Wednesday, August 15, 2012

A Valuation Too Far

CNL Lifestyle Properties released its second quarter 10-Q yesterday.  Lifestyle disclosed deep in the 10-Q a new share valuation of $7.31 per share and a distribution reduction.  A drop in the distribution (from 6.25% to 4.25%) was not unexpected based on previous disclosures from Lifestyle.  The 27% drop in value was not unexpected either, despite the proclamation in June by the REIT's CEO that Lifestyle would steer clear of a sharp drop in valuation (I'll let you decide whether 27% is "sharp").   More disturbing than the distribution cut or value loss was Lifestyle's weak valuation methodology.  It mocks investors and broker / dealers*.

Lifestyle describes its methodology below:
In determining an estimated fair value of the Company’s shares, the Board of Directors considered various analyses and information, a portion of which was provided by the Company’s advisor. In preparing its value estimate, the Company also consulted an independent valuation advisor.
The independent valuation advisor was not disclosed, nor was the scope of its work.  "Consult" can mean many things, but it doesn't mean that the third party firm valued the REIT's assets.  The value was determined by REIT's advisor, and it used a 10-year discounted cash flow analysis.  This a discounted cash flow methodology that involves significant assumptions about future revenues and expenses.  The REIT gives its weighted average growth rate but no information on its expense growth.   A large portion of Lifestyle's debt matures over the next five years, and the assumptions  made for repaying or refinancing this debt would play into the valuation  Lifestyle has had issues with a number of its properites since its inception, so I'd question whether a linear, assumption-based cash flow analysis is the most appropriate methodology.  (Lifestyle did not assign a premium for enterprise value or portfolio aggregation.) 

The valuations for non-traded REITs are getting more and more unbelievable, and Lifestyle's internal valuation, to me, is one valuation too far.  Broker / dealers need to call foul and demand independent valuations**.  Non-traded REIT sponsors are not going to stop these self-serving internal valuations until forced.  The non-traded REIT's use of an independent consultant or advisor is not good enough.  Dropping the name of a third party firm when the actual valuation is done by the REIT's advisor is a joke.   As I have noted before, there are only a few valuation methodologies, so having a third party valuation firm affirm a methodology is not the same as having a third party firm calculate the valuation.  Investors and broker / dealers are the ones harmed by nonsense valuations.  Non-traded REIT sponsors, whether too desperate or thick to realize it, will ultimately be hurt, too.

*  Lifestyle is externally advised by an affiliate.  It does not appear that the advisor will be impacted by the new, lower valuation.  The advisor receives an asset management fee of 1% of the purchase price of the REIT's real estate and principal amount of any mortgage assets.  This fee is not impacted by the new valuation because its based on the purchase price of the assets not Lifestyle's new asset value.  Investors just received a 27% reduction in their investment value, and had 32% chopped from their distribution, but Lifestyle's advisor's income stays steady.   

** For an independent valuation done right, look at last fall's valuation by Wells REIT II, which was completely done by a third party valuation firm.


Anonymous said...

Really dude?

All valuations are subjective and come with a $#!@ ton of assumptions. That's what valuations are--estimates of intrinsic value. Intrinsic value is not ever known, and buyers' market value may or may not accurately know intrinsic value. An you're calling BS on them using DCF??? Really??? What method would you prefer?! Direct cap with significant debt maturities?? Comparable sales by square foot with all of their historically troubled assets (I'm joking, of course, that's only considered meaningful in non-income-producing property. Of course, you knew that, right?)

I'm beginning to legitimately question your finance/valuation credentials for real estate or any other asset class.

And how in the world is having these REITs get an MAI appraisal better than doing it on their own with third party confirmation?? After leaving the corporate analyst world to becoming a real estate analyst, I realized that MAI stood for "Made as Instructed." If you don't think you can buy any valuation you want, ask Moody's...

Perhaps you also forgot that the value shouldn't mean much for investors who aren't selling, so spending more money than necessary may be a wasteful use of shareholder capital.

Rational Realist said...

Thanks for the comments. You're right, all valuations can be made as instructed, and as I've written before these values have nothing to do with an actual market value if the REIT were to list on an exchange or be sold.

I didn't read that the third party firm confirmed the valuation. Most of the times the third parties confirm the methodology, like your DCF, not the valuation itself, which as you must know is a big difference. A sponsor-derived valuation with its $#&% ton of assumptions would be more credible if a third party put its name and reputation behind the final value, not just the methodology.

You're right too, that for investors that aren't selling their shares the new paper value doesn't mean much. Lifestyle has nearly stopped its share redemption progam. Last quarter it only redeemed 2% of shares in its redemption queue. Future redemptions, I'm sure, will be based on the new lower price.

Non-traded REITs have to provide a value 18 months after their offering closes. The wide difference in how these REITs value their shares makes the process a joke. Lifestyle's weak disclosure didn't help the process and confirms that the valuation process is ineffective execpt for meeting a regulatory requirement.

Anonymous said...

" Direct cap with significant debt maturities??"

uh, yes, I would definitely prefer they use a cap rate than some nonsensical DCF.

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