Monday, May 14, 2012

The Valuation's Too Damn High - Part II - Garbage In, Garbage Out

There was an article last week in InvestmentNews on non-traded REIT valuations.  The article discussed the split between non-traded REITs that want outside firms to value their shares and non-traded REITs that prefer to value their own shares.  This passage with a quote from Martel Day, the chairman of the non-traded REIT industry's trade group, Investment Program Association, sums up the problem with valuations:
One of the private-investment industry's leading trade groups, the Investment Program Association, for example, wrote: “The [pending Finra] rule should not dictate that the estimate be based on an "appraisal' of the issuer's assets and liabilities.”

The letter, signed by IPA chairman Martel Day, said: “Many non-listed REITs and DPPs use very common and highly accepted methodologies to estimate value. Many issuers have engaged third parties to estimate value, while others have engaged third parties merely to analyze the methods and reasonableness of the assumptions used and conclusion arrived at in estimating value.”

The IPA's letter added that it is developing uniform valuation guidelines.
Martel Day is right, most non-traded REITs that value their shares - rather than using a third party firm - use commonly accepted methodologies to estimate value.  The methodologies non-traded REITs use to determine value are not the concern, the worry is the inputs that non-traded REITs plug into their valuation models, because small changes in assumptions can result in big changes in valuations.  Some non-traded REITs use third party firms to confirm the REITs' internal valuation methods, but this should not be confused with an actual third party valuation, because non-traded REITs are still determining their own values and just having the third parties verify their processes.

There are a few accepted valuation methodologies, which include discounted cash flow analysis, comparison to public REITs using Price-to-Funds from Operation multiples (similar to P/E ratio comparisons for stock valuations), and property cap rate analysis.  Non-traded REIT valuation disclosures I have read included the use of some or all of these methods, so the non-traded REIT trade group's defense of internal valuations because of the use of these methods, or having a third party firm affirm these methods, does not allay valuation concerns.  Just because a non-traded REIT uses an accepted methodology doesn't mean the final valuation is accurate.

The discounted cash flow analysis - which combines a REIT's properties' estimated income for a certain period, usually ten years, and then multiples each year's projected income by a discount rate, adds the results to derive a current estimated value - is one big assumption.  You have to estimate nearly every input - growth rate, expenses, discount rates  and more.  The more variables in a REIT's business - lease expirations, debt maturities, expenses - the more the assumptions for these variables can impact value.  Then you have the assumed discount rate which will impact the final value.    Discounted cash flow analysis is a basic valuation method, and anyone who had a basic business class in college learned some form of discounting cash flow, but I am not convinced of its relevance related to valuing non-traded REITs. 

Valuing a non-traded REIT based on its Funds from Operation (FFO) multiple is a legitimate valuation method, but one with significant limitations.  Publicly traded REITs all publish their FFO, and its easy to calculate a multiple - stock price divided by FFO.  Non-traded REITs take their FFO and then compare it to multiples of publicly traded REITs.  The higher the multiple used in the valuation the higher the assumed value.  The trick is to watch the multiple.  For example, if a non-traded REIT has FFO of $.60 per share and uses a FFO multiple of 18, its share value is $10.80.  If a FFO multiple of 14 is used, the share value drops to $8.40, a big difference.  In my opinion, the FFO valuation metric is weak for new REITs.  Public REITs that are being used as benchmarks have established track records and a history of FFO, while new non-traded REITs have much less history, making accurate comparisons more difficult.

Cap rate analysis, to me, is the most relevant valuation method, as well as the most common real estate valuation metric.  If done correctly, cap rate analysis takes actual property net operating income, not a projected, "stabilized" net operating income, and divides it by an appropriate capitalization rate - i.e. an assumed return rate - to arrive at a property's estimated value.  Each property value is then aggregated to determine total value.  The lower the capitalization rate the higher the property value.    The assumed cap rate has a large impact on the valuation, and REITs that use too low a cap rate are inflating values.   For example, a REIT that values its properties using a 6.5% cap rate is going to have a higher valuation than if it used a 7.0% cap rate.  I like cap rate analysis because it takes actual property net operating income, and therefore has fewer management assumptions, but the capitalization rate utilized is critical. 

The InvestmentNews article referenced above discusses enterprise value.  The article has a quote that mistakenly calls enterprise value the "brand" value.  The enterprise value is an amount that is added to a REIT's net asset value to adjust the share price as if the REIT was listed on an exchange.  Stated another way, it's a management acumen premium.  This is an arbitrary figure determined by REIT management, then affirmed by the REIT's board of directors, and added to the REIT's net asset valuation.  The article references Dividend Capital Total Return's (TRT) enterprise value that was part of its valuation last September.  TRT is in the process of revaluing itself as part of re-opening its offering period as a NAV REIT.  It has not released a new offer price, but I'd be shocked if its new offer price included a line item for enterprise value.  It would make TRT's new offering a joke and prevent it from obtaining selling agreements.  The inclusion of enterprise value is no longer common, and I suspect industry peer pressure has prevented many sponsors from including this irrelevant, ego-driven figure in their non-traded REIT value estimates.

All the valuation methods use both pro forma and market estimates.  It's naive to think that non-traded REITs that determine their own valuations aren't going to overweight optimistic assumptions that result in higher net asset values.  Non-traded REIT board of directors must turn the valuation process over to third party firms.  Third party valuations should be subject to little, if any, management adjustment.  Independent directors need to step-up, earn their pay, and accept the valuations provided by the third party firms, and most importantly, avoid the pressure from REIT management.  The use of third party firms to confirm non-traded REIT managements' valuation processes and methodologies is insufficient.  All the non-traded REITs use accepted valuation methods, and its not the methods that are question, it's the input to the formulas that make non-traded REIT valuations a subject of concern.

5 comments:

Anonymous said...

Good stuff.

Rational Realist said...

Thanks.

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Anonymous said...

Which non traded reits use third party valuation companies? Do you have the reports?

Rational Realist said...

Anonymous, only firms doing a secondary offering get valuaitons, which are usually one-time engagements. REITs don't typically release the reports, only summaries in their filings.