ALT 3 – Investments in Real Estate through Publicly Traded Securities

Real estate used to be an asset class for the very largest investors only. Buying a shopping centre or an office tower directly requires capital in the tens or hundreds of millions, specialist operating knowledge and a willingness to hold an illiquid position for years. Securitisation changed that. By packaging property ownership and property lending into exchange-traded shares and bonds, the market made an entire asset class reachable by investors of any size.

Three families of security dominate the listed market, but they sort into only two economic camps. An equity REIT and a real estate operating company both give the holder an equity claim on buildings. A mortgage REIT sits with mortgage-backed securities instead, because it makes or buys loans rather than owning property, so it gives the holder a debt claim on mortgages secured by buildings.

Real estate investment trusts

A real estate investment trust owns, finances and, within limits, develops income-producing property across a range of sectors. What separates a REIT from an ordinary property company is a bargain with the tax authorities: the entity accepts a set of qualification rules, the most visible of which is an obligation to distribute most of its taxable income, and in exchange it escapes tax at the entity level. In most jurisdictions this works either by allowing dividends paid to be deducted from income, which drives taxable income close to zero, or by exempting qualifying REITs from corporate income tax outright. Most REITs are required to pay out 90% to 100% of taxable income to shareholders.

REITs divide into two economically different groups. An equity REIT owns buildings and collects rent. A mortgage REIT makes or buys loans secured on real estate and collects interest. The valuation tools in this reading are built around equity REITs, because their earnings come from property operations rather than from a spread on lending.

Real estate operating companies

A real estate operating company is an ordinary taxable property company. It pays corporate income tax like any other business, and in return it faces none of the REIT restrictions. A property business ends up structured as a REOC rather than a REIT for one of three reasons: it operates in a country that has no tax-advantaged REIT regime; it does a large amount of development of property built for sale rather than for rent; or it earns significant income from activities that would not qualify under REIT rules, such as brokerage or managing property owned by third parties.

Mortgage-backed securities

Mortgage-backed securities are securitised debt obligations that pass through the cash flows of a pool of mortgage loans. Where the underlying loans are secured on homes, the security is a residential mortgage-backed security. Where they are secured on income-producing commercial property, it is a commercial mortgage-backed security. The two differ sharply in granularity. A residential pool commonly contains thousands of individual loans, so its behaviour is statistical. A commercial pool typically holds somewhere between about 100 loans and, where a single asset is very large, as few as one loan, so its behaviour is driven by the credit of a small number of named borrowers and buildings.

It is easy to overstate the size of the listed equity market. The market value of real estate debt securities, and of RMBS in particular, greatly exceeds the market capitalisation of publicly traded real estate equity securities. Alongside the listed market sits a substantial private one: private REITs, private REOCs, privately held mortgages, private debt issues and bank debt. Many private equity partnerships in real estate set up a private REIT as the vehicle that actually holds their income-producing buildings.

A REIT is best understood as a conduit. Rent flows in at the bottom, passes through the entity without being taxed there, and flows out to shareholders as dividends. Most REITs are organised as corporations or as trusts. The conduit treatment is not free, and the price is a long list of qualification requirements.

What a company must do to qualify

Three requirements appear in most countries that operate a REIT regime. A qualifying company must:

• distribute 90% to 100% of its otherwise taxable earnings;
• hold at least 75% of its assets in real estate; and
• take at least 75% of its income from rental income on real estate or from interest on mortgages.

Individual countries add their own conditions on top. Common additions include a minimum number of shareholders, a cap on how much of the company one shareholder may own, a minimum number of properties or a limit on how concentrated the asset base may be, a ceiling on non-rental income, a limit on development activity, and restrictions on leverage and on the kinds of loans that may be held. In the United States a REIT must have at least 100 shareholders, and no five or fewer shareholders may together own more than 50% of the shares, a condition known as the 5/50 rule. Taken together these restrictions do real work: they make it effectively impossible for one person or a small group to wrap a single building in a REIT and collect the tax benefit.

Internal against external management

Most REITs in the United