Sunday, 8 September 2013

Cash Over Valuation for REITs

Price-to-Book (P/B) ratio is actually a measure of cash over valuation (COV). Since no buyers like to pay high COV for properties, should REITs be treated the same way? This question has baffled me for some time, and my position has shifted a couple of times. Let us try to tackle this question by understanding why shares can trade above book value and whether the same arguments apply to REITs.

Why Shares Can Have COV

Shares typically trade at a P/B ratio greater than 1. The main reason is because the assets bear very little relation to the earnings power of the company. A company can have very little assets but have considerable earnings power due to its brand value, intellectual properties and/or favourable regulations. As these factors are considered intangible, they cannot be included as assets in the balance sheet (unless they are taken over by another company, after which these intangible assets become reflected as "goodwill" in the new company's balance sheet). However, these intangible assets have real earnings power, which allows the share price to be higher than the book value.

Another reason why shares trade above the book value is because the assets are depreciated annually but seldom revalued. For example, a company might own the land on which it is sited. The land might appreciate in value over time, but the value of the land in the balance sheet is reflected at historical cost, which could be just a fraction of the prevailing land value. Investors who understand this would price the shares higher than the book value.

Since the subject of this topic is REITs, the shares that bear the closest relation to REITs are that of property developer/ holding companies and hotels. Interestingly, property shares generally trade below their book value. Examples of property developers are Capitaland (0.9x), City Dev (1.2x), Keppel Land (0.8x), UOL (0.8x) and Wing Tai (0.6x). Examples of property holding companies are Bonvests (0.6x), GLP (1.3x) and Hong Fok (0.4x).

Why REITs Should Not Have COV

Having understood the reasons why share prices can exceed book value, we can now review whether the same arguments hold for REITs. The assets of REITs are mostly properties. While they are allowed to engage in some property development that might lead to increased future earnings, their core business must be in holding and leasing out properties. Therefore, the earnings power (i.e. rental income) are closely tied to the assets. Unlike shares, REITs value their properties on a regular basis. Any increase in rental income will translate to increased valuation and is reflected in the balance sheet on an almost annual basis. Hence, the book value reflects the prevailing value of the assets.

On brand value, while some properties are more desirable than others, this is reflected in the rental income and eventually the book value. Nevertheless, there could be some premium attached to the sponsor company of the REITs. This will be discussed further in the next section.

On management skills, while REITs have engaged in Asset Enhancement Initiatives (AEIs) to enhance the rental income of their properties, the increase in rental income is relatively small compared to the overall portfolio and should not confer a major premium over the book value.

Why REITs Can Have COV

As mentioned in the earlier section, there is some brand value in having a strong sponsor company for the REIT. Firstly, the sponsor company could have the financial strength to support the REIT during a difficult period. This is evident during the Global Financial Crisis when many REITs faced difficulties in refinancing their loans. REITs with strong sponsors generally fared better than REITs that do not. Secondly, the REIT may have a right-of-first-refusal over the sponsor company's properties, which could generate a pipeline of yield-accretive acquisitions for the REIT. Investors who like the pipeline of potential acquisitions and its impact on future earnings will have to pay a premium for this REIT.

Perhaps the biggest reason why REITs can have COV lies in the differences valuation is carried out for physical properties and financial assets. For properties, valuers would consider the prices of similar properties and/or compute the discounted cashflow of the rental income that the property can bring. The asset value thus computed, minus the debt, becomes the book value. Property valuers are limited to similar properties in this valuation. However, for financial assets, investors can compare across all asset classes (shares, bonds, commodities, etc.). The discount rate that valuers and investors use to value the income stream of the property is thus different and can lead to different asset values.


REITs can have COV because of different discount rates adopted by property valuers and financial asset investors. However, the COV for REITs should never be as high as those for shares, as assets for REITs are mostly tangible properties and the valuations are updated regularly. It is always safe not to pay a high COV for REITs.

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