REIT Valuation: The 4 Most Common Approaches Used in Practice
REIT valuation is commonly performed by analysts using the following 4 approaches
- Net asset value (“NAV”)
- Discounted cash flow (“DCF”)
- Dividend discount model (“DDM”)
- Multiples and cap rates
REIT valuation vs traditional valuation
Companies operating in industries like technology, retail, consumer, industrials, healthcare are valued using cash flow or income based approaches, like the the discounted cash flow analysis or Comparable Company Analysis.
By contrast, the Net Asset Value ("NAV") and dividend discount model ("DDM") are the most common REIT valuation approach.
So what's different about REITs?
With these other types of companies, the values of the assets that sit on their balance sheets do not have efficient markets from which to draw valuations. If you were to try to value Apple by looking at its balance sheet, you would be grossly understating Apples true value because the value of Apple's assets (as recorded on the balance sheet) are recorded at historical cost and thus do not reflect its true value.
As an example, the Apple brand - which is extremely valuable - carries virtually no value on the balance sheet.
But REITs are different. The assets sitting in a REIT are relatively liquid and there are many comparable real estate assets constantly being bought and sold. That means that the real estate market can provide much insight into the fair market value of assets comprising a REIT’s portfolio.
In addition, REITs have to pay out nearly all of their profits out as dividends, making the dividend discount model another preferable valuation methodology.
Summary of REIT valuation methods
|Net asset value (“NAV”)||The NAV is the most common REIT valuation approach. Rather than estimating future cash flows and discounting them to the present (as is the case with traditional valuation approaches), the NAV approach is a way to calculate a REITs value simply by assessing the fair market value of real estate assets As a result, the NAV is often favored in REIT valuation because it relies on market prices in real estate markets to determine value.|
|Discounted cash flow (“DCF”)||The discounted cash flow approach is similar to traditional DCF valuation for other industries.|
|Dividend discount model (“DDM”)||Because almost all of a REIT's profits are distributed immediately as dividends, the dividend discount model is also used in REIT valuation. The DDM discounts all future expected dividends to the present value at the cost of equity.|
|Multiples and cap rates||The 3 most common metrics used to compare the relative valuations of REITs are:
REIT Valuation using NAV (7 Step Process)
The NAV valuation is the most common REIT valuation approach. Below is the 7 step process for valuing a REIT using the NAV approach.
Step 1: Value the FMV (fair market value) of the NOI-generating real estate assets
This is the most important assumption in the NAV. After all, a REIT is a collection of real estate assets - adding them up should give investors a good first step in understanding the overall REIT value.
- Take the net operating income ("NOI") generated from the real estate portfolio (usually on a 1-year forward basis) and divide by an estimated “cumulative” cap rate, or when
feasible, by a more detailed appraisal.
- When the information is available (usually it isn’t), use distinct cap rates and NOIs for each region, property type, or even by individual properties.
Step 2: Adjust NOI down to reflect ongoing “maintenance” required capex.
REITs must make regular capital investments in their existing properties, which is not captured in NOI and the result is that Capex is sometimes left out entirely or grossly underestimated in the NAV.
However, ignoring the recurring cost of capex will overstate the valuation so a proper NAV valuation must reduce the NOI down for expectation for required annual capital expenditures.
Step 3: Value the FMV of income that isn’t included in NOI
Income streams not included in NOI like management fees, affiliate and JV Income also create value and should be included in the NAV valuation.
Typically this is done by applying a cap rate (which can be different from the rate used to value the NOI-generating real estate) to the income not already included in the NOI.
Step 4: Adjust the value down to reflect corporate overhead
Now that you've counted the value of all the assets, make sure to adjust the valuation down by corporate overhead - this is an expense that does not hit NOI and needs to be reflected in the NAV to not overstate the valuation. The common approach is to simply divide the forecast for next year's corporate overhead by the cap rate.
Step 5. Add any other REIT assets like cash
If the REIT has any cash or other assets not already counted, add them usually at their book values, perhaps adjusted by a premium (or more rarely a discount) as deemed appropriate to reflect market values.
Step 6. Subtract debt and preferred stock to arrive at NAV
Debt, preferred stock and any other non-operating financial claims against the REIT must be subtracted to arrive at equity value. What's more, these obligations need to be reflected at fair market value. However, practitioners often simply use book value for liabilities because of presumed small difference between book and fair value.
At this point, the NAV will arrive at the equity value for the REIT. The final step is to simply convert this to an equity value per share.
Step 7: Divide by diluted shares
This is the final step to arrive at the NAV per share. For a public REIT, the NAV-derived equity value is compared against the public market capitalization of the REIT. After accounting for potentially justifiable discounts or premiums to NAV, conclusions about whether the REIT’s share price is overvalued or undervalued can then be made.
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