By Art Gering

Analysts and investors may debate the mechanics of NAV calculation, but many use it as a starting point for analyzing the relative value of REITs.

Equity market investors and analysts have developed a variety of measures to help them assess the valuations assigned by the market to the stocks of different companies. These measures include the ratio of stock price divided by earnings per share (the P/E ratio), the ratio of stock price multiples divided by earnings per share growth, dividend yields and the ratio of stock price divided by net book value per share (the price-to-book ratio).

When it comes to assessing the relative valuation of real estate stocks, the price-to-book ratio is severely hampered by the treatment of property costs and depreciation according to generally accepted accounting principles (GAAP). Under GAAP, the book value of real estate assets represents the asset's original historical cost reduced uniformly to zero, whereas the market value of those assets actually may rise or fall over time. Thus, the net book value of a real estate company reported under GAAP often significantly understates the market value of the company's net assets.

To correct for the downward bias of the net book value, real estate stock analysts and investors have developed an alternative measure–the net asset value (NAV)–which estimates the market value of a real estate company's real estate assets plus other assets, less the company's liabilities.

Best Estimate

However, many who use NAV acknowledge that calculating it is part science and part judgment. As a result, NAV figures might be more accurately called "very rough estimates." Still, any financial analysis requires some subjectivity, and calculating NAV is no exception.

"Although NAV estimation is poorly implemented by some market participants, it does not render the valuation parameter meaningless," asserts Warner Griswold, the director of operations for Newport Beach, CA-based Green Street Advisors. "A good starting point for determining the value of a real estate corporation is to understand the value of its underlying real estate.

"If NAV is to be used as a valuation parameter," he continues, "it's essential that analysts and investors are thorough and diligent in the analysis."

The problems with NAV, the experts contend, are the assumptions made to value portfolios and whether the metric captures any of a REIT's "franchise value."

"The issue I have with NAV is accuracy," says Gregory Whyte, a managing director with Morgan Stanley in New York City. "There are a number of different objective methodologies that can be used to calculate NAV, but unfortunately the data inputs require a certain degree of subjectivity. It is those somewhat subjective calls in terms of cap rates or what replacement costs per square foot are that lead to a fairly inexact science when it comes to using NAV."

Selecting the appropriate cap rate to value the property portfolio requires confronting a number of questions. For instance, investors and analysts must often decide whether a single cap rate should be applied to a portfolio or whether the assets should be broken down into smaller groups.

"You certainly want to group properties at least on a quality cut and geographic and submarket cuts if you're able to," says Karen Knudson, principal and portfolio manager at Chicago-based RREEF. "If you have a company that has relatively few properties and you estimate on a property-by-property basis, then you can have a lot of confidence in the valuation. But you will have some companies that will have a large number of properties and you have to group those logically and then apply logical cap rates to those groups."

A Different Approach

Whether the approach is to value the portfolio on a property-by-property basis or apply a single cap rate, an analyst must obtain that cap rate from a reliable source of market information. Often, the sale of comparable properties in specific markets or submarkets provides a useful indicator of cap rates. But this practice has its downside, especially in the hands of less-skilled analysts.

For one, using a cap rate from a comparable sale assumes the property being valued is identical to the one sold. Many analysts will tweak the cap rate to reflect differences in buildings or markets.

"Part of being an analyst is making subjective judgments for various components of the analysis," stresses David Taube, NAREIT's former director of financial standards.

Also, transaction activity in the private market is often the basis for comparable sale cap rates. Analysts must decide whether private market activity is a reliable indicator of property values.

"Ideally, you would have a very liquid market with lots of transactions but that is not really what we have," Knudson says. "How can you say exactly what the NAV of a company is when even the company would have trouble telling you because there are just not enough transactions to measure against? Real estate just does not trade that regularly."

