People outside real estate often treat property companies with suspicion. Partly because property companies are prone to blow themselves and others up, and partly because the language is unfamiliar.
(If you haven’t already read my post on how to value a property, you might want to start there first.)
REIT ≠ Property company
This starts from the whole class of property companies imprecisely being called ‘REITs’ when the term is really being used as a synecdoche.
Real Estate Investment Trusts (REITs) are a subset of property companies which benefit from favourable tax treatment. Typically they pay no corporation tax both on income and capital gains. In Europe, REITs represent the minority of property companies (~40% by market value). They typically have ‘REIT’ in their name but not always.
There are strict rules on what allows a company to qualify as a REIT to avoid abuse (e.g. requirement to distribute 90% of income, not closely held). Certain geographies across Europe have more developed REIT sectors than others which is a function of history and how relatively onerous the rules are (e.g. the UK has many and Germany few1 despite being of similar market size).
You may think no tax is always a good thing but there are two key disadvantages. The first is that while the REIT may be tax transparent, you are not - so you may just end up paying the tax rather than the REIT (e.g. REIT dividends in the UK are taxed at higher levels by their recipients). The second is that the rules restrict management teams in a way that can be value destructive (e.g. during Covid there was a lot of hand-wringing about how dividend suspension could fall foul of REIT status despite being the prudent thing to do).
EPRA is your friend
The European Public Real Estate Association (EPRA) is an industry body of which practically all publicly listed property companies are a member.
One of its key (and very helpful) roles is to devise standardised reporting metrics for property companies across Europe. This is driven by a recognition that IFRS accounting standards were designed for different purposes compared to what real estate investors would like to see. EPRA reporting is voluntary, but realistically is mandatory when all your peers report the same metrics (albeit not all metrics might be reported).
We’ll go through the main metrics in turn before applying them to a real property company.
EPRA Net Tangible Assets (NTA)
People intuitively understand that a lot of a property company’s value should be found in its balance sheet. They are often surprised to learn that this is not necessarily true in the US where all real estate is held at historical cost and depreciated. In Europe however properties are revalued by external valuers at each reporting date so the balance sheet should be an accurate reflection of current value.
EPRA NTA takes IFRS equity as reported in the balance sheet and makes a series of adjustments which are outlined in the middle column below2.
I won’t go through each of these but suffice to say EPRA is trying to remove the impact of any balance sheet items which are not ‘property like’. At its simplest, what you should be left with is an equity value representing the property value less net debt.
EPRA Earnings
Also know as Funds From Operations (FFO). Similar to EPRA NTA, this takes IFRS net income and adjusts for any items which are not ‘property like’ to get to a normalised operational earnings figure.
Key adjustments include removing revaluation and disposal gains/losses.
EPRA Net Initial Yield (NIY)
The income statement reflects earnings over a period of time. When valuing property this is not very relevant. What you really care about is the rent roll at any given time (or ‘run rate’ in corporate speak).
If you were to sell a property today nobody would care if it was vacant for 6 of the last 12 months that you owned it as long as you now have a lease in place, however the income statement would only show half that rent for the full-year period.
It’s for reasons such as this that property company earnings can be very misleading. EPRA NIY takes annualised cash rents as at the reporting date less expected direct property costs and divides this over the completed property portfolio value (excluding developments which do not generate rent). This produces a yield comparable to those in the private real estate market.
Putting it into practice
Now we know the metrics, we’ll apply it to a real example.
I’ve picked Target Healthcare REIT (THRL) only because it is a simple business. It owns 100 care homes across the UK which are let on long (26.8y average) leases to 33 different operators across the UK.
EPRA Net Tangible Assets (NTA)
THRL reported £644.5m IFRS equity at Dec-22 from which they deduct £5.4m interest rate derivatives3 to get to £639.1m EPRA NTA. Dividing this by the 620.2m shares in issue gets you 103p NTA per share.
However, the current share price is only 70p or a 32% discount to NTA. Why can you buy 103p of value for only 70p?
The simple answer is because the market does not believe believe the 103p of value. And to understand why not we need to move to our next metric.
EPRA Net Initial Yield (NIY)
THRL reported £55.5m annual cash rents plus £1.5m rent free periods leads to £57.0m total rent. This is divided by the £859.1m property book value plus £58.0m purchaser's costs4 for a total £917.1m to get to 6.2% NIY (or 6.6% cap rate if you exclude purchaser's costs).
