REIT Valuation Methods

REIT Valuation Methods

REITs (Real Estate Investment Trusts) are corporations that invest in real estate assets. They are designed to provide investors with regular income, diversification, and long-term capital appreciation. REITs can be valued using two broad categories of methodologies:

Intrinsic Valuation is based on the REIT’s own fundamentals, independent of market comparisons. The two main approaches for doing this are using net asset value (NAV, and discounted cash flow (DCF).

Relative Valuation is based on comparisons with other companies and the sector overall. The two main approaches used for this valuation methodology are typically trading comparables and transaction comparables.

REIT Valuation: What are the Four Methods?

REIT valuations rely on both fundamental valuations as well as sector-wide relative valuations. Analysts will often prefer one methodology but will back it up with conducting other valuations to ensure that the end-value has been cross-checked against other metrics.

Here is a reminder of each method:

Net Asset Value (NAV) calculates the market value of a REIT’s assets minus liabilities and other claims. This is then divided by the number of shares in the REIT to create a NAV per share.

Discounted Cash Flow (DCF) projects future cash flows and discounts them back to present value using a cost of capital. This relies on the analyst creating appropriate earnings and cash flow forecasts and calculating a suitable WACC for the company.

Trading Comparables compares the REIT’s valuation multiples (e.g. Price/AFFO) with similar publicly traded REITs. Adjusted Funds from Operations is used as its factors in regular capex outgoings, rent rises and routine maintenance on the properties.

Transaction Comparables uses acquisition prices of similar REITs to infer a value for a REIT. This method will also consider the scale and the timeframe of the most recent transactions to ensure an accurate valuation.

How to Determine the Value of REITs?

To determine the value of a REIT, analysts typically use a combination of intrinsic and relative valuation methods. One common approach is the Net Asset Value (NAV) method, which involves estimating the market value of a REIT’s real estate and other assets, then subtracting liabilities and other claims to arrive at a net value. This figure is then divided by the number of fully diluted shares to calculate NAV per share.

Another method is the Discounted Cash Flow (DCF) approach, where future cash flows—often represented by Adjusted Funds From Operations (AFFO)—are projected and discounted back to their present value using the REIT’s cost of capital. This method is particularly useful for capturing the long-term earning potential of a REIT.

Relative valuation techniques are also widely used. These include trading comparables, where valuation multiples such as Price to AFFO or EV/EBITDA from similar publicly traded REITs are applied to the target REIT to estimate its value. Transaction comparables, which use acquisition prices of similar REITs, provide another benchmark for valuation.

Finally, analysts often assess whether a REIT is undervalued or overvalued by comparing its implied share price from these models to its current market price.

REIT Metrics

The total return on a REIT can be measured by its dividend yield and share capital growth.  Traditional measures such as EPS or FCF are not as accurate for REITs. Competent management can use combination of debt and equity along with selecting high ROI investments to prevent dilution. For these metrics, AFFO and FFO can be used interchangeably, much like EBIT and EBITDA; however, AFFO is seen as the purer value driver.

When looking at the important REIT metrics, AFFO or FFO payout is more often used by investors to determine the return. Price/AFFO or FFO is very similar to PE for REITs.  It reflects how much you must pay in terms of share price to get a dollar of AFFO or FFO.

Download the free Financial Edge template to walk through the steps to calculate AFFO when analyzing company financials.

If we invert this ratio, we get the AFFO or FFO yield. This is sometimes used as proxy for the cost of equity. The higher a Price/AFFO, the lower the yield or cost of equity. This is because the high share price indicates high value and thus lower compensation or return. Lower the multiple, the higher the yield, as the company is less valuable and the risk to the equity holder is greater.

Lastly, investors can look at Total Debt to Market Cap. Balance sheet management in a REIT is vital and most REITs are leveraged at between 30% and 60% of capital. While leverage is a cheaper source of financing than equity, as leverage increases so does risk. The blend of debt or equity in a company will impact its cost of capital, or the rate at which it considers taking on new projects.

What Makes REITs Different from Traditional Companies in Valuation?

REITs are asset-heavy and often hold liquid real estate, making NAV-based valuation more applicable. Unlike traditional companies, REITs typically increase asset value over time and are not taxed at the corporate level, which affects how cash flows and cost of capital are treated.

What is Net Asset Value (NAV)?