Sample Range of NAV Values Rather than being an absolute number, estimates of REIT NAV per share tend to fall in a range. REIT Merrill Lynch Banc of America Bear Stearns Green Street Advisors Aimco $44.61 $39.56 $46.00 $41.25 AvalonBay 46.58 46.32 47.00 47.50 Boston Properties 43.65 50.78 46.70 38.00 Equity Office 32.04 31.72 35.46 26.50 Equity Residential 29.15 27.48 26.00 25.75 Kimco 28.17 28.50 28.69 26.75 Mack-Cali 37.23 39.94 38.51 35.00 ProLogis 23.91 25.32 25.26 22.25 Simon Property 33.64 32.50 38.60 34.75 Weingarten Realty 31.22 34.50 33.82 31.25 Sources: Merrill Lynch, Banc of America Securities, Bear Stearns and Green Street Advisors Merill Lynch's estimates of NAV are as of Sept. 19, 2002; Banc of America's estimates are as of Sept. 26, 2002; Bear Stearns’ estimates are as of Sept. 6, 2002; Green Street Advisors’ estimates are as of Oct. 1, 2002.

Others disagree. "Private market prices contain the collective opinions of thousands of buyers and sellers about the growth prospects and risk of a given type of real estate in a given locale," Griswold contends.

David Fick, a managing director at Baltimore-based Legg Mason Wood Walker, agrees that the private market can provide guidance. "There is a very large market outside of the public companies that trades actively at almost any point in the cycle," he says. "So it's fairly easy to identify the private value of assets."

To offset concerns over transaction volume and market liquidity, firms such as Green Street Advisors examine factors other than recent transactions to calibrate cap rates. According to Griswold, the firm looks at portfolio growth rates and risk characteristics and gathers local intelligence, among other factors, to determine and validate its measures.

Monitoring current cap rates is important if NAVs are to be relevant and meaningful. Critics of NAV contend cap rates are static, examining only one point in time. But this argument may only be an academic exercise because, in practice, cap rates can be forward looking.

"We predominantly cap current or future 12-month NOI (net operating income) as the primary metric for calculating NAV," says Steve Brown, managing director and portfolio manager at Neuberger Berman in New York City. Brown says the company freshens up the numbers periodically. "We try to update it as frequently as possible because we find that the more accurate our inputs, the more reliable our outputs. We strive for at least quarterly updates."

Completing the Equation

A REIT's other assets must also be factored into the NAV equation. Here again, the assumptions one makes influence the estimate. For instance, how does an analyst value a development pipeline?

Fick explains that most analysts start by examining the REIT's investment in development that isn't yet producing income. "We make a judgment as to whether it's worth a discount or par, which is essentially what they've invested," he says. "Or maybe it's worth a premium. Any good management team that is a good developer is always going to have a premium."

Assumptions must also be made concerning a REIT's vacant space, an important consideration today when vacancies are high and demand is low across all property types. Steve Sakwa, an analyst with Merrill Lynch in New York City, recently changed his NAV model to reflect more normalized occupancy levels. Others adjust their formulas or approach in different ways to account for unused space.

"If it was a property type in an overbuilt market, we probably wouldn't give much credit for empty space, meaning that we would use a relatively high cap rate," Brown says. "If there is vacant space in, say, New York City or Washington, then the cap rate would probably be lower. It would reflect the asset being in a more difficult to build market."

Occupancy levels cut both ways, Taube says. "If there is vacant space and there is no likelihood of it getting leased, you wouldn't give it the benefit," he explains. "Then again, if a portfolio was 98 percent or 99 percent leased, an analyst might deduct for that because they reasoned that level wasn't sustainable."

Quantifying Franchise Value

Besides questioning the assumptions analysts make, critics of NAV also contend that the metric doesn't credit a company's franchise value. Franchise value may be simply defined as a company's ability to create value for its shareholders. Despite the critics' claims, many analysts recognize franchise value and attempt to incorporate it into NAV estimates.

"We look at many things when we're looking at a company," Fick says. "We look at management and the quality of management. That is, good management that makes right capital allocation decisions. You should pay something for management beyond real estate value."

