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Time to change the way we look at Reits
Changing market conditions call for changing valuation methodologies
IC - Published on November 6, 2024
by Natasha Voase
The property sector has always liked to do things differently. While other sectors debate price/earnings ratios and enterprise value to Ebitda, real estate investors wax lyrical about discounts to net asset value (NAV) and loan-to-value (LTV).
This approach made sense in the old world of declining yields and interest rates, says Tim Leckie, an analyst at Panmure Liberum. Falling rates meant shifts in portfolio valuation were a large component of returns. But now that rates are higher and valuations unsteady, Leckie says the focus must be on cash flow generation. Reits need to be able to generate enough cash to pay down increased interest costs and grow. For the low-yielding, low-risk portfolios of times gone by, this is a problem.
Yet for Reits, just as when it comes to valuing companies more generally, no valuation metric should be taken in isolation.
Harm Meijer, managing director and co-founder of real estate fund manager ICAMAP, says that this is why investors need to look at multiple valuation metrics, including net debt to Ebitda, funds from operations (FFO) yields and price/earnings ratios. "Every ratio metric has its drawbacks," Meijer says. "Because if [for example] you only look at the cash flow... the problem is you can really increase your FFO by just taking on more leverage, by buying assets."
Analysts at Panmure Liberum have created what they call the Medium Term Sustainable Earnings (MTSE) metric, a seven-year figure encapsulating reversionary potential, administration costs and refinancing drag. The MTSE total return blends yield plus growth to give investors an idea of what their medium-term cash earnings per share might be. The chart below shows the result of those calculations, albeit outliers such as Grainger's estimated growth rate should be treated with caution. With that in mind, the stocks that stand out: Sirius Real Estate (SRE), Urban Logistics Reit (SHED), Segro (SGRO), CLS Holdings (CLI) and Life Science Reit (LABS).
Analysing Reits through the lens of cash flow throws up some new names that look mispriced. Discounts to NAV alone might encourage investors to buy giants such as British Land (BLND) and Land Securities (LAND), given their discounts sit at around 30 per cent. However, from a forward-looking price/earnings perspective, they trade at 13.6 and 12.1 times, respectively, implying earnings per share of 41p and 71p. Even if investors favour Epra EPS of 42p and 50p, respectively, these valuations look fair or potentially a little high. |
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