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moneysense.ca, 14/11/07
Fair Value of REITs
In an earlier post on REITs, I quoted from David Swenson’s book that the price of publicly traded REITs fluctuates between a premium to a discount to fair value. Obviously, investors would like to invest in or add to their positions in REITs when they trade at a discount to fair value.
To compute the fair value of a REIT, you would need to add up the value of the land and buildings that it owns and subtract its debt obligations, which isn’t an easy exercise. However, if you have access to TD Waterhouse, search for the TDSI Morning Action Notes for the REIT you are interested in. The analyst reports helpfully include a NAVPU (Net Asset Value Per Unit), which you can use as an approximation for fair value. For instance, the report on RioCan REIT estimates the NAV at $23.10, suggesting that RioCan is currently trading at a modest discount. At its current price, RioCan (REI.UN) is yielding 6.25% representing a 2% spread relative to current 10-year bonds. Since I did not have any exposure to REITs, I picked up some units last week but still far from my 5% target allocation.
moneysense.ca, 14/11/07
I also plan on having 5% eventually but I just haven’t added it yet. Thanks for doing the research for me, maybe now is as good a time as any then.
You forgot to mention one more factor in the complicated calculation of the so-called fair value of a REIT… You forgot to consider the credit quality of the REIT’s tenants. That has to be carefully considered whether you’re considering a REIT containing apartments (typically 1-yr leases, credit quality depends upon the tenants who live there) as compared to say a Government office building, with a 20-yr lease. In between those two extremes you have Retail and Office spaces containing businesses of varying credit qualities and lease lengths. Most REITs include in their annual report some footnote discussing the quality of their tenants.
For me personally, I am trying to pick up REITs tenanted by supermarkets, drugstores and other relatively recession-proof businesses. After all, if you’re hungry or are sick, it doesn’t really matter to you what the economy is doing, you’re going to buy food and medicine.
I think that the credit quality of the tenants of the REITs should be factored into the value of the properties owned by the REIT so as long as the properties are properly valued then it should already be included in the NAV of the REIT.
I also picked up some RioCan last week (and watched it sink even lower after I bought it). There were a bunch of REITs on sale last week but they all seem to have slightly recovered. My target allocation for REITs is 10% and I am just over 4% now (last week’s RioCan purchase was my first entry into REITs).
Dave: Not sure if this is the best time but I thought a 10% discount is okay, not a screaming buy. Of course, it could get even cheaper but I’ll just add to my holdings then.
Phil, 0xCC: Not sure how you’ll factor credit quality into NAV. NAV is simply the current value of land and buildings less outstanding debt. However, I would want a bigger discount to NAV and a larger spread over 10-year Canada bonds for lower quality REITs.
It’s exactly the same thing the USA is going through with regards to their mortgage debt. If you loan $250K to someone who doesn’t have the capability to pay it back, then do you still value your loan at $250K? Most of the banks down there now have to write down the value of their mortgages because people are walking away from their homes.
The same general rule applies when you’re evaluating the credit quality of a REIT’s tenants. For a tenant who is 25% likely (high risk) to default, go bankrupt, break the lease or whatever, then that income from that tenant should be written down by 25%.
Suffice it to say that REITs with high credit quality tenants in long term leases are much better than either poor credit quality tenants or tenants in short term leases. Many investment advisors on BNN, for example, don’t like the hotel REITs because their tenant’s lease terms are measured in days, not years.
We’re probably splitting hairs here but I don’t see how you’ll write down the value of a property because a client didn’t pay the lease. The way I see it, if I own a rental property and a client didn’t pay the rent, why would I discount the value of the property? The owner would evict the client and get new renters, the risk of which is partly reflected in the discount over the risk-free rate. But, if I lend money to someone and only expect 50% of it back, I’d definitely write down the value of the loan by 50%.
Keep in mind that shares of a real estate company is not the same as owning real estate, like your house. A REIT is still a business like every other business and it is concerned about cash flow. If they have empty properties, it’s not generating revenues which means that the mortgage owing is not getting paid down (not keeping up with the amortization) and hence the debt side goes up and the net asset value goes down. Would you rather invest in a REIT that has 10 million square feet of space that is rented out, or 10 million square feet of vacant space? If the REIT holds, for example, 100,000 sq ft of industrial space in suburban Winnipeg, would it really be that easy to kick out the renter and find another business to occupy that space?
I am not an accountant but bad tenants/uncollected rent would probably go towards reducing the capitalization rate of that particular property and the REIT’s ability to continue its distribution. NAV is measured traditionally by the book value of assets minus liabilities which is not affected directly by the capitalization rate (which would affect the market value of the asset) and is more of a measure of the share price in the REIT context.
Both are equally important but probably for different reasons.
TMV: The NAV quoted in the analyst report uses current FMV of properties, not the book value but otherwise my understanding of NAV and cap rates is the same as yours.
Phil: I understand your point and that could very well be the reason why REITs sometimes trade at significant discounts to NAV (investors are expecting future NAVs to fall). I’m hoping that a 2% spread over the risk-free rate AND a discount to current NAV gives me a reasonable margin of safety.
I think many of these comments show the real reason its hard to invest in REITs… why valuation method is the best to use? The assets may be worth more than the stock trades for, but the company may not be making as much money as it should be… (poorly run?).
I do like Income Trusts and REITs will live while the average Income Trust will cease to exist… I’ve done particularily well with Northern Property a few years ago. It was 100% leased with long term government contracts and its dividend yield was above 10% if I remember correctly. Either way, the dividends continue to flow and the unit price is doubled.
I’m having trouble with this NAVPU.
I took RIOCAN total Assets – total liabilities = 1798000000
NAV = 1798000000
units outstanding = 220000000
NAV/Units out = $8.1
well below current market???
Is riocan very overpriced or am I calculating wrong?
James
James: The numbers you are using are the book value of RioCan’s properties. The NAVs estimated by analysts are a better reflection of actual market values of the properties. My understanding is that analysts use price per square foot of comparable properties that were sold recently to arrive at a market value of RioCan’s properties.
I don’t have acces to the TDSI newsletter, do you know what they are quoting the current NAVPU at for rei.un?
James
James: According to the TD Newcrest report of July 30, 2008, RioCan’s NAVPU is estimated at $21.40, roughly what it is trading at right now.
Thanks, BTW love your site. I’ve been one of your regular readers for quite some time. Always great content.
James
I bought $ 19000 gold stocks in 1987 they are now worth $ 485ooo. I have not sold. Buy when when they are under valed I think every one should have a little gold.