Valuing Real Estate Investment Trusts (REITs) involves several core methods commonly used by seasoned investors and analysts: the Discounted Cash Flow (DCF) approach, valuation by multiples, and the Net Asset Value (NAV) method. The NAV method calculates the value of a company’s assets minus its liabilities, providing an estimate of the fair value of the company’s equity. For companies reporting under the International Financial Reporting Standards (IFRS), the equity adjustment method is often the most efficient and practical way to apply NAV valuation. This method requires making adjustments to the book value of equity, aiming to reflect a more accurate, fair market value. In this article, we will delve into this technique, explain the steps involved, and highlight the potential pitfalls. Let’s explore how we can value REITs using the equity adjustment method, an approach that adjusts asset value, deferred taxes, and General & Administrative (G&A) expenses.
Equity Adjustment Method: A Deeper Dive
The equity adjustment method adjusts the book value of equity to better reflect fair market value. By making specific modifications to the equity calculation—focusing on assets, deferred taxes, and G&A expenses—analysts can come up with a valuation.
In this section, we’ll break down how the equity adjustment method works, explaining each key element:
- Yielding Asset Value Adjustments
- Development Assets Value Adjustment
- Debt Value Adjustment
- Deferred Taxes Adjustment
- G&A Expenses Adjustment
1. Yielding Asset Value Adjustment
A major part of equity adjustment is recalculating the value of the REIT’s yielding assets (those that are producing rental income). Under IFRS, assets appear at their fair value in the balance sheet, determined through annual appraisals. However, these appraisals may not always reflect current market conditions accepted by the stock market or may be performed using methods that are less relevant to stock market participants.
To adjust for fair value, we will calculate the appropriate fair value by use the following formula:
Asset Fair Value = Net Operating Income (NOI) / Appropriate Cap Rate
The NOI represents the revenue generated by a property, minus operating expenses. The cap rate, on the other hand, reflects the expected return on the asset, factoring in current market dynamics and the risks associated. By dividing the NOI by the appropriate cap rate, we calculate the asset value which reflects current market conditions.
Consider this example:
Imagine a REIT that owns office buildings that generate $20 million annually in NOI. If the cap rate that reflects the current market environment is 6%, the asset’s fair value can be calculated as follows:
Fair Value = $20 / 0.06 = $333
If the book value of those buildings is $300 million, the equity adjustment involves adding the difference, $33 million, to equity.
2. Development Assets Value Adjustment
Next, we have development assets, which are usually listed at cost in the company’s books. To adjust their value, we must consider the development stage and the expected cash flows involved. The goal is to determine the fair value, which takes into account the risk and potential returns of the project.
For development assets, we use a discount rate to reflect the inherent risk in the project. The calculation involves:
- Discounting Expected Cash Outflows for Construction: Costs that will be spent until the asset reaches a stabilized stage.
- Discounting Cash Flows During Stabilization: Revenues expected during the ramp-up phase.
- Calculating Stabilized Value: Similar to yielding assets, we determine the stabilized value by capitalizing the projected NOI.
To put it simply, we calculate the discounted value of the entire development process—from start to finish—using a discount rate that represents the project’s current risk level.
Consider this example:
Assume our real estate company is building another office building which is expected to yield $3 million in NOI upon stabilization (on the second year, after yielding half of that in the first year) and the cap rate of similar stabilized assets is 6%. The expected remaining construction costs, for the 2 years construction remaining, is $10 million annualy, and the appropriate discount rate for the development of such assets is 10%. We discount these cash flows to estimate the fair value, and arrive to an net present value of $18 million.If the book value of this project is $10 million, the equity adjustment involves adding the difference, $8 million, to equity.
3. Debt Value Adjustment
The value of the debt may be higher or lower than the face value recorded on the balance sheet, as it depends on how the interest rate compares to current market conditions. If the interest rate on the debt is lower than the current market rate, the value of the debt is actually lower than its face value, which in turn increases the value of the equity. To adjust for this, we calculate the debt value adjustment by valuing the outstanding debt through discounting the expected cash flows using a cost of debt that reflects current market conditions.
Consider this example:
Our company has $100 million of debt, with an average interest rate of 4%, and even amortization over the next 5 years. If current market conditions dictate a cost of debt of 6% due to an increase in the interest rate environment, we discount the cash flows using this updated rate. The resulting value is $94.7 million, which is lower than the face value, as expected. We will add the difference, $5.3 million, to the value of equity.