Others concur that a portion of franchise value is attributable to a company's management team. Brown examines management strategy and the firm's long-term growth rate. "While management strategy is very subjective, it has a big impact on the relative performance of the company," he says. "Some management teams have been more successful as public companies as opposed to being private companies. We spend a lot of time assessing management strategies and assigning a quantitative score to that."

Fick also assesses the quality of the company's real estate and their market concentration. "We then look at the areas of growth for the company and whether they create value through development or acquisitions," he adds.

Although franchise value may defy expression in numbers, many insist trying to measure it is beneficial and offers valuable insights. Like Brown, Sam Lieber, the CEO of New York City-based Alpine Management & Research, has tried to assign a number to the quality of REIT management.

"It's hard to quantify," he confesses. "We've tried to create a black box model and it didn't predict stock prices. But it did help us in our process of evaluating stocks and it provided a methodology in which to think about these issues and apply them at different times."

Certainly, there is no lack of appreciation for franchise value among REIT market participants. Over time, the winners and losers among REITs will be decided by the ability of the winners to enter new markets and create new value and growth opportunities that others cannot match, contends Peter Baccile. "That's franchise value," says the managing director and global head of real estate and lodging investment banking for JP MorganChase in New York City. "Over time, there will be some measure of franchise value in the trading levels of some companies.

"AvalonBay, Archstone-Smith and Post Properties have all recently made inroads into the New York City apartment market," he continues. "This isn't a market that's easy to enter. One could argue that the management teams in those companies are adding value above and beyond just buying and building real estate."

Underlying Value

Whether real estate stocks are trading at a premium or a discount to NAV requires knowledge of underlying value. Regardless of the criticisms, NAV assumes a vital role in this respect.

"The estimation of NAV is just a starting point for determining a warranted share price," Griswold maintains.

REIT share pricing reverts to the mean, or NAV, in the long term, research from Green Street Advisors confirms. In fact, the average discount or premium in the firm's coverage universe for the past 11 years has been about 0 percent. Recognizing when stock prices are at a premium or discount to NAV benefits investors.

"NAV is not a steady number that you can't exceed or have to maintain," Lieber says. "When prices are at a premium, we like to understand why to gauge whether NAVs should be going higher over the next few years or whether it's simply a market factor that's pushing prices."

Fick adds that if you look at history, stock prices have proven to return to the mean. "To the extent stock prices exceed NAV, it bears asking some questions," Fick says. "And to the extent that they are below NAV, it should indicate opportunity."

Judgment Call

Still, rendering an estimate of NAV is often a judgment call and differences exist between various analyst's NAV calculations and whether stocks are trading at a premium or a discount.

Bear Stearns, for instance, provides NAV estimates for 51 REITs. Through early August, 24 stocks were trading at a discount to NAV. Banc of America Securities also found 24 REITs trading at a discount, but that figure represents about 65 percent of the 37 firms in its coverage universe.

The firms' coverage universes overlap on 26 REITs. In nine instances, the firms disagree on whether the stocks are trading at a premium or discount. With such differences, how can NAV be useful at all in guiding investment decisions?

Morgan Stanley's Whyte says a range of NAV estimates exist in the same way a range of estimates appear for other financial metrics and it's important to consider the consensus of a range.

"We understand some of the shortcomings and know that when you are estimating NAV, you're within a range," Knudson adds. "But if I didn't have the resources backing me up that I have and I consulted Wall Street analysts' estimates, I'd have to decide which one to believe."

Although estimates of NAV fall within a range, they still have value as a benchmark. "We assess our estimates with other sources, but we do our own calculations," Brown says. "We calculate them ourselves because an important key for NAV is consistency in approach so that you can have comparability among REITs in the same property sector as well as REITs in different property sectors."

Whatever inaccuracies are inherent in NAV estimates, the metric still appears to be the most applicable in the REIT industry. "Every time anybody says NAV isn't exact, I say that there is always a tradeoff between precision and relevance," says George Yungmann, NAREIT's vice president of financial standards.