By Frederick S. Carr Jr.

We have not been proponents of the relevance of net asset value to REIT analysis, except at certain points of the real estate cycle. In our view, at those points at which NAV becomes relevant, it is actually more NAV’s close cousin-replacement cost-that deserves attention. At other points, the value of a good REIT, our Elite group of companies, for example, as well as a number of near-elite REITs, is driven more by its value-creation process than by the value of its assets in inventory. These holdings are more properly looked at as raw material for that value-creation process, and the value of the business enterprise is more properly viewed as the net present value of future value creation.

Not all companies are members of the Elite group of REITs, or even credible candidates for inclusion in that group of companies, however. NAV may be far more relevant for index REITs. The market would then decide how to strike a balance among the various considerations that would argue that an "index REIT" should be valued at a premium or at a discount to NAV.

Perhaps the persistent discounts of share prices to NAV over the past couple of years convey the market’s conclusion that NAV is irrelevant for REITs that are ongoing businesses, where the realization of NAV has zero net present value. If this is the case, then NAV might be more relevant for the brain dead, whose likely future directions have to include, among other options, an orderly liquidation.

Our general skepticism regarding NAVs also has been increased by what we consider the often very clumsy calculation of NAV by some of the partisans of the approach. All too often, it seems, a schedule of assumptions underlying NAV estimates for a universe of companies will show most cap rates at neat multiples of 25 basis points, or some other simple fraction, while a few others will be at cap rates that reflect no such simple fraction, but rather numbers stated with mock heroic precision down to one one-hundredth or one one-thousandth of one percent.

What is really going on is that some numbers-the neat fractions-have been unilaterally assigned by the analyst, while the more detailed figures have been subjected to a process of negotiation between the analyst and the company, a process in which all sorts of relevant and sometimes not-so-relevant considerations come into play.

Of all the factors that go into such a valuation, cap rate seems to have the greatest leverage; a 25 basis point cap rate decrease in our standard model would boost values from 2.5 percent to 6 percent, or by $0.57 to $1.93 per share. Decisions on cap rates should not be so capriciously made.

Companies know the significance of NAV to the investment community and are just as interested in jawboning NAV estimates as they are in managing funds from operations/adjusted funds from operations expectations. Indeed, if there is any difference in management’s interest in negotiating NAV estimates, as compared to FFO/AFFO estimates, it is that there will be no day of reckoning, no time at which the certain truth comes out of the closet on real asset value. FFO expectations, on the other hand, must be met every 90 days.

With NAV, all interested parties are operating in an area where value is in the eye of the beholder and where valuation is more an art than a science.