Net Asset Value Model Overview Transcript
In this video you’re going to get an overview of how a net asset value model works for a real estate investment trust. Now this is a topic that we covered in some of the overview videos and that I’ve mentioned throughout the course. If you’ve been through some of the equity research that we looked at for the valuation segment for the public comps and precedent transactions, for example, then you’ve probably seen references to this in equity research models as well.
But for real estate investment trusts and specifically equity real estate investment trusts as opposed to mortgage REITs the net asset value model is really the key valuation methodology. It’s something that’s almost universally used. Yes, you can use a DCF, you could use a dividend discount model. You could look at replacement value or replacement costs as other intrinsic valuation methodologies, but really the net asset value is by far the most common one.
The reason for that is, as you know, with a real estate investment trust it is really just a clutch of individual properties and the gross real estate operating assets and the net operating real estate on their balance sheet; their total real estate assets are the biggest value driver from the company and how they drive usually over 90% to 95% of their revenue and net operating income.
So, with a net asset value model the idea here is that we’re going to take the asset side of the balance sheet. We’re going to make some adjustments here because of this gross real estate operating assets number of $5.3 billion. That may be accurate, but it may also not be accurate. It really depends on what kind of net operating income and CAP Rates for earnings for the assets that we have.
So, we may have to make some adjustments to this. We’re going to adjust for that. We’re going to leave out accumulated depreciation all together because that should not affect our value here at all. Remember, that with accumulated depreciation we’re recording this over time and we have to depreciate real estate assets over time, but in reality with real estate usually the value of properties goes up, unlike with say computers or equipment or factories that are actually going to wear down over time. Usually with real estate the value of actual property goes up and so that is why we’re going to ignore the accumulated depreciation in our net asset value analysis.
The other real estate assets we’ll also take into account, for these we won’t necessarily look at CAP Rates and the NOI being generated because for some of them for the land held for development, for example, it’s not yet in use, so it’s not generating any income and construction in progress so this one again it is not actually finished yet, so it’s generating little or no income. You might look at the NPV of this or the present value, something like that, but, in general, you don’t adjust these terribly much in a net asset value analysis.
Then for the other assets, these will be a little bit more straight forward. Generally you are just going to take 100% of the value of these. You may adjust the investments in equity interest one, depending on how you calculate your gross real estate asset value in the NAV analysis. Specifically, what I mean is that for this one you could just count this as a 100% and use this for your value but, another approach would be to look at the NOI from these equity interests and factor in up here when we adjust for our gross real estate operating asset value. If you do that, then this one is going to be zero because you don’t want to be double counting it in the analysis.
On the liability side, generally, you are going to count the debt and accounts payable, accrued expenses, other liabilities like that. Whether you have one tranche of debt or many tranches which is often the case with REITs, you are pretty much going to count this as 100%. If you have reason to believe that the market value of the debt, for example, is significantly different from the balance sheet value; the book value, then you may adjust for it, but it’s usually not common to see that because as bankers and financiers we usually don’t have enough insight into the actual debt to really say anything and unless we’re in some kind of extreme market condition usually you just leave this as is at a 100% of the balance sheet value.
Besides these we are also going to subtract out from our adjusted asset value anything else with a claim to the company’s equity. So, in this case non-controlling interests and preferred stock would both qualify. Redeemable non-controlling interests may qualify, but they may not. This is sort of like convertibles for normal companies.
Remember how redeemable non-controlling interests work. Basically it’s a put option for the company to buy back shares from the operating partnership unit holders. So, what this means is that if they exercise that put option and they force us to buy these shares back, then the share count is going to change and the redeemable non-controlling interests up here is actually going to go down if they actually exercise that put option.
Should we include this when we calculate and subtract our total liabilities? It sort of depends on what we are using for our share count. If we include the operating partnership units or the Op Units, as they are sometimes called, or the DownREIT units, then we should not be counting redeemable non-controlling interests because we would be double counting it. If, on the other hand, we don’t do that then we should be subtracting it out from the liabilities here. Very similar to how a convertible works for normal companies.
The treatment here is that if you add this in to your liability count, then you should not also be adding in the OP units. On the other hand, if you don’t add this in, then you should be taking into account the OP units. That’s the overview based on their balance sheet of how we are going to determine this.
