REIT selection and valuation

JC Project Freedom What is a REIT

How can you select a REIT?

From a top down approach, analyse and decide which country, sector and real estate asset class you would like to invest in based on the macro environmental conditions and your risk profile and time horizon.

Consider the risks associated with REIT and whether it is in line with your own risk appetite. In particular, the gearing ratio can indicate default risk. This can be simply calculated by dividing a REIT’s total borrowings with its total assets. This information may not be readily available, but a proxy would be debt to equity ratio (D/E).

Consider liquidity, profitability based on real estates, and pricing using various parameters which are readily available on SGX website.

  • Market Capitalization gives you an idea on how big the REIT’s portfolio
  • EBITDA allows us to evaluate the REIT’s pre-tax operating performance without regard to the REIT’s capital structure.

Price to earnings (P/E) and Price to Book (P/B) tells us whether the REIT is overpriced. However do bear in mind that earnings is a more important number rather strictly the P/E ratio. Do bear in mind that comparisons across different REITs in different sectors and geographical locations may not be an apple to apple comparison.

Valuation of REIT

Valuing a REIT generally follows the concept of valuing stocks (for example P/E ratio, NAV, discounted cash flow and for REITs using the capitalization rate).

1 – Yield Based Method

Since investors are looking for steady cash flows from REITs, it is common to compare the yields of different REITs just as bond investors do. However the difficulty lies in different REITs having different property tenures, operating in different countries or sectors, or having different leverage ratios. This results in comparisons which may not fully reflect all the risks.

The best way is to compare against a risk free rate. Analysts generally use the fixed deposit rate or the Singapore government bond yields over the same tenure as the risk free rate since they are deemed very safe.

Investors naturally demand a higher rate of interest from REITs compared to the Singapore government bonds because of their higher risk. The risk premium depends on how safe the investors’ perception of the REIT is, based on factors like portfolio exposure, earnings resilience, leverage ratio and the quality of management.

2 – Net Asset Value Method

Another method used to value REITs is based on the Net Asset Value (NAV). This is the estimated market value of a REIT’s total assets minus value of all liabilities. MAS requires all the properties to be valued by a professional valuer on a yearly basis.

For share price comparison of different REITs, we divided NAV by the number of units outstanding to arrive at the net asset value per unit.

3 – Capitalization Rate

The capitalization rate for real estate is derived by dividing the net operating income by the capital cost to determine its value.

For instance, if a property generates a net operating income of $70m and the property is valued at $1bn, then the capitalization rate is 7%.

There is an inverse relationship between the valuation and the cap rate. In other words, the higher the cap rate, the lower the valuation of the property.

4 – Discounted Cash Flow Method (DCF)

The DCF method involves estimating the future rental income streams over the years and discounting the back to present value at an appropriate rate of return.

The challenge is that rental income over the years may be difficult to estimate and establishing the desired rate of return may also be difficult, especially for the general public.

Use simplified = Expected Dividend/(r – g)

For instance, expected dividend is $3, r is 10% and g is 4%, we will get $50. If the REIT is trading at $40, there is value.

To have basic understanding on REIT, refer to here.

To have understanding on selection on REIT, refer to here.

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