A Better Way to Value REITs

For years, a fierce debate has raged among fundamental investors who follow property companies over the best way to value these unusual entities, most of which are known as real estate investment trusts, or REITs.

The battle has been pitched between two camps. On one side, the vast majority of REIT investors have relied almost exclusively on the net-asset value (NAV) model, which I've written about in the past. The idea behind this model is that a REIT is worth no more or less than the value of the buildings that it owns minus the debt that it owes. To estimate the value of the REIT, investors simply estimate the rental income the firm can earn over the coming year and divide by a discount rate, known as the "cap rate." In this valuation approach, the company is worth just as much dead as it is alive, liquidated versus a going entity. In the other camp, a much smaller minority of investors relied on some sort of discounted cash-flow model. The idea here is that a REIT stock--like any other investment--is ultimately worth the sum total of its future cash flows, discounted back to the present.

Thus, the debate over how to value REITs has hinged on one major idea: Should investors value the buildings (NAV) or the earnings (discounted cash-flow)? In other words, can active REIT managers add value to the firms that they're running? Or, when investors sink money into a REIT stock, are they buying nothing more than plots of land and some boxes of bricks?

Today, we declare the debate over. The discounted cash-flow method is superior.

We're very excited to announce that we've rolled out a new discounted cash-flow model to value all of the property REITs that we cover, and that we've ceased using our old NAV model to generate fair value estimates for these firms. As a result, you'll notice a lot of valuation changes on our site today. This move impacts 61 property REITs that Morningstar covers.

Fair Value Estimate Upgrades
The difference between our old fair value estimates and the new values can be startlingly large. Across the board, our REIT fair value estimates have jumped about 18% on average. But averages mask the wide range of changes occurring on a company-by-company basis. In some instances--like  General Growth --our estimates are up 80% or more. Meanwhile, we've lowered our valuation for certain firms, such as  BRE Properties .

There are countless reasons we believe a discounted cash-flow approach is superior to NAV. But, ultimately, our decision to head in this direction came down to a few major factors:

• REIT managers can create or destroy value for shareholders as a result of their actions.
• Because of this, REITs with good management teams--those capable of generating returns in excess of the REIT's cost of capital--will trade at levels above the net asset value of the firm.
• Cash flows and earnings ultimately drive the value of the stock in a real estate firm--just as they drive the value of any other stock.

Intuitively, this makes sense. Just as  Microsoft (MSFT) or  General Electric (GE) trade for multiples well in excess of their book value, so too can REITs trade above or below their net asset values, depending on the actions of their managers.

The challenge lies in quantifying this performance. To do so, we settled on a measure that we've dubbed "return on real estate assets"--or ROREA--which is used to measure the amount of cash flow a firm generates relative to the real estate assets it owns. This sounds complex, but the core concept behind it is quite simple, and is similar to better-known measures like return on equity (ROE) or return on invested capital (ROIC). In all three cases--ROREA, ROE, and ROIC--we're simply trying to measure how much cash or earnings a company can spit off relative to how much capital it has. The most desirable businesses throw off tons of cash with as little invested in the business as possible.

Measuring Success
Our research not only showed that a REIT can create value by earning returns above its cost of capital, but we also found strong evidence that this superior cash-flow generation has already driven returns for investors through higher stock prices and growing dividends. For instance, if we divide the firms in our REIT coverage list into two halves based on ROREA, the top half generated a compound annual return to shareholders of 25.8% per year over the past five years versus 19.2% per year for the bottom half. The difference is even more marked when looking at the true creme de la creme. The top quartile of firms, as ranked by ROREA, offered a compound annual return to shareholders of 29.3% per year on average over the past five years versus just 16% for the bottom quartile. As confirmation of these results, if you look at things in a slightly different fashion--growth in book value per share--similar results are attained. After adjusting for differing dividend policies, REITs that were better at compounding book value (a byproduct of superior earnings) delivered far greater returns for investors.

It's very clear that the stock market cares about the cash flows and profits received from a REIT investment--not just the value of the buildings.

Tough to Create Wealth
That said, it's no easy task for REIT managers to add value. On the whole, their actions and other intangibles that a firm might have account for a small percentage of the overall value of these firms, compared with other industries. We can gauge this by comparing our discounted cash-flow values, which measure the value of the full enterprise (buildings, management, and other earnings streams), with current NAVs, which estimate the value only of the buildings. In most instances, management decisions and these other intangibles account for only about 15%-25% of the overall value of the stock.

