AI 2.3 Flashcards
Describe benefits & disadvantages of investing in REITs
Liquidity, transparency, diversification, high-quality folios (properties), active professional mgmt, high & stable income, tax efficiency.
Disadvantages are REITs will mostly lack retained earnings and another major one is that they are constrained in the types of asset classes they own.
What are the valuation methods for pubically traded real estate securities?
Just like equity valuation, there are three methods to value Real estate equity:
1. Asset based approach
2. Price-multiple (Relative value) approach
3. DCF method
Explain Net Asset Value approach
Just like equity, it’s based on BVPS (book-value per share) or majorly NAVPS (net-asset value)
NAVPS is the largest component of the intrinsic value & share can trade at a premium or a discount (given the assumption that the NAVPS is the intrinsic value and the price of the share will eventually catch up with the calculated intrinsic value)
Differences of accounting methods used for investment properties under IFRS & GAAP?
Already covered in FSA, REITs under IFRS can use either the cost method for valuing investment properties or the fair value method (but has to be consistent with what it opts for all the investment properties). If fair value method is used, then better for us or else we’ve to compute fair value like for a company reporting based on GAAP (which makes no specifications of which method to use for accounting)
What are the steps in calculating the NAVPS?
- The biggest chunk and the first step is to calcute the ‘estimated value of operating real estate’. (NOA)
We come to estimated value of operating real estate by starting with last 12 month’s real estate NOI. - The first step is obvious to start with last 12 month’s real estate NOI and subtract is the non-cash rent.
Non-cash rent is the difference generated in the NOI by using a straight line method to calculate growth of rent in NOI (instead of a curve). - In forecasting NOI for the next year, 2 adjustments are made to the current-period NOI:
1st -> The impact of acquisitions (if any) for the current year, which are not fully reflected in the current period’s NOI are added.
Gives Pro forma cash NOI for the last 12 months
2nd -> Application of a growth rate.
Gives Estimated next 12 months NOI - Estimated first-year NOI is capitalized using a market cap rate. So, we divide the Estimated next 12 month NOI with the market cap rate (a comparable rate determined from relatable transactions in the market)
- Gives us the Estimated Value of Operating Real Estate! NOI/Market Cap Rate = Net Operating Assets. (NOA)
- Next, we add the value of other tangible assets and subtract the value of REIT’s liabilities to find total NAV (Net Asset Value). Generally, deferred financing expenses, deferred tax assets, and goodwill are excluded from total assets so as to only include “hard economic assets.” (Cash & Equivalents, Land held for future development, A/Cs receivable, Prepaid/Other assets)
Gives us Gross Asset Value!
Now subtract the value of REIT’s liabilities (Total debt, other liabilities)
Also, only hard liabilities are considered when calculating NAV like (Loans, long-term loans, Accounts Payable) and deducted from the Net Operating assets. Soft liabilities like deferred tax liabilities aren’t considered.
Now we have the NAV - Next divide by the no. of shares outstanding to get the NAVPS!
NOI (based on the last 12 months) -> starting point
Less: non-cash rents*
Add: adjustment of full impact of recent acquisitions on NOI
Gives Pro Forma cash NOI for the last 12 months.
Add: Growth rate of next 12 months in NOI
Gives estimated next 12 months NOI
Divide by the market cap rate to get Net Operating Assets
Add: Hard economic assets
Less: Hard economic liabilities
Gives us NAV
Divide: No. of shares outstanding
Gives NAVPS
What are the applications of NAVPS?
NAV is used by different kinds of investors. Reflects the value of RIET assets to a private market buyer.
Public equity investor might have different perspective. Is based on a static pool of assets.
Estimates are problematic if transaction data is limited.
Explain the price-multiple approach.
It is based on comparing a multiple for a REIT to some other multiple to get an estimate of the value.
Here, we use P/FFO or P/AFFO.
How are FFO & AFFO calculated?
FFO is the accounting net earnings excluding:
1. Depreciation charges on real estate (as real estate assets are barely affected by depre & tend to hold on to their values in the long run)
2. Deferred tax charges (Deferred portion of tax expenses)
3. Gains/losses from sale of property & debt restructuring (as they’re one time charges)
Remember DDG
AFFO is a refinement to FFO,
FFO - Straight line adjustment - recurring maintenance type capital expenditures and leasing commissions.
Thus, AFFO is the best measure of economic returns to the shareholders.
What are the advantages & disadvantages of Relative value approach?
Advantages:
1. Widely accepted in the investment industry
2. PMs can use RIET valuations into context with other investment alternatives
3. FFO estimates are readily available (published by RIETs)
4. Can be used in conjunction with growth rates & leverage levels for relative value analysis.
Disadvantages:
1. Doesn’t capture intrinsic value of real estate assets (only captures assets that are giving a cash flow to the RIET)
2. P/FFO doesn’t adjust for recurring capital expenditures
3. One time gains/losses create an issue with this model.
Important point to remember:
AFFO is not published in a REIT report or a research report on a REIT by an analyst as it’s subjective and only the FFO and Revenues are provided.
NAV and FFO are connected by the NOI. FFO is almost equivalent to the NOI to make assumptions about impact in P/FFO price multiple from a change in the NAV.
Private Investment advantages & drawbacks
Advantages:
1. Direct exposure to the real estate class.
2. Returns dictated by property performance.
3. Tax benefits (accelerated depreciation, timing option for capital gains).
4. Inflation hedge.
5. Illiquidity premium.
6. Control and ability to pursue diverse strategies.
7. Lower correlation with other asset classes (superior diversification).
Drawbacks:
1. Illiquidity.
2. High fees and expenses.
3. High minimum investment.
4. Low transparency.
5. Fewer regulatory protections for investors.
6. Appraisals lag actual market values.
7. Higher returns derived from the use of leverage, but increases risk.
Public Investment advantages & drawbacks
Advantages:
1. Tracks real estate asset class fundamentals over the long term.
2. High liquidity.
3. Professional management.
4. Inflation hedge.
5. Tax efficiency (for REITs).
6. Access to a (diversified) pool of assets.
7. Access to special sectors (e.g., data centers).
8. Low minimum investment.
9. Low entry/exit costs.
10. Regulatory protection for investors.
11. High transparency.
12. Limited liability.
Drawbacks:
1. Higher volatility.
2. Higher correlation with stocks (compared to the correlation of stocks with private real estate).
3. Dividends are taxed at high current income tax rates.
4. Poor governance/agency conflict.
5. Equity markets penalize high leverage.
6. Market prices differ from NAV.
7. REIT structure limits possible activities.
8. Compliance costs may be prohibitive for smaller companies.
