Bong Water

I encourage you to read the letter sent to investors in the Inland Western REIT.  It is obscene.  Inland Western has valued itself, for ERISA purposes, at $6.85 per share.  I am going to conclude that the valuation is also part of FINRA Notice to Members 09-09 requiring non-traded REITs to provide a NAV eighteen months after the close of their offering period.  The letter (which I am unable to reprint without retyping it) states that, in general, real estate prices and REIT prices have declined since the start of the financial crisis.  As such, the value of Inland Western has dropped, too.  My question is whether the $6.85 per share estimate reflects enough of a discount.

Where to start, where to start?  The facts are usually the best place to start.  The book value, as of Inland Western at September 30, 2009, was $5.19 per share, a straight calculation of equity divided by outstanding shares.  The REIT is yielding 1.0%.  Its portfolio is approximately 84% occupied.  Its Funds From Operations is $.34 per share, which I annualized based on nine months of operations.  Now, pick an FFO multiple.  Developers Diversified (DDR), a publicly traded REIT specializing in retail properites, is trading at 8.3 times forward FFO.  If you apply this to Inland Western, its value is $2.82 per share, assuming its FFO does not decrease.  If you use a 10 or a 12 multiple, the value jumps to $3.40 or $4.08.  A multiple of over 20 times FFO is needed to arrive at the $6.85 value.  I don't think, even in the REIT frenzy of a few years ago, that FFO multiples ever got too far above 15 for the best REITS.

Inland Western acquired its properites in the middle of the 2000s during a real estate bull market.  As I posted last week, Ray Torto, chief economist at CB Richard Ellis told the New York Times that anyone who acquired commercial real estate in the last six years has had their equity wiped out.  I'll admit that this is an extreme statement, but even Inland Western, quoting the NCREIF property index, tells investors that commercial real estate prices have fallen 27%.  So, if Inland Western had 12% offering costs, and the remaining share value has dropped 27%, this puts the value at $6.42.  But this is false, because if a property is leveraged, equity holders feel the drop in value more than the decrease in property value because the debt obligation is approximately a constant.  For example, if a property or portfolio that is 60% leveraged drops in value 27%, the equity holders lose 68% of their value. 

Inland valued the properties itself using a "combination of different indicators."  It used a direct capitalization approach.  It must have used a forward, pro forma, net operating income with some optimistic assumptions on lease rates, occupancy and lease growth rates.  I wonder whether all properties were valued, or if a sample was valued and then a total value extrapolated from the sample. If this was the case, I bet all those properties with vacant space due to Mervyn's, Circuit City and Linens & Things bankruptcies were excluded. Most important is the admission that Inland Western did not use independent appraisers.

I am not going to value Inland Western's share price, but question its $6.85 per share value. I think investors need to press Inland Western on its valuation and push to get an independent valuation.  I have heard that Inland with its Inland Western REIT valuation is not the only non-traded REIT sponsor valuing its REITs at prices that seem high.  It is time to stop swimming in the bong water and face reality.