4. G&A Expenses Adjustment
The next critical component is the adjustment of General and Administrative (G&A) expenses. These expenses are crucial to the management of assets and the overall operations of the REIT. Since these costs continue into the future, they must be factored into the equity valuation.
To adjust for G&A expenses, we calculate their present value in perpetuity. After-tax G&A expenses are discounted using a rate similar to that used for asset valuations.
An important nuance is that not all G&A expenses contribute equally. Some G&A costs relate directly to property management, while others may be geared towards growth initiatives and future developments. Typically, we subtract the portion of G&A allocated to future development from the valuation adjustment, as these costs are related to value-adding activities which we’re usually not accounting for in valuation of real estate companies.
Consider this example:
If the annual G&A Expense is $4 million, of which $1.3 million are related to future development, we will discount the after tax ongoing G&A Expense of $2.1 million. We will use the same discount rate as the assets, 6%, to get a value of -$36 million, which we will substruct from the equity.
5. Deferred Taxes Adjustment
Deferred taxes can be misleading if treated at face value. In real estate, deferred taxes represent tax liabilities that will not be realized soon, since usually the company isn’t planning to sell assets immediately. Therefore, the book value of deferred taxes might overestimate the liability.
In equity adjustment, we often reduce the deferred tax value to account for the fact that these taxes will likely not be due for many years. More detailed information about deferred tax liabilities and their valuation is provided in the article “Deferred Tax Liabilities“. By adjusting the value of deferred taxes, we aim to determine a more accurate net worth of the equity.
Consider this example:
We calculate the tax liabilities created by asset adjustment values we made before, and add them to the balance sheet deferred tax liability. Then, we discount the amount to today. Typically, we receive a value between a third to half of the balance sheet item. In this case, the balance sheet value should be decreased by $18 million, which we should add to the equity.
6. Equity Value Calculation
We use all the adjustments we made to calculate the value of equity, as follows:
By adding all the adjustments to the book value of equity, we arrive at the fair value of the equity. In this scenario, the fair value is $197 million, which is 15.9% higher than the book value. This increase is primarily due to the difference between the value assigned to yielding assets and their book value.
Pros and Cons of the Equity Adjustment Method
The equity adjustment method has several advantages, but it is not without its drawbacks. Let’s explore both:
Advantages
- Reflects Fair Market Conditions: The equity adjustment method allows analysts to better align the value of assets with current market conditions, providing a clearer valuation.
- Detailed Consideration of Asset Value: Adjustments for yielding and development assets ensure that valuations capture the true nature of the company’s properties.
- Relatively quick: By choosing to adjust only the value of deferred tax liabilities and G&A expenses, a relatively easy and quick calculation, without making asset value adjustments, we can quickly obtain a basic indication of value.
Drawbacks
- Leverage Risk Is Overlooked: One of the drawbacks of this method is that it does not take into account the risks associated with leverage. Debt plays a critical role in the financial health of REITs, and ignoring it can lead to incomplete conclusions.
- No Direct Cash Flow Visibility: Unlike the DCF approach, the equity adjustment method does not explicitly model cash flows to shareholders, which can make it difficult to understand the distribution potential.
- Sensitivity to Cap Rate Changes: The method’s accuracy heavily depends on the cap rate used. A slight adjustment in the cap rate can lead to significant changes in the valuation, making it sensitive to market assumptions. Consider an example: If we use a 6% cap rate to value an asset and then adjust it to 6.5%, the value can change drastically. For an NOI of $1,000,000, the value at a 6% cap rate is $16,666,667. If we increase the cap rate to 6.5%, the value drops to $15,384,615. If the company is levered by 50%, the equity was $8,333,334 but now droped to $7,051,282, a difference of over $1.2 million or 15%, just from a 0.5% change in the cap rate.
Summary
- The equity adjustment method provides a detailed approach to valuing REITs, especially those that report under IFRS, focusing on the fair value of the assets.
- Adjusting the book value of equity involves recalculating fair values for assets, deferred taxes, and G&A expenses.
- The method seeks to align asset values with current market conditions for a clearer valuation.
- Limitations include ignoring leverage risks, interest rate variability, and cash flow visibility.
- The method is highly sensitive to cap rate assumptions, making careful consideration of market conditions essential.
Disclaimer: The information provided in this post is for informational purposes only and reflects my personal opinions. It should not be considered as professional financial, legal, or investment advice. Please consult with a professional before making any investment decisions. I am not responsible for any actions taken based on this information. The full disclaimer can be found here.