Investment Analysis Struggling With Net Asset Value With REITs trading at a significant discount to their net asset values, investors are wondering what will close the gap. by Barry Vinocur Photo Illustration by Mark Kseniak

Calculating NAV   Properties AMB Property (AMB) Boston Property (AMB) Financial information based on… 2Q99 2Q99 Cap Rate Assumptions: GAAP NOI Cap Rate (1) 9.06% 8.18% Cash NOI Cap Rate (2) 8.76% 8.00% Economic Cap Rate (3) 8.27% 7.52% Start with…. GAAP NOI from owned properties $337,172 $535,502 Straightline rent adjustment ($11,340) ($12,000) Cash NOI from owned properties $325,832 $523,502 Recurring capital expenditures ($18,300) ($31,275) Adjusted NOI from owned properties $307,532 $492,227 Divide cash NOI by... Assumed cash NOI cap rate 8.76% 8.00% Produces... Market value of owned properties $3,719,545 $6,543,772 Then add benefit of management income by dividing... Management income $2,000 $10,000 Economic cap rate applied to management income 20.00% 20.00% To derive... Implied benefit of management income $10,000 $50,000 Then add... Cash, cash equivalents, and securities $40,130 $33,225 Other assets $69,226 $52,224 Pro rate share of joint venture properties $0 $0 Notes receivable $0 $0 Residential development corp $0 $0 Recent Acquisitions $0 $0 Land held for future development $43,800 $130,428 Value of unleased space (4) $0 $0 PV of net interest expense on exchangeable debentures (5) $0 $0 Investment In Executive Suites Business $0 $0 Development Projects (at 110% of cost) (6) $145,158 $141,446 We are left with... Gross market value of assets $4,027,859 $6,951,094 Proceeds of dilution $0 $0 Then subtract... Total liabilities $1,509,054 $3,118,511 Preferred Stock $354,767 $0 Produces... Net market value of assets $2,164,038 $3,832,583 Divide by... Total shares/o.p. units (000) 91,098 105,520 Our result is... Net Asset Value Per Share $23.76 $36.32 Valuation Measures: Current Stock Price $21.19 $33.31 Price/Net Asset Value 89% 92% Total Enterprise Value/Gross Mkt Value of Assets (7) 94% 95% Source: Merrill Lynch & Co. (1) GAAP NOI cap rate is defined as net operating income divided by the total purchase price. (2) Cash NOI cap rate is defined as cash NOI (NOI minus straightline rent adjustment) divided by total purchase price. (3) Economic NOI cap rate is defined as adjusted NOI (Cash NOI minus recurring cap ex) divided by total purchase price. (4) Value of vacant office space (assumes office portfolio reaches 95% occupancy * 50% of implied value per fully leased sq. foot. (5) PV of $12.8MM net interest expense discounted at 10% for period of 25 years. (6) Development projects are valued at 110% of cost. (7) We define total enterprise value as the sum of the market value of equity plus total liabilities.

Green Street may be on the fence on this issue, but others increasingly are not. Though there's no evidence that real estate prices are plummeting, industry veterans are suggesting that property fundamentals have peaked - though not everywhere - and that the next major move in real estate pricing will be down rather than up.

Regardless of which way prices go, investors generally agree that calculating NAV is important. How important depends on whom you ask. Jon Fosheim and Mike Kirby, Green Street co-founders and principals, have steadfastly maintained for more than a decade that REIT prices should be more closely tied to NAV than is typical of the non-REIT operating company. "A discounted cash flow model is clearly the better way to value the shares of, say, a car maker, software firm, or retailer, but a value-based model may well be superior for a REIT."

Eric Hemel, who heads the REIT research effort at Merrill Lynch & Co., and his colleagues include NAV estimates for their coverage universe in the weekly report they send to the firm's clients. Once a quarter, Hemel and his colleagues publish a handbook on REIT NAVs, including the NAVs of more than five dozen REITs and non-REIT real estate operating companies and the methodology underlying their calculations.

In a recent report, the Merrill analysts explained that when it comes to evaluating public companies, investors generally focus on price-to-book ratios as one key valuation measure. "Unfortunately, price-to-book ratios are inappropriate for REITs insofar as a company's book value, which is based on historic cost figures, may not accurately reflect the earnings capacity of otherwise well-maintained assets. Also, the balance sheet consolidations accompanying initial public offerings were often pursued using different accounting conventions, resulting in an apples-to-oranges comparison between companies."

As a result, Hemel and his colleagues use NAV as a surrogate for book value. They note that this substitution is appropriate "insofar as book value is meant to represent the liquidation value of an entity."

Though NAV is useful when analyzing REITs and non-REIT real estate operating companies, Hemel and his fellow analysts underscore that while the sector is awash in discounts, a company's NAV per share is "only a rough estimate, not a number carved in stone." Further, they point out that given the impact of small-cap rate changes on value and the fact that cap rates do change over time, the accuracy of NAV estimates should not be taken too seriously. They also note that NAV provides investors with a starting point in their overall analysis. "What is most important is to be able to compare NAVs within a sector, and across sectors, using a consistent methodology."

Despite the vastly different operating characteristics of each real estate sector, Hemel and his colleagues, like other analysts, have devised a consistent framework for determining NAVs. "The biggest challenge investors and analysts face when undertaking this exercise is determining the appropriate cap rate to use for each company's theoretical liquidation value."

Establishing a Framework
Hemel and his fellow analysts use a six-step approach in calculating an NAV (see page 32):

Step 1 - Determine a company's forward 12-month cash net operating income (i.e., preleveraged cash flow minus straightline rents). The reason for choosing this period rather than the prior 12 months or the latest quarter annualized is that purchasers of real estate generally focus on the earnings potential of a property, not its past performance, and cap rates are generally defined as a consequence of the next 12 months' income.

Step 2 - Apply an appropriate cap rate to the company's cash NOI figure.

Step 3 - Determine the value of third-party income. After determining the actual cash flow derived from a company's ancillary businesses, apply a cap rate to the income stream. Since management contracts are typically cancelable on short notice - often 30 to 60 days' notice - the Merrill analysts ascribe a substantially lower valuation to fee income than to rental income. With few exceptions, they use a 20 percent cap rate - equal to a multiple of five times cash flow - for fee income vs. property level cap rates that range from 7.5 percent to 12 percent depending on the asset class.

Step 4 - Determine the gross market value of assets. After adding the results from steps 2 and 3 together, the Merrill analysts add cash and cash equivalents, other assets, land held for development, and existing development projects (which are generally valued at 110 percent of cost) to derive the gross market value of assets.

Step 5 - Determine the net market value of assets. Subtract total liabilities from the gross market value of assets to arrive at a net market value of assets.

Step 6 - Determine NAV per share. Divide the net market value of assets by the total number of shares outstanding to derive the net asset value per share.

Other Tools
Though they give NAV its due, the Merrill analysts note that "an equally important valuation measure involves calculating a company's implied economic cap rate based on its respective share price. This approach is essentially the inverse of the net asset value analysis. In other words, what economic cap rate would an investor have to value a company's properties at for that company's NAV to be $19.50 per share?"

When calculating an implied cap rate, the Merrill analysts begin by multiplying the number of shares outstanding by the current stock price to find the market value of common equity. Next, they add total liabilities and subtract other assets - such as cash, cash equivalents, development projects, and land held for future development - to arrive at the implied market value of the company's properties.

Then, they divide the current adjusted NOI figure - defined as NOI minus recurring capital expenditures minus a straightline rent adjustment - by the implied market value of properties to arrive at their implied cap rate.

A third and final valuation measure, Hemel and his fellow Merrill analysts note, is to compute an adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple, which is defined as the implied market value of properties divided by adjusted EBITDA. To derive adjusted EBITDA, they subtract a corporation's general and administrative expenses (G&A) from the adjusted NOI figure they use in both the NAV calculation as well as the implied capitalization rate calculation. By computing an adjusted EBITDA multiple, they are able to "look through" different accounting policies at the various REITs with respect to the allocation of overhead expenses.