This is not a knock on the hard work that many REIT managers undertake. Rather, this reflects that REITs' buildings have a tremendous amount of intrinsic value, regardless of who happens to manage them. This is the reason that investors depended on NAVs historically. In contrast, the tangible assets of a software company or a drug firm are worth very little.

Additionally, REITs face unique regulatory constraints. For instance, these companies are very limited in the businesses that they can pursue, with federal regulations requiring the vast majority of income to come from properties or a handful of other assets. Plus, REITs must pay out most of their income in dividends, limiting reinvestment opportunities.

Roads to Success
Despite these constraints, we found that there were five major ways in which REIT managers could boost the overall value of their firm, and integrated these value drivers into our DCF model. First, REITs can focus on boosting earnings from their existing portfolio.  Simon Property Group (SPG), a leading mall REIT, is an excellent example of this. Even as more retailers have moved away from malls and consumers have begun shopping more on the Internet, Simon has boosted its rental income substantially, charging 20% more on new leases than it did on expiring leases year after year and filling its malls with high-margin revenue sources like advertising and kiosks. A second way that REITs can add value for shareholders is by increasing the portfolio externally, often through "capital recycling." In particular, this can be accomplished by purchasing undervalued properties that can be developed or redeveloped into a higher-productivity asset.  Vornado (VNO) is an example of a company that creates value this way; the firm has an exceptional track record of seeking out "real estate plays."

A third way that a REIT can boost its value is by expanding into property asset management, usually through joint ventures. In these arrangements, the REIT partners with another group--usually a pension fund--to jointly own a property, with the REIT taking a minority stake, say of 20%. The REIT then pockets a stream of high-margin fees, with little capital requirements, to manage the assets.  Taubman  is an example of a company pursuing this strategy. A fourth value-creating strategy is broadly known as "financial engineering," a catch-all phrase for other balance-sheet maneuvers REITs can undertake, such as cutting debt costs, seeking out tax-free property exchanges, buying low-cost options on properties, and so forth. Most REITs seek financial engineering opportunities wherever possible.

The final way that REITs can add value for shareholders is to retain earnings and reinvest the funds at above-average returns. After all, if a REIT has access to investments in the private real estate market that can generate a 15% per year return, and investors' required return in the stock market is only 10%, then this is a value-adding activity for shareholders. Predicting who will be the best investors in the future is no small task. However, just as investors can look at the track records of mutual fund managers to gauge their investment track record, so too can REIT investors consider managers' track record at investing in good projects above the REIT's cost of capital.  Alexandria (ARE),  Ventas (VTR), and  Universal Health Realty (UHT) have been good performers over the past five years, and you'll find other firms noted in our REIT reports.

Building discounted cash-flow models for REITs requires significantly more work; these models require literally hundreds of inputs, compared with a NAV model, which is a basic valuation tool requiring little more than assumptions about next year's operating income and the cap rate. But we feel that this additional detail is very important and will ultimately help us better select appropriate investments to recommend. In little more than two years, we have greatly expanded the breadth of our REIT coverage. We started with basically no REITs under coverage just a short time ago, and now there are few other research shops that provide coverage on as many REITs as we do. With this breadth, the next logical step was to deepen our coverage, and discover new insights into the REITs we cover.

Real Estate Bubble?
Since REITs have been one of the hottest sectors of the stock market the past five years, it's not entirely surprising that these stocks are trading at premiums to our fair value estimates. REITs on average have generated a compound annual return of 20%, by some measures, and the cash flows for commercial space--whether offices, industrial properties, shopping centers, or hospitals--simply do not support these values, even after we add in all the things that management can do to boost returns.

Is there a "bubble" in the national housing market? Our discounted cash-flow work further supports the thesis that houses--or at least condos--have reached overheated prices. There's only a handful of REITs that we believe are worth less under the discounted cash-flow approach than under the NAV. But the three firms with the biggest drops in fair value all run apartment complexes:  Equity Residential (EQR), BRE Properties and  Apartment Investment and Management (AIV). What's the reason for this? Apartments are fetching such high prices as condo conversions that it's highly unlikely that these firms can generate enough cash flows from the properties they own--or through other efforts of management--to justify not liquidating their balance sheets. We've given apartment firms some credit for the steps they are taking to sell off properties at high market prices, but none so far have announced plans to sell off every last unit and ride off into the sunset.

We're thrilled to roll out this new REIT model and are excited about the insights we've already been able to glean from this work. We look forward to bringing you further insight in our REIT analyses in the years to come.