Now let’s go over to the actual model here, and I am going to walk you through this and show you how we will calculate this at each step of the process. Generally with the NAV model, you split it into capitalized income and then balance sheet assets and liabilities down here. With capitalized income we are looking at the net operating income from wholly owned properties and then from unconsolidated joint ventures. In other words, investment’s equity interest for a year and then we may also look at other sources of income, such as third-party management fees. These are not directly coming from property in the same way that rent from tenants is, but other people may be paying us to manage property. Things like that, so it’s not as directly associated the CAP Rate there is going to be calculated a little bit differently, but that could be another source of NOI contribution.
If you want to see another example of a net asset value model, If you go to the equity research report I’ve linked to UDR this is from Barclay’s Capital. Here is their model they have the capitalized income here, the balance sheet assets; other balance sheet assets; balance sheet liabilities and then other claims on equity and they are doing exactly what I just said for the non-controlling interests or minority interests, as they call it. They are excluding the redeemable non-controlling interests because they are counting the operating partnership units for a year. That is what says diluted shares and units outstanding.
When we go and divide by that, when we go and divide our net market value of assets by the share count if the OP units are in there we should not be counting the redeemable non-controlling interests in minority interests here and we should not be subtracting that to get to our net asset value.
You can see what they have done, basically they have split it into different segments, much like we have assumed a CAP Rate for each one of them and then looked at the NOI and then used that to get to the current value. One interesting thing that they’ve done is looked at the nominal CAP Rate and then the economic CAP Rate. The difference between these two, if you go down and read the footnote, is that the economic CAP Rate includes a deduction for recurring maintenance CapEX for a year.
This goes back to one of the points I made in the overview videos that with real estate there is some controversy over how to calculate CAP Rates and NOI. Some people will include recurring maintenance CapEX some people won’t. So you really have to dig in and make sure that you are looking at it on the same basis that everyone else is. They have split it in two and looked at it based on the NOI before and after CapEX. We are not going to bother with that here we are just going to assume one cap rate mostly because with real companies it’s difficult to get this kind of information and this level of detail. So, we are not going to follow quite what they have done here, but the basic concept is the same.
Where do we get these CAP Rates for the different types of property they might own? That is a mix of art, science and guess work. One method is that you could just look at their current portfolio and you could take their CAP Rates based on the estimated forward NOI for all those different real estate segments. So similar to what we did in our segment by segment build up for AvalonBay you could just go in and look at historical or projected CAP Rates. You could talk with local people in the market see what the going CAP Rate is. You could even split this into different regions you could look at their Northeast US properties versus West Coast US properties. If they own properties abroad you could look at Europe or Japan or other countries separately. You could split this out by region as well.
It doesn’t make quite as much sense to do that if it’s confined to one country as our sample equity REIT is here, but that is another approach. Basically you are going to be using all of those; talking to local people in the market; looking at comparables; looking at properties that have recently sold to establish the CAP Rates on those and you could also look at the company’s own historical portfolio and your projections for them as well; what the CAP Rate is going to be going forward.
In this case I am going to say 5.5% for the wholly owned ones then 5.5% for the unconsolidated joint venture properties as well and then 15% for the third-party management fees. Now, why are the third-party management fees being valued at a significantly higher CAP Rate than the other ones here? Remember that with CAP Rates the higher the CAP Rate, the lower the valuation that is being assigned to the segment. Since they were saying here that the actual property, the NOI from the property is receiving a much higher valuation than the revenue for the third party management fees.
If you look at the Barclay’s report they are doing the same thing where they assign a much lower CAP Rate and therefore a much lower valuation for the property NOI and a higher CAP Rate and therefore a lower valuation for third party management fees. The reason for this if you pull up the PDF that I have linked to and called REIT University NAV Overview they are doing something very similar here where they assign a much higher CAP Rate to the management income.
They are saying around 20% and their analysis is on page two of the PDF. They actually have a note about the explanation for this under step three here. ‘Since management contracts are accumulatively canceled on short notice, often 30 – 60 days we describe a substantially lower valuation of fee income than to rental income’.
