Real estate investment trusts or REITs are companies that own, manage, and finance income-producing properties. By law, these businesses must distribute at least 90% of its profits to shareholders as dividends. Valuing REITs is a difficult proposition because of the structure of the business and the fact that shareholders receive the majority of the free cash in the form of dividends.
Coming to the rescue is the net asset value model, which is a model we can use to determine the value of the REIT based on its financials and additional inputs.
Tools such as price to earnings and price to book are not useful when valuing REITs because of the structure of the business, mainly because all of the assets are in real estate. Therefore depreciation of those assets is a real cost. All of which makes earnings for a REIT not representative of the value of the company.
In today’s post, we will learn:
- What is a Net Asset Value Model
- Steps to Calculate the Net Asset Value Model
- Practical Examples of NAV with Real Companies
Ok, let’s dive in and learn more about using the net asset value model to find the intrinsic value of REITs.
What is the Net Asset Value Model?
One of the most important questions to consider when considering REITs is whether the businesses are fairly priced. REITs present special considerations we must consider when attempting to value them.
Because REITs throw off rental income due to their investments in different properties, they are similar to bonds, which are easier to value because of the fixed income of the dividends or coupons.
The difficulty with REITs is the changing values of the real estate the company owns and valuing that property and the potential growth of the revenues, or rental income.
The net asset value model or NAV estimates the current market value of the REITs properties, net of other non-real estate assets, and liabilities.
We must consider the use of NAV over the book value of the assets because the book value doesn’t account for the changes in the value of the underlying land and properties built on that land. Nor does it take into account the future earnings potential of the properties or the REIT assets.
We use the NAV as an attempt to bypass book value in favor of providing a more accurate value of the market value of the holdings of the REIT.
The usual metrics, such as the P/E and P/B, are GAAP numbers, but when working with REITs, we must stray away from those numbers and use non-GAAP figures to assess the value of the REIT.
The most common figures we use are the funds from operations (FFO), or the adjusted funds from operations (AFFO), of which you can find more information here:
To calculate the net asset value of the REIT, we must use the following model:
Net Asset Value = Net Operating Income x Cap Rate / Mortgage Liabilities
To calculate the NAV, we must capitalize the operating income based on market rates. A cap rate for the present market values of investments is defined and then used to divide a property’s operating income, which results in the property’s estimated market value. Once we have that value, we subtract out any mortgage liabilities to arrive at the net asset value of the property.
Steps to Calculate the Net Asset Value Model
There are several calculations involved in estimating a REITs NAV, but the basic concept is simple: estimate the current market of the REIT’s portfolio, then add any other intangible assets, subtract all the mortgage-related liabilities, and then divide the NAV by the shares outstanding.
There are four major steps to calculating the NAV of a REIT; below, we will walk through each step and outline where we can find each data point.
Step 1: Finding the “Cash” NOI
The first step to calculating the NAV of any REIT is determining the NOI or net operating income for the REIT. In this step, we are going to find the NOI, which we find by looking at the income statement for several items:
- Rental income
- General and administrative
We ignore the other incomes and expenses because those line items don’t directly relate to the assets of the company, in that income from interest is not a direct income from the purchase of the real estate, for example.
When working with REITs that deal with shorter leases such as apartments, retail, and office spaces, we can use the numbers directly from the income statement.
However, when working with REITs that operate in longer-leases such as medical, then GAAP accounting gets in the way. Longer-term leases tend to have clauses that allow for graduated rental increases, which are either fixed or tied to inflation. These rent increases can happen annually or every few years, depending on the lease agreements.
GAAP accounting requires that rental revenue reported on the income statement be the average annual rent over the entire lease term, which means that rental revenue could be overstated in the early years and understated in the later years of the lease.
For us to adjust to that GAAP accounting rule, we must adjust the rents on a straight-line basis, and all REITs must disclose that information.
In the case of Omega Healthcare Investors, I use the “Ctrl-F” function to search for “straight-line rental revenues,” and we can see that the company breaks out the straight-line rent over the next eight years.
If you run across a REIT that doesn’t provide you with the numbers relating to straight-line rents or any adjustments to the numbers, don’t get excited, you can use the NOI from the rental revenues and costs associated with those rents and roll with those numbers.
Therefore, our net operating income equals:
- Rental income $808,076
- General and administrative $57,869
- Straight-line rent $1,802
NOI = $808,076 – $57,869 – $1,802
NOI = $748,405
Step 2: Adjust the cash NOI for adjustments or placements coming online during the quarter.
Next, we need to adjust our NOI by any acquisitions made during the year, construction in progress, or any purchases that might have come online during the year. We make these adjustments because they are direct costs to the cash of the company as it relates to the real estate portfolio.
In the case of Omega Health, they are substantial cash outflows, that is not always the case, as we will see in the next section as we examine other REITs.
In the case of OHI, I will use the numbers from the cash flow statement to locate our data.
Taking the numbers from above, we add them up and then subtract them from our NOI.
- Investments in construction in progress – $59,616
The total for those numbers equals $139,678, and next, if add that total from our NOI, we arrive at:
NOI = $748,405 + $59,616
NOI = $808,021
Step 3: Divide the Cash NOI by the Cap Rate for the REIT
In this step, we are looking for the fair value of the assets of the REIT that a buyer would pay for those assets, taking into consideration any debt or preferred shares.
In the actual transaction, the buyer would analyze each property and determine the present value of the expected cash flows, or rents from that portfolio over a five to ten year period.
A short-hand way of doing this is to assume the rate with a capitalization rate.
The cap rate or capitalization rate is the measure of the expected unlevered return on the REIT assets. Think of it this way, the cap rate is the P/E ratio upside down, in that the price is the fair market value of the assets, and the earnings are the cash NOI of the REIT.
Cap rates are difficult to calculate, and there are several methods to determine the cap rate of a REIT; some REITs are generous and provide the rate for us by using our favorite CTRL-F function and searching for “capitalization rates.” The other method is to use the Google machine and search for the cap rates on sites such as REIT.com, or search for the REIT sector you are valuing.
In our case for OHI, I Googled the healthcare sector for REITs and found the cap rate of 6.3%
Now to find the market value of the NOI, we divide the NOI by the cap rate.
Fair market value = NOI / Cap rate
Fair Market Value = $808,021 / 6.3%
Fair market value = $12,825,730
Step 4: Adjust Fair Market Value for Other Investments and Financing
In the final step, we adjust the fair market value in the above step to include values for assets that are not generating NOI, and then we subtract total debt and preferred stock outstanding.
Using the balance sheet, we find tangible assets such as cash and restricted cash, accounts receivable, and prepaid expenses. We do not include items such as deferred leasing, financing costs, or deferred rents. Also, add any assets held under the sale listed on the balance sheet.
Next, we subtract any debt and preferred stock to arrive at our net asset value or NAV.
- Assets held for sale – $4,922
- Cash and equivalents – $24,117
- Restricted cash – $9,263
- Contractual receivables – $27,122
- Other receivables – $381,091
All of which totals $446,515
All of which totals $5,202,774
And now that we have all of our numbers let’s add and subtract them from the fair value.
NAV = $12,825,730 + $446,515 – $5,202,774
NAV = $8,042,349
Then to arrive at our per-share value, we divide our above NAV by the shares outstanding, and we find our NAV per share.
NAV = $8,042,349 / 222,125
NAV = $36.21
Ok, now that we see how to break that down, why don’t we put this to work with some other real companies to determine the NAV of a few other REITs.
Practical Examples of the NAV Model with Real Companies
As we work through our next example, I will pull all the numbers together, and then we will walk through each example so you can see how we calculate the NAV for each REIT.
For our first example, I would like to analyze Federal Realty Trust (FRT).
Step 1: Rental Revnues – $935,788
Expenses – $298,758
NOI = 935,788 – 298,758 = $637,030
Step 2: Acquisitions made during the year – $205,516
Net gains from sales during the year – $116,393
NOI = $637,030 + $205,516 – $116,393 = $726,153
Step 3: Fair market value based on cap rate
Cash NOI = $726,153
Cap rate = 6.3%
Fair market value = $726,153 / 6.3% = $11,526,238
Step 4: Adjustments to the Fair Value
Accounts receivable – $152,572
Cash and other Tangibles – $127,432
Assets HFS – $1,792
Total Debt – $3,502,300
NAV = $11,526,238 +$152,572 + $127,432 + $1,792 – $3,502,300
NAV = $8,305,671
NAV per share = $8,305,671 / 75,400
NAV per share = $110.15
Ok, let’s do one more, shall we?
I want to analyze Simon Property Group (SPG) next for giggles.
Rental Revenues – $5,170
Rental expenses – $907
NOI = $5,170 – $907 = $4,263
Acquistions made during the year – $51
Gains from sales during the year – $288
Adjusted NOI = $4,263 + $51 – $288 = $4,026
Cash NOI – $4,026
Cap rates – 8%
Fair value = $4,026 / 8% = $50,325
Fair market value – $50,325
Cash – $514
Debt – $23,305
NAV = $50,325 + $514 – $23,305
NAV = $27,354
NAV per share = $27,354 / 308 shares outstanding
NAV per share = $89.40
Now, let’s compare all three of our NAV calculations to their current market values.
NAV Market Price MOS%
OHI $36.21 $29.54 18.4%
FRT $110.15 $71.46 35.1%
SPG $89.40 $62.89 29.6%
Typically, the NAV trades approximately 15% above or below the NAV of REITs based on the current average cap rates available to investors.
But, after COVID-19, the market is currently pricing most of the REITs down, which accounts for many of the REITs having a value below their market values.
And the basing of the pricings is a result of the higher debt loads that many REITs carry and the justified worrying about the ability of many businesses to continue paying the rents.
Most of the sector has seen difficulty with the collection of rents, but it varies by a subset of REITs. For example, the healthcare sector has had no trouble collecting their rents, where the malls and retail sectors are experiencing much more trouble.
All of which highlights the efforts needed to value any company you want to buy.
Many investors make the mistake of investing in REITs without understanding the fundamentals of the businesses, and without understanding what the companies are worth. Remember that the price we pay matters in the long-run.
Valuing a REIT brings with them a few issues, such as what to do with the debt of those investments and how to treat the income of REITs. But once you understand how to speak the language of REITs, then valuing the companies becomes much easier.
Using models such as relative valuations based on comparisons with other REITs is ok, but I would rather use a model such as a dividend discount model or the NAV model we analyzed today. The trouble with relative valuations is the comparison of one company to another, and if the whole sector is over or undervalued. Once you cross that slippery slope, then it is hard to determine the true value of the company.
That is why using multiple models to determine your value is always the best strategy so that you can arrive at a range of values, and then you can use your judgment and business acumen to determine what is more likely.
That is going to wrap up our discussion for today.
As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care, and be safe out there,