adjustments to vacancies and rent roll.
Cap Rate
Cap rate is an important metric in commercial real estate which is derived from dividing the NOI (Net Operating Income) by the purchase price. An increase in cap rate, assuming NOI is constant, indicates that prices are under pressure (as it has an inverse relationship). This can happen at times when interest rates are rising since real estate investment is in competition with bonds for investors’ money. As interest rates rise, the bond yields rise as well, and some investors might want to invest in IG (Investment Grade) bonds as they are more secure. Therefore, real estate must increase its yield to remain attractive to investors, which means cap rates will be higher. If the NOI remains unchanged, then a higher cap rate will result in a lower purchase/sale price. In Q2-2022, we are almost in this situation. We said ‘almost’ because there is an expectation that the NOI will increase which will salvage the property price to a certain degree.
A survey conducted by CBRE indicated that cap rates in H1-2022 were slightly higher than H1-2021. However, prices for well-located neighborhood retail centers and prime offices have held up (no cap rate expansion). Please note that the Fed hiked rates after June 2022 when the abovementioned survey was conducted with a more hawkish tone that followed toward the end of August. Against this backdrop, higher cap rates are expected in Q3-2022 and going into Q4-2022.
Increase in 10-year treasury and Baa corp yield:
As mentioned above, interest rates have a direct impact on the value of the properties through the cap rate. The specific metrics are the yields on 1) 10-year treasury notes and 2) investment grade corporate bonds (Baa by Moody’s standard). As the yields rise on these two bonds, they put upward pressure on Cap Rates. The Baa bond rate as of August 1, 2022, was 5.15% which is close to the preceding two months, but it increased to 5.48% by September 1, 2022. We expect a 75bps hike in federal reserve rates late September, which will push the Cap Rates even higher.
All-Property average cap rate per CBRE survey was close to 5.5%. The cap rate expansion is mostly expected in lower-tier office buildings, followed closely by retail. The expectation of cap rate expansion for multi-family and industrial is less.
Implied Cap Rate
When we assess a public REIT, we can perform reverse engineering to estimate what’s the cap rate on the properties in the REIT’s portfolio. This method would work best if there was only one property in a REIT, and as you can imagine, many things can go wrong if one wants to estimate the implied cap rate. That being said, a detailed enough model can provide an estimate. But remember, this is a rough estimate.
Basically, as the first step, we assume that the market cap of the REIT equals NAV. From there, we calculate the implied value of properties:
Asset = Liability + Equity (NAV)
Assets include: Properties + Cash + Marketable Securities + Investment in JV + Receivables + Other Assets
Therefore:
Implied Properties Value = Liabilities + NAV - [ Cash + Marketable Securities + Investment in JV + Receivables + Other Assets ]
As the second step, we calculate NOI, using the information in the REIT’s SEC filing.
The implied cap rate = NOI / Implied Properties Value
Let’s say the implied cap rate is 8, and we know that the cap rate in the markets that the REIT owns properties averages 6. The fact that the implied cap rate is higher than the actual indicates that the assets (and shares for that matter) are undervalued.
FFO (Funds From Operations)
FFO is calculated by adding back depreciation, impairment, and gain/loss to net income.
This is one of the most widely metric used for valuation. It’s used as a multiple. Basically, we calculate price per share and FFO per share, then calculate price per share as a multiple of FFO. Nareit has defined a standard for FFO and most of the REITs have adopted that methodology.
At GGC, we believe this is grossly inaccurate measure for valuation and should not be relied on.
AFFO is a more appropriate measure but not all of the REITs report it, and those that report have different definitions for AFFO, so it’s not very comparable. AFFO is calculated by making further adjustments to FFO, most notably adjustments for: acquisition, transaction, and other codes; straight-line rent; and amortization of deferred financing costs.
FAD (Funds Available for Distribution)
FAD is a non-GAAP, non-accrual measure that shows the cash left after we deduct all of the REIT’s obligation, which includes debt service (both interest and principal) and capital expenditure.
Calculating FAD requires more work, but it is definitely a good metric to estimate the viability of REIT’s dividend distribution as well as operations.
Borrowing Costs
Borrowing costs can have a significant impact on the financial health of a REIT. Those REITs that have fixed and low mortgage rates can sustain unfavorable financial conditions (for example, the one that we are going through in 2022 as the Fed is raising rates and the lending terms are becoming more restrictive as per CBRE).