The property book value is determined by external valuers. In the 6 months since their last results in Jun-22, the value of THRL’s portfolio has declined by 4.8% with NIY moving from 5.8% to 6.2%.
Property valuation is backward-looking. Professional valuers rely on comparable transactional evidence to determine their valuations. When the market moves fast (for example with the recent rate rises), it takes time for this to be evidenced in transactional data. Property company balance sheet valuations are therefore slow to move.
The less charitable also point out that valuers are paid by property companies and have often worked for them for decades. Valuers’ professional body (RICS) is consulting right now on whether to implement mandatory valuer rotation given these concerns.
Implicit in the share price is the market’s belief that the property book value remains too high. Put another way, if you wanted to sell the portfolio today the market believes nobody would pay a 6.6% cap rate.
If you take THRL’s current market cap of £435.0m and add net debt of £218.2m you get £653.2m Enterprise Value (EV). With rent of £57.0m you can see the market implied cap rate is 8.7%, or 2.1 percentage points higher than the book valuation.
The implied discount to Gross Asset Value (GAV) is 24% (being £653.2m EV / £859.1m property book value - 1). The discount to GAV will always be lower than the discount to NTA give the magnifying impact of leverage.
Discount to GAV is the more accurate metric to use in my view. A heavily indebted property company might trade at a very large discount to NAV, but by the time you get to discount to GAV this might be much smaller (given the debt is valued at par for the equity to have value).
You can hopefully now also see how you can apply your own cap rate assumption to get to an implied value. The market can often overreact and if your view is that 8.7% cap rate is excessive, you may want to buy5.
EPRA Earnings
THRL reported adjusted EPRA earnings of 3.01p per share. I start from a place of scepticism for any adjustments to EPRA, but I agree with THRL’s adjustments here not least because they lead to lower earnings than the 3.89p per share under EPRA6.
The 3.01p is only for a half-year so if you annualise this to 6.02p and divide into the 70p share price you get an earnings or FFO yield of 8.6%.
The dividend is 5.60p per share or an 8.0% dividend yield which is typical of the ~90% of earnings REITs are required to distribute.
To conclude…
We’ve taken a pretty simple property company as an example here. The more complex the business the more wrinkles you need to adjust for.
To take one example, property companies often have joint ventures / associates where they own 50% or less of the equity in a property owning vehicle. They do this as a way of raising capital on which they also earn management fees. Under IFRS these are equity accounted which can lead to a misleading picture, particularly of leverage. Investors therefore adjust metrics to be on a proportionally consolidated or ‘look-through’ basis, or the property company will often separately report this way themselves.
This will be for another post, but once you appreciate the lens through which property companies are judged you can begin to understand how management might behave and what levers they can pull. For example, management teams will often announce disposals “at book value” to much fanfare when they are trading at a discount as a ‘we told you so’ to the market. Any property company trading at a discount will also find it very difficult to raise equity as it is dilutive for existing shareholders - that can leave property companies stuck in a rut.
The above few key metrics will cover the majority of what drives value so don’t be put off by the complexity. If in doubt, remember it’s just a bunch of properties.
To give you an idea of how cumbersome the German REIT rules are, they state that no single owner is permitted to hold more than 10% ownership. However, if an owner of 50% splits this across 5 vehicles owning 10% each this is within the rules. It is also very odd to have a rule over which the REIT has no control (i.e. the REIT cannot stop somebody buying >10% in the open market leading to loss of REIT status).
Taken from the EPRA guidelines found here. You’ll see EPRA Net Reinstatement Value (NRV) and Net Disposal Value (NDV) are also shown in the table. They are trying to reflect different purposes as explained in the guidelines but NTA is what the market focuses on.
Target has £70m of interest rate hedges struck when rates were lower. Given rates have risen, they now have a positive mark-to-market. This is removed from EPRA NTA as it is not ‘property like’ and a property company is not in the business of making money from rate speculation.
As explained in how to value a property (and you will also spot that I’m technically using Topped-up NIY as it includes rent frees).
This is obviously very simplistic and you would want to consider alongside other metrics, sector dynamics, rent sustainability, management team, relative value etc.
THRL are removing the benefit of future guaranteed rental uplifts which have to be recognised earlier on a straight-line basis under IFRS, and removing interest income they receive for forward-funded developments which is not part of core earnings.