NAV, or Net Asset Value, is an intrinsic valuation method used to estimate the value of a REIT based on the market value of its assets minus its liabilities and other claims. If a REIT has assets of $350m and liabilities of $90m then its NAV is $260m.

How is NAV Calculated for a REIT?

The NAV calculation begins by determining the market value of the REIT’s operating real estate assets. This is done by applying capitalization rates (cap rates) to the forecasted net operating income (NOI) of properties, both wholly owned and joint ventures. Management fee income, if applicable, is also capitalized but typically at a higher cap rate due to its riskier nature.

Next, the market value of other assets on the balance sheet is added. These include developments, land held for future use, and other non-income-generating assets. These are usually adjusted conservatively, often valued at 100% to 110% of book value depending on their stage and risk profile.

Then, the market value of liabilities and other claims, such as debt and non-controlling interests, is subtracted. These are typically taken at book value unless more accurate market data is available.

Finally, the resulting NAV is divided by the number of fully diluted shares outstanding to calculate the NAV per share. This figure is then compared to the REIT’s current share price to assess whether it is trading at a premium or discount to its intrinsic value.

What Are Trading Comparables and How Are They Applied?

Trading comparables involve selecting a peer group of REITs, cleaning their financial data, and applying valuation multiples like Price/AFFO or EV/EBITDA to the target REIT. This helps estimate an implied share price and assess whether the REIT is undervalued or overvalued relative to the peer group. Often comparisons are made on a forward-looking basis but will reference historical comparables to identify any changes within the peer group or individual companies.

Why is AFFO Preferred Over EPS Or Free Cash Flow for REITs?

AFFO Adjusted Funds from Operations, is a key financial metric used to evaluate the performance and valuation of REITs. It is considered a more accurate measure of a REIT’s recurring cash-generating ability than traditional metrics like earnings per share (EPS) or even free cash flow. It excludes non-cash items and better reflects the REIT’s ability to pay dividends, which is a key investor focus.

What is a Cap Rate and How Is It Used in REIT Valuation?

A cap rate is the ratio of a property’s net operating income (NOI) to its market value. It’s used to convert income streams into asset values in NAV models. Different cap rates are applied to wholly owned properties, joint ventures, and management fees based on risk and liquidity. A higher cap rate (e.g. 7% vs. 5%) may suggest potential higher returns, or it may indicate higher risk. Lower cap rates typically apply to more stable, lower risk investments.

What is the Difference Between Trading and Transaction Comparables?

Trading comparables reflect the value of a non-controlling stake in a REIT based on public market data. This type of valuation is used on companies which are still publicly traded and can valued at market trading prices. Trading multiples will move when market conditions change reflection the company REIT performance relative to its share price.

Transaction comparables differ as they reflect the price paid to acquire control in M&A deals. These are metrics based on the price that buyers have paid to acquire assets at a specific point in time. The latter often includes a control premium or acquisition premium.

How is the Cost of Capital Calculated for REITs?

The cost of capital (WACC) includes the cost of equity and cost of debt, weighted by their proportions in the capital structure. WACCs will vary depending on how much debt and equity a REIT has. For REITs, tax shields are typically ignored, and market values are used. The cost of equity is often estimated using the Capital Asset Pricing Model (CAPM).

What Makes DCF Valuation Different for REITs?

DCF, Discounted Cash Flow, is a valuation method used to estimate the present value of a REIT based on its expected future cash flows. DCF for REITs often uses AFFO instead of traditional free cash flow. It also accounts for equity dilution due to frequent share issuance and may use either unlevered or levered cash flows depending on the analysis goal.

Conclusion

Valuing Real Estate Investment Trusts (REITs) involves a blend of intrinsic and relative valuation methods. The Net Asset Value (NAV) and Discounted Cash Flow (DCF) approaches provide insights into the REIT’s fundamental value by assessing its assets and projected cash flows. On the other hand, trading and transaction comparables offer a market-based perspective by comparing the REIT to similar entities.

Understanding these methods is crucial for investors seeking to make informed decisions about REIT investments. By combining these approaches, one can gain a comprehensive view of a REIT’s value, ensuring a balanced and well-rounded investment strategy.

Additional Resources

Adjusted Funds from Operations
Trading comparables
Discounted Cash Flow DCF Valuation
Transaction Comparables