Compounding Errors

If you make a mistake early enough in a multi-step mathematical problem, the error compounds at each step. By the time you reach your solution, it’s been so distorted it makes little sense. We see this phenomenon in action now in the commercial real industry, where early inputs into value computations are currently flawed. In today’s newsletter we explore how this can lead to capital market values that look only half as big through some accepted methods compared with others.

Predictable long-term leases are a pillar of the commercial real estate industry going back centuries. Market Valuations are essentially the sum value of these long-term leases, which in turn are the foundation for much of the industry’s workings.

A seller might get a Market Valuation to determine the sale price for a property that is filled with long-term leases. Believing they can add value to the Market Value by improving the rent roll, a REIT may decide to purchase that building. The same REITs auditors will get a Market Valuation to inform their financial statements which, in turn, are used by the capital markets to value the REIT.

But what if a rent roll is no longer made up of predictable, long-term leases? What if the Market Valuation is wrong? 

Abstraction

The word ‘Value’ can mean many different things in real estate. There is Use Value (value to a specific user) and Public Interest Value (value when the best use is a non-economic use like a public park).

Investment Value is the value to a specific investor and factoring in their individual situation. While two investors may have the same assumptions on a property’s returns, they may have differing tax situations, costs of capital, internal costs or access to financing, making the property more valuable to one investor than the other.

Ultimately, what investors are valuing is a property’s profits, generated by earning rents from their tenants.

In most real estate contexts, the term value refers to the Market Value of a property which is the most probable sale price in a ‘fair market’. Since in most cases commercial real estate investors are purchasing the income stream from a property, the Market Valuation is an abstraction of the Investment Valuation, which in turn is an abstraction of the property’s profit from lease revenue. 

Abstraction of an Abstraction

Market Valuations are important tools for reporting financial results to investors in the capital markets who use them to determine the value of the securities holding the real estate–the already abstracted Market Valuation is then abstracted again.

For example, REITs engage valuers to determine the Market Valuations of their properties. The Market Valuations find their way into financial statements in two ways - firstly they are factored into a REITs balance sheet and secondly any changes to the valuations between periods are booked as income (or losses) on the REITs Income Statement.

The nature of a REITs business means that Market Valuations have a huge impact on a REIT’s financials. In 2022, the Market Value of the investment properties fully owned by Great Portland Estate made up approximately 80% of the REIT’s assets and positive movement in Market Valuations was the source of almost half of Land Securities profit for the year.

Capital market analysts, whose job it is to provide guidance to investors on the value of REITs, typically use a combination of three models when determining the expected future value of real estate securities:

• Asset based models such as the Net Asset Value (NAV) per unit
• Earnings (to the REIT) based models such as the Earnings Yield
• Income (to the investor) based models such as Dividend Yield

REITs which hold similar underlying properties can be benchmarked against each other. 

For example in 2021, UK office REITs traded at an average of:

• 85.48% of the European Public Real Estate Association (EPRA) NAV, 
• 3.19% EPRA Earnings yield, and
• 2.53% yield on distributions.

Historically the outputs for each of these valuation methodologies for real estate securities have moved in tandem with each other. REITs must earn the majority of their income from real estate and must also distribute the majority of their earnings to their investors. So if a REIT’s properties earn more income, distributions must increase and, all else being equal, the underlying properties must have also increased.

Exposing the Mathematics Error

But what if income was to increase by adding flexible leases, but valuations remained the same?

As a thought experiment let’s launch Flex REIT, a new entrant into the London market in the first half of 2021. Flex REIT will still utilize traditional leasing, but it will implement a flexible leasing strategy, providing tenants with access to swing space. The strategy is a success–Flex REIT earns premium rents, both with the flexible space and the traditionally leased space, resulting in a 25% increase in NOI.

Understandably the external valuers are cautious–they decided that Flex REITs leasing strategy was risky, so they provided Market Valuations for the portfolio as if the properties were leased traditionally. How would this information be digested by the capital markets?

The underlying Net Asset Value would remain the same since valuations haven’t moved–but there has been an increase in earnings. And to keep their REIT status, Flex REIT has to increase their distributions to their investors.

Based on the ratios from the other UK Office REITs, the capital market analyst would have diverging predictions. 

The sum total of the portfolio, valued as private direct real estate holdings, would be £2,000 million. Factoring in a leverage ratio of 32%, the portfolio would be worth £1,360 million.  

The Earnings and Dividends methods would produce very similar results with REIT values of £2,403 million and £2,396 million. However the NAV method would produce a market capitalization of only £1,163 million.

A 25% premium in earnings creates a huge discrepancy in predicted market capitalizations such that the NAV method becomes less than half of the other valuation methods!

Correcting the Mathematics Error

Modern capital markets are incredibly efficient at matching investors with opportunities that fit their risk profile, but those capital markets need the right information to do that job properly.

In reality, the capital markets wouldn’t simply apply the benchmark ratios to Flex REIT–they would recognize that they’re trying to compare apples to oranges. The market may decide that Flex REIT’s dividends and earnings are more risky than traditional office REITs and therefore should trade at a lower ratio. 

But even then, it is doubtful that Flex REIT would trade as low as what the NAV method suggests. The NAV method creates implied yields that reflect riskier industries than commercial real estate such as Pharmaceuticals, Insurance, Oil & Gas, Retail and Media. While the commercial real estate industry is facing some strong headwinds, it would be hard to argue that the long-term risks from asset backed flexible leasing is greater than the Oil & Gas industry.

The fundamental issue, the initial mistake in the mathematics problem, is that the industry has historically been built around long-term leases. But demand has fundamentally changed and the universe of leasing strategies has widened. The current Market Valuation models need to adjust with the new reality. 

What is missing from the equation is a measure of risk.  If each set of REIT financial statements included a measure of risk, the capital markets would be able to properly compare REITs against each other, matching the right investors with each REIT. Unfortunately, until Market Valuations change, REITs and other landlords are hemmed in–playing a game where they are benchmarked against a reality that is eroding in real-time. And until REITs and landlords choose to stop playing the dying game, they’re at risk of getting squeezed out of the market.