They are saying 20%, Barclay said 12%, we are going to say 15% roughly in the middle. This is really the explanation that rental income usually applies to long term contracts. Usually at least a year for offices and retail it might be more like two, three, five or even ten years. There is a lot more liability with that type of revenue, but with these contracts just to manage their properties you can cancel them at any time. As a result the management fee receives a lower valuation than the other segments on here.
To calculate the current value, we are going to take our NOI and divide by the assumed CAP Rate for each segment. Copy this down and let’s add these up and see what it comes out to. $5.6, $5.7 billion and that’s actually a little bit more than our real estate operating assets over here. In this case it looks like our assets may be undervalued according to our balance sheet. That is not an uncommon scenario.
Usually with real estate the whole reason why you do the NAV model in the first place is that people argue that the balance sheet undervalues their assets and they can extract more value if you actually look at CAP Rates and apply CAP Rates to each of the different properties and look at the forward NOI and use that to get the current value.
That’s how we look at the capitalize income segment of the net asset value model. Moving down now the next thing we want to do is look at their other balance sheet assets. All of these we are going to go to our balance sheet and pull these in. Do the same thing for these other non-real estate assets as well. Then we’ll even do the same thing for the liabilities and then the other claims on equity. I’ll explain all of this when we get to it. For now I just want to fill this in to save us a little bit of time later on.
We have all these values the relevant question now is how much of these should we really be counting toward our current value our market value of assets here. Generally, for something like real estate assets held for sale you take this at 100%. The reason is that they are already being held for sale and are probably not generating much income, if anything, from them. You might just be selling land, for example, or maybe even construction projects that you haven’t even finished.
Generally, for this one you will just say 100%, sometimes you may even say zero for this because it’s so minimal that it does not make a difference? You don’t want to be counting something that they are selling toward a market value asset for the company. I would say, for this one, zero or 100% are the two most common ones.
Here we are going to be a little bit more aggressive and say 100% even though they are selling it soon we are really looking at the current balance sheet that is why I am saying this. If we acknowledge that they are going to sell this tomorrow or something like that, then maybe we would set this to zero instead.
Now for these other two for construction in progress and land held for development one thing that you see for construction in progress some might take the NVP of this and they will actually try to calculate the present value when the construction in progress finishes and they will adjust the balance sheet based on that.
In general that is a little bit difficult to apply to Real Estate Investment Trusts, though. Unless you have very detailed information because companies don’t really disclose the level of detail that you would need to do that in their filings. You would need to know the exact time line, how much income they will be generating from it when it finishes? For example the total cost to finish the project; the balance sheet value when it finishes. Very hard to get all of that information up front.
Sometimes you will see people try to adjust and make some kind of present value adjustment here and say right now it is worth $500 million, but when it finishes it is going to be worth $1.5 billion and based on the construction time line finishing it in three or four years we can discount it back at a discount rate of 10% and get to an NVP value of such and such.
You could make that type of adjustment. It’s a little bit questionable especially because as I just said most of the time you don’t have nearly enough information to do that. The more common one to see is to hold this one and also land held for development at close to 100% and maybe a slight premium to that. Here we are going to say 110%. As you can see from my footnote here, I just made a note about the NVP adjustment as well, but here I am going to say 110% for construction in progress and 105% for land held for development. Under the assumption that once these are finished they will be worth more than their current balance sheet value because we will actually be generating income from that.
For the current value of these we are going to take the balance sheet value and multiply by the percentage here copy this down. We have that in general much less of a difference between these and the balance sheet value than there was for the properties that gross real estate operating assets that they own.
For these other balance sheet assets these are going to be pretty straight forward for cash the standard assumption with the Net Asset value model and even the Liquidation model is usually to say 100% and we are going to do the same thing for the other ones on here you could make an argument that so small you have to be careful here because depending on how you are calculating this it might actually be 0% or it could be 100% or something else in this case we have already counted these because we looked at unconsolidated joint venture up here and the NOI CAP Rate for them.
We have already factored that in if I were to say 100% here we would be double counting this one we don’t want to do that in this case I am going to say 0% because of the fact that we have already included the values of the equity interest here at the top. Again, you don’t have to do it like this you will see net asset values being done many different ways. This in just one example, one way you could do it, but if we’re not going to include this here if we didn’t have enough information if we didn’t have the valuation, we would probably just CAP this at 100% or something close to it and keep it at the current balance sheet value.
Let’s copy this down now. Sum these up. That is actually wrong. This is the other balance sheet assets value let’s take all the other total asset value. You get to $7.2 billion here going back to our balance sheet what were our total assets there we get to $5.4 billion. What explains the difference? Part of it is that we have left out accumulative depreciation and the rest of it is really explained by all the adjustments we’ve made really. It’s really the fact we have left out the accumulative depreciation because it makes no difference for real estate assets and then the fact that we have adjusted the value of the current real estate operating assets and so on.
We have that and then for these other ones for liabilities pretty straight forward pretty much just a 100% for all of these so I am going to copy that down. Once again, as I mentioned before if you had advanced knowledge that the debt for example the market value of the debt was significantly different from the balance sheet value then you might adjust for that. In this case we do not have that because this is just a quick example, but in the real world you might see more of an adjustment here if the market conditions are different and the market value of the debt is significantly different.
In general, in investment banking and private equity and other fields like that we are looking at real time. In general, it is uncommon to see too many adjustments to debt. The reason is that the information is difficult to come by. If you look on websites like Bloomberg, for example, they may not always have the market value of debt or it may not be that different from the book value. Unless the debt is constantly being traded it can be hard to establish the market value.
Unlike with real estate, for example, remember that the reason this works for real estate is that the market value here is pretty easy to establish you look at what other similar properties have sold for recently you look at the CAP Rates on those and then you can adjust your own value accordingly. There are constantly transactions going on the whole assumption behind our analysis here is that the private markets with real estate are more efficient than the public markets and the CAP Rates in the private markets on properties are going to change more quickly than the actual equity value or the share price of publicly traded real estate investment trusts.
That is why the adjustment works here we can actually look at data and it is not that difficult to get fairly active markets. Debt this can be much harder and that is why we usually don’t pay attention to this type of adjustment.
Then for the other claims on equity such as non-controlling interests and preferred stock, for non-controlling interests we are excluding the redeemable non-controlling interests. The reason being that if you look at our calculation below for our diluted shares we are actually calculating the operating partnership units. We do not want to be double counting this similar to convertible bonds if it is convertible you want to count it as shares, if It is not convertible you want to count it as debt; same idea with the redeemable non-controlling interests.
If we are going to count it toward our total liabilities here then we don’t want to include it in our shares we are not doing that then we do want to count it in our shares that year. You will see it being done differently this is just one way to do it. That is the general rule of thumb for an item like that.
For both of these I am just going to say 100%. Now we will copy down our formulas and now we can and now we can get to our Net Asset Value. Let’s take a look at this we are going to take our total market value of our assets so that the market value of our total assets on the balance sheet we are going to subtract our liabilities and then we are going to subtract the other claims on equity we get $4.7 billion for our net asset value. By itself it really does not mean that much we could go back to our balance sheet for our REIT and take a look at and compare it to shareholders equity.
If we took out the non-controlling interest from shareholder’s equity we get about $2.9 billion on the surface it seems like it’s significantly higher than the book value here but remember for real estate we have accumulative depreciation on the other side of the balance sheet. If we were to move this and we were also to get out of this side for shareholder’s equity this number would be significantly different and we would be much closer to the net asset value that we have here.
That is why, unlike with commercial banks, for example you cannot place too much stock in shareholder’s equity for REIT because you have accumulative depreciation on the other side of the balance sheet that may be a very large number and that would destroy the values of equity. By itself this sum for the Net Asset Value does not really mean that much. What we’re going to do here is look at the Net Asset Value per share and compare that to the current stock.
For this one we are going to take the diluted shares and then also the operating partners units and shares. Basically any from options, warrants, convertibles, and so on will be listed here. If we count dilution from convertibles and option units here then we should not be counting under liabilities. That is the basic idea. Let’s add these up and we get 105 million shares outstanding and then we get to our net asset value per share. Take net asset value divide by share count, so we get a NAV per share of $45.57.
What can we do with this? Clearly, it is much higher than their stock price right here. What we usually do with the net asset value per share is to compare it to the stock price to get the premium or discount to it. In this case, we are going to take the net asset value or actually the stock price divide by the net asset value per share and subtract by one and we get a 34% discount to net asset value per share.
What does this mean? On the surface it’s telling us that the assets on this company’s balance sheet are worth significantly more than what the stock price and the equity markets are giving them credit for. All else being equal if they have nothing else strange going on this company to us as investors would seem like a great deal because their net asset value is significantly higher than the current stock price the NAV per share is much greater than the stock price.
If this were reversed if the NAV per share were much less than the stock price then it would not be as good a deal because in that case the stock price that you have to pay to invest in them is greater than what their balance sheet is actually worth according to this analysis
How important are the results in this analysis? This is actually not something you look at all that much if you were looking at public comps or precedent transactions for example. It tends to be more common in non US markets. If you are in Europe, let’s say, this might become more important there.
Generally in the USA you don’t pay too much attention to this as a multiple valuation network. This is extremely important and you will see that all the time in equity research. Most equity research analysts for Real Estate Investment Trusts focus on this and FFO and AFFO multiples when they are valuing companies so this one is extremely important. The actual premium or discount is also looked at and calculated but you don’t necessarily include in your public comps or precedent transactions.
This is an alternate way of looking at the intrinsic value of a company or real estate investment trust. Compared to a DCF analysis the argument for a net asset value model is that it’s more reliable because you are basing it on their current balance sheet values. It is not as if you are projecting five or ten years into the future and one of the reasons why DCF could be unreliable some time. So you are mostly basing it on their current balance sheet value from that perspective it can be more reliable.
The problem, though, is that much like a DCF or dividend discount model or other types of intrinsic value methodologies, the issue is that assigning CAP Rates can be very problematic. You may not have enough information. You may not know exactly what to pick. That is really the hardest part of this analysis The actual mechanics are not that complicated. It’s really not rocket science. The problem is once again finding the right used and picking the appropriate CAP Rates.
Some real estate focused banks and research firms actually go through an extended process to determine the appropriate CAP Rates to use in this type of analysis. It goes well beyond what we did here. These are just simple estimates to teach you how the mechanics work, but that is really the crux of the net asset value model, picking the appropriate CAP Rates and then make sure you have the forward numbers to use right here.
Go back and look at the Barclay’s Report once again quickly. They have done pretty much what we have. They have assumed similar numbers for construction in progress, land held for future development. Of course this is for a different company, UDR. It’s not our sample company, but the concept is pretty similar.
They have assumed normal values for the balance sheet assets, not really adjusting them in any way. For debt and other liabilities again they have assumed the same numbers here. Pretty similar to our own analysis. One addition here is under other balance sheet assets, they have the benefit of tax exempt debt that is an interesting one to look at and we will see it when we get into our net asset value for AvalonBay.
For now I’m keeping it out because in our simple model here we do not have any insight as to what this might be and I haven’t really included it so we are leaving it out. But that is an interesting one to look at and we will go through it when we look at the model for AvalonBay. As we did, they get their net market value of assets, the current value per share according to that, and just like we did they are looking at the price per share comparing it to the net asset value per share.
They also get to their applied CAP Rates down here. We saw this with the public comps and precedent transaction lessons. I am not going to go through it again but that is something else you could do here. Once again, we’ll get to that when we see our net asset value for AvalonBay coming up over the next few lessons.
Those are a few different ways you can approach this methodology for the net asset value for REITs definitely one of the most important and one of the most common ones. It is really important to understand how the mechanics work and also that the key issue is how to take CAP Rates for your Real estate operating assets on the balance sheet.
Coming up next we are going to jump into this analysis for AvalonBay. In some ways it’s going to be easier than this. In some ways it’s going to be more difficult. It will be easier because we do have more data we have more insight into the company. But it will be more difficult because some of our more simplified assumptions won’t necessarily hold up there.
Look at that compare it and contrast it to our model here. We will also look at a few additional metrics like our implied CAP Rates. We will look at sensitivity analysis that tells us over a range of different CAP Rates what does the net asset value per share actually come out to be.
Once we are done with that, then we will move onto the other intrinsic valuation methodologies, namely DCF, the dividend discount model, and the replacement value or the replacement cost methodology.
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