How to Calculate Discontinued Operations for a REIT: Financial Modeling Tutorial

How to Calculate Discontinued Operations for a REIT: Financial Modeling Tutorial

In this lesson, you’re going to learn how to project the dispositions of communities and real estate assets from Avalon Bay, and how that impacts their income from discontinued operations going forward. So just to recap what we’ve been through so far with our segment-by-segment build-up, we’ve learned how to project their same store communities and the rental growth, and the net operating income from them.

We’ve looked at other stabilized communities as well, which are similar but a little bit different, in that you may have more changes to the assets on that side. We looked at development / redevelopment, basically creating communities, apartment complexes from scratch or renovating them. And then, acquiring additional properties from other sources, or just going out and talking to individual property owners, and acquiring properties from them. So these are really the four major categories, the three or four major categories, by which a real estate investment trust can grow.

[01:00]

They can increase their rent on existing properties, and maintain them by spending some maintenance CapEx on maintaining the properties. They can develop or redevelop properties or they can acquire properties. So those are the three major methods, by which a REIT can actually grow its assets, and grow its revenue and net operating income. But of course, in addition to growing they can also dispose of assets over time.

And if you go back to the operating model here, if you go to the discontinued operations part down here, this is exactly what this is referring to. The income from discontinued operations, this is basically the net income of these properties that they’ve disposed of. And then the gain or loss is just what they’ve sold the properties for, over the balance sheet value, the book value of those properties.

Now why would a real estate investment trust choose to do this? Well, remember they have to pay out a huge amount in dividends, over 90% of their taxable income most of the time, sometimes over 100%, depending on the REIT in question, so they need a lot of funds for that. They’re also very acquisitive. They’re going in and buying new properties all the time.

[02:00]

So, they need a lot of funds on an on-going basis. And in addition to equity and debt, another source of financing to get those funds, to actually buy properties to issue dividends and so on, can be from selling their existing properties. Sometimes these properties are under-performing and that’s why they’re selling them. Other times they are doing well, and they’ve been doing so well that they think they could get a premium value for them, so that’s why they go to sell them.

So the reasons vary, but essentially, they are just a source of funding in real estate investment trusts in contrast to normal companies are constantly acquiring and disposing of properties. And so, they almost always have a fairly sizable amount here for discontinued operations, and the income that’s coming from that.
So to actually project this, we need to look at a couple of things. And we’ll go back here to the segments page, go to the bottom, and I’ll show you exactly how to do this. So first off, when figuring out how to project the income from discontinued operations, and the dispositions of communities here at a basic level, at the highest level, we need to figure out how much they’re actually selling each year.

[03:00]

So what are their asset sale net proceeds each year, and then what type of gain or loss are they seeing on those assets? Put those two numbers in place, we can get to this discontinued operations line item right here, at least the gain or loss on the sale of communities. Now for the income from discontinued operations, we need slightly different information.

For that second piece, we need to know what the rental income is, the operating expenses, the interest expense, the depreciation. All the normal items that you see for REITs that go into the net income for a REIT. We need them for the operations that they’ve discontinued, as well. So when we have those, when we put both of those together that will allow us to actually get to our total, for the discontinued operations here on the income statement.

And then later on, when we get to our balance sheet and cash flow statement, we can fill in further information based on the numbers here. So those are the two major pieces we need, the income from these discontinued operations, and then how much they’re actually selling each year. So there are a couple of ways to do this. For the asset sale net proceeds, to get these numbers we could look at the cash flow statement.

[04:00]

So let’s go down to the cash flow statement on our operating model right now. So under investing activities, there’s usually a line item here, proceeds from sale of real estate assets. So we see these numbers $530 – $189 – $194. Those are close to, but not exactly what we have here. So the cash flow statement is not always going to be the most accurate source here, because they may have adjusted the numbers in other ways.

The way that I prefer to get this is to actually search in the company’s filings, and find out what they’re giving for their dispositions and discontinued operations. So if you go to the PDF that I’ve created called Real Estate Disposition Activities or just Dispositions, under note seven here; this is also on p. F-24 of the 10-K; if you want to look at it yourself. They give a summary of their real estate disposition activities, and over here, they have the net proceeds from selling all these properties. So we are going to exclude debt and anything else like that. We are strictly looking at the net proceeds.

[05:00]

The difference between gross sale price and net proceeds here is that the gross sale price may include debt, of course. It may include fees and other types of expenses, associated with the sale. We just care about the net proceeds though, because the net proceeds are what determine the difference between these values, and what was on the balance sheet, so the gain or loss. And then also the rental income, and the net operating income, from these disposed properties.

So that is where I’m getting these numbers from. Again, we could take the cash flow statement numbers, it doesn’t make a huge difference here, but I prefer to get it from the specialized section in the 10-K, instead. And then for the rental income and the net income numbers here, you see it right at the bottom here rental income.
OPEX, interest expense, depreciation, so that is where I am pulling all these from. So nothing terribly complicated, we are just getting these directly from what they’ve told us in the filings. And again, if you try to match these up, the income from discontinued operations, this will actually match what is on Avalon Bay’s income statement.

[06:00]

So let’s go up here, and you can see right here, we can actually go in, and if we wanted to we could actually, just go back and link these to our dispositions of communities right here. So these actually match up perfectly, so those are our sources for this information. Now to actually project this going forward, we need to figure out what they’re going to sell each year. How do we do this?

Well, one method is to look in the 10-K, and remember they have this Financial Highlights and Outlook section here. And they’re actually giving projections for their EPS, their net operating income growth, at least for established communities their rental growth and so on. The problem is that although they give a few numbers here for development, redevelopment, acquisitions and so on, all they say here is that they’re going to be active, in both acquisition and disposition activity.

So during 2011, we expect to be active in both acquisition and disposition activity, but they’re not giving us specific numbers. So it’s not as if we can just go to the 10-K here, and pull exactly the numbers we need. Another approach would be to go to equity research, so let’s look at this Citigroup report from March 2011, here.

[07:00]

And once again, they give us some numbers for dispositions. They’re saying ($270) then $80 and $80. No idea why they have a negative there, that may actually be a typo for the dispositions. And they’re giving a CAP rate, or yield as they call it here, of 5.1% – 5.3% – 5.3%. So Citi has their own estimates, and the company itself doesn’t have any of their own estimates, so we are kind of at a loss here, in terms of the numbers to use.

One approach would be to average these, so to take the three year average. That comes out to about $291. That is probably a little bit high, because you can see that the amount here dropped sharply in 2009 and 2010. So what I’m going to do instead is just use our own numbers. I’m going to say that our disposition activity; and I’ll set up a frame here, so that you can see this better; I’m going to say that our disposition activity is $150 in 2011.

So you can see the overall trend here, going a little bit lower still, and then we’re just going to straight line that one going forward. We don’t want to make income from discontinued operations, or gains or losses on discontinued operations a huge part of our model here, because that’s not really one of the key growth drivers for a REIT most of the time.

[08:00]

It’s really about how much they’re acquiring, how much they’re developing, how much they’re raising rent. If we place too much emphasis on discontinued operations, then it’s a little misleading, and it’s hard to actually keep growing on a recurring basis each year, if a lot of our income here, is actually coming from discontinued operations.

So we have our asset sale net proceeds. Now the next thing we need to look at is what kind of gain or loss we’re going to have on these. Remember that usually, when we sell real estate it has appreciated over time, so normally we see a gain. What this means is that, when we sell these assets for $503 million and we have a gain of $285 million, well the balance sheet value of these, is really the $503 minus the $285.

So the balance sheet value is really the $218, and so that is what we need to get to with the next part of our model, here. So as I just said, the book value would be our asset sale net proceeds minus the gain. Or if we have a loss, we’d be adding in the loss, so accounting-wise the way that works if we had a loss here, of say $100-million and we sold it for $500-million, then on our balance sheet it would show up, as being recorded at $600-million because we’ve taken that $100 million dollar loss.

[09:00]

So this is our book value of these dispositions, and then we also need to look at the gain or loss as a percent of the net proceeds here. We could also look at it as a percent of the book value of dispositions. It doesn’t make a huge difference. So, we’re going to take the gain or loss and then divide by the asset sale net proceeds. And here we can see that it is actually fairly sizable in the 35% to 55% or 60% range.

To look at both of these going forward, for the gain or loss as a percent of net proceeds, we’re going to take the three year average, so around 45%. We can take this percentage going all the way across, so it’s 45% each year. And then for the actual gain or loss, so for this one, we’re going to take our asset sale net, and then multiply it by the percentage here, so we have a gain or loss of around $67. That’s really a gain of $67 each year here.

[10:00]

Now you could potentially have a loss as well, but it’s far more common to see a gain on the sale of assets with real estate. So that is why we have all positive numbers, these all represent gains. These mean that on our balance sheet, the actual value of the assets that we’ve sold is well below this $150 number. Specifically, let’s copy this formula across for the book value; specifically it’s around $83 each year.

So that is how we get to the gain or loss. And going back to our discontinued operations in the income statement, this line item now, the second one here, we could now potentially go back and fill in. I’m going to save that for an upcoming lesson, when we link together the statements, but we could go in and fill that in now. The next part of this is to fill in the income from discontinued operations.

To do that, we’re going to have to look at the CAP rate, and some of the other key metrics for these discontinued operations. As with anything in real estate, any segment-by-segment build-up like this, we’re going to look at the CAP rate, the NOI margin, to get our net operating income, and then to get our rental income, based on the margin. And then the other expenses will either be zero, or for depreciation we’re going to make that just a simple percentage, of the book value here.

[11:00]

I have net book value, but I can actually just change that to book value instead, to reduce any confusion. So for the CAP rate, for this one initially on a historical basis, we’re going to take the net operating income. So we have to actually calculate the net operating income first, and then divide that by the book value of the dispositions.

So for the NOI we’re going to estimate this, and say that it’s the rental income minus operating expenses. Now some of these may actually be corporate overhead, so we don’t know for a fact that these are all property level expenses. If you go back and look at the Dispositions PDF that I created, they’re not telling us here explicitly, that these are only property level expenses.

So it is a bit of a simplification. This might be off by a little bit, but it is the best that we can do with the numbers that we have, for now. So let’s take this, copy it across. So that is our NOI, and now we can take the NOI, divide by the book value to get our estimated CAP rate.

[12:00]

Okay, so this is jumping around a lot, going from over 20%, which is a really, really high CAP rate, you hardly ever see that in real life, down to around 2.0% in 2010, which is an extremely low CAP rate. So this is very random, and we can’t really say anything definitive here.

Given how much the CAP rate is jumping around here, these numbers don’t seem particularly reliable. So in this case we are actually not going to use this CAP rate going forward. We’re going to take a slightly different approach here, and link this instead to some of Avalon Bay’s other real estate segments.

For the actual NOI margin, this one we can just take our NOI, and divide by the rental income. Get that, and this one is a little bit more consistent in the 50% to 70% range. Generally, what you see for real estate, so this looks reasonable.

So now for the CAP rate, basically, how much of this book value they’re earning in net operating income. So how can we estimate this, given how much it’s jumping around? Well, the easiest thing to do here is to link it to one of Avalon Bay’s other segments.

[13:00]

So what I’m going to say is assume that these dispositions of these communities the assets that we’re disposing of, we’re going to assume here, are all coming out of their other stabilized communities right here. So we are assuming that these are directly linked to the other stabilized communities segment, and that the gross real estate assets here after we finish, will be going down by whatever we’ve disposed of.

And that takes care of a few things for us. That handles that fact that, over time we’re going to be earning less income from the categories that we have up here, because we are disposing of assets. Remember that on the income statement, you already take into account the fact that you’ve lost the rental income from discontinued operations, in the revenue and expenses line items.

And then you just list discontinued operations separately at the bottom, so you don’t even take those into account at the top line. So by taking our assets out of other stabilized, and by using the CAP rate for this one, that handles these cases. And it ensures that our assets and revenue and NOI and everything else, are linked to the assumptions that we have for this specific segment.

[14:00]

One question you may have, “Wait a minute, how do we know that they’re going to be coming out of other stabilized communities? Couldn’t they be coming out of established communities or what about development or redevelopment or acquisitions?”

The answer is that yes, they could be coming out of these other communities, as well. Or these other segments of Avalon Bay’s operations, but for development and redevelopment, it’s a little bit questionable. Because these are communities that are under construction to begin with, so they wouldn’t necessarily dispose of them.
Acquisitions, you could assume that they come out of here, but again, this is mostly for new properties that they’re acquiring, so usually they’re not going to acquire something and then go around, and sell it quickly. Established communities, these are really the base of Avalon’s Bay operations.

And these are going to stick around for a while, so these are really more stable overall than the other stabilized category down here. These ones may be shifting around a little bit. These ones may have been recently reclassified. So just as sort of a simplifying assumption here, we are going to assume that everything comes out of the stabilized category.

[15:00]

Now to do that, we’re going to link the CAP rate and the NOI margin up to what we have for the stabilized communities, the other stabilized communities right here, so I’ll link directly to that. And the NOI margin, we’re going to do the same thing, so we have the 64.3%. Now if you’re wondering how this stacks up to the three year averages here, well if we take the average for the CAP rate. Let’s take a look at these, that’s 14.9%, that’s a really high cap rate, so that is probably not the best measure here.
The NOI margin will be a little bit closer, let’s just take a look at this number quickly. So the average there is about 62%, so that one is actually fairly close. Let’s take these and copy these across. Do the same for the NOI margin, so we have that in place.

So now to get the actual net operating income that’s coming from these dispositions. We’re going to take our book value of dispositions, and then multiply it by the CAP rate, so that comes out to around $5 million. I will just fix the formatting here quickly, so that’s about $5 million of net operating income each year.

[16:00]

Then for the NOI margin, and the rest of these numbers; so for the rental income all we do is take our NOI, and divide by the margin; that gets us to our total revenue of $8 million each year. For the operating and other expenses, remember we’re assuming here that net operating income is just the rental income, minus these expenses, so we can just take our NOI minus rental income and get these expenses right here.

For the interest expense, this one is very small and actually goes to zero, in the last historical year. So, I’m going to set this to zero, and carry that all the way across. Then for depreciation, this final one, we don’t really have a good sense of how to project this, but we could make it a percentage of the book value of dispositions. On the assumption that when they dispose of these assets, they will have a certain amount of accumulated depreciation built up.

And in relation to that accumulated depreciation, they’ll also have a certain amount that they’re depreciating that year, so basically we’re just assuming that the size of the assets that they’re disposing of the amount of the assets they’re disposing of is linked to the depreciation number here.

[17:00]

To do this let’s take our depreciation, divide by the book value of the dispositions; and this one is actually jumping around a little bit. What we’re going to do is, once again, is just take a three year average of this. In this case we cannot link it to the other stabilized communities above, because those we were not looking at any depreciation or anything like that.

So we don’t have anything to link to there. So all we can do here is really look at the three year historical average, which comes out to about 5.4%, and so we will copy this across. Then for the depreciation, we can use a negative sign, take our book value, and then multiply it by the depreciation percentage rate here. Copy that across, and then we’ll add up everything here.

So we get to a very, very low number for income from discontinued operations. Let’s take a look at this. It’s about half a million dollars each year. Very, very low compared to the total revenue of Avalon Bay, which is around $1.0 billion dollars a year. So almost insignificant, you might wonder why we even go through the trouble of doing this, given how low this is.

[18:00]

The answer is that we like to do it, just to make sure we have all our bases covered. We like to do it to make sure that we have actually addressed this properly within our model. And if it turned out to be a much different number, we would want to incorporate that, as well. So, with financial modeling, you don’t always ignore something, just because it has a minimal effect on the model.

In this case, it’s good to look at this anyway, because who knows, this might have been a much higher number. So it’s good to look at this anyway, even though in this case, it’s not having a tremendous impact on our model. So with all these in place, we could go back to the income statement now and link them in.
But what I’m going to do instead is one final step here. And that is to go all the way back up to our other stabilized communities, and here we want to reduce the gross real estate assets, by the book value of whatever we’ve disposed of. And essentially, we’re assuming that these dispositions come straight out of the other stabilized real estate assets.

[19:00]

Now if we have done this properly, then the net operating income should fall by around 5.0% here each year, because we have used the same CAP rate and the same NOI margin. So the revenue should fall by around 8.0% each year, and then the NOI should fall by around 5.0%.

So once we have done this we’ll take a look at this, and make sure that’s what actually happens here. So in the first year it looks like that’s what happened here. I’m just going to undo this, so you can see it again. So the revenue used to be $157. The NOI used to be $101. Then afterwards it falls by 8.0% to $149, and the NOI falls by 5.0% to $96.

And then at the very end here, I just redid the changes there quickly, so we can see this, and make sure that it’s being subtracted. At the end here, the total revenue has actually fallen by quite a bit more than the 8.0%, that I just mentioned. That’s because we have to take into account the cumulative effect of all these dispositions.

Remember that in the overview video, in this course, that is something that we sort of skipped over. The cumulative effect of disposing of assets, acquiring assets and so on, but now you can see exactly what happens here. That since our assets keep going down by the amount that we’re disposing of each year, our revenue and NOI actually fall by more than anticipated in this case.

[20:00]

Now of course on the income statement, overall from doing this, we will probably still show a gain to our net income, because we have the gain to take into account here, the gain on the sale of those assets. But you can see how disposing of assets over time, over five years, ten years and so on, it actually builds up to a cumulative number that is fairly substantial, especially given how the revenue and NOI numbers here look for other stabilized communities in the first place.

And then going back up to our segment-by-segment build-up here, you can see this same exact effect here, that overall our other stabilized communities; the revenue is going down by an increasingly higher number each year here; as a result of these dispositions.

So that is it for how we project our dispositions and discontinued operations for Avalon Bay. Coming up next, in the final lesson in our section here on how to do a segment-by-segment build-up for the company, we are going to tie everything together. So we’re going to look at all of our asset changes here, all of our revenue and net operating income.

[21:00]

We’ll look at how the assets actually change going forward, and then here we will actually put together all of our revenue. We will make projections for everything else, figure out our OPEX, property taxes and so on, and then look at some of these key metrics like the rental income growth, the NOI margin, the NOI growth rate, and then the portfolio-wide CAP rate, for all of Avalon Bay’s real estate assets.

Note to Lesson Above:

Remember that we’re including both the gain or loss on sale of communities and land in these numbers.

That is why they do not match what’s on the income statement under discontinued operations. They match the cash flow statement numbers since the CFS includes gains and losses on everything (both land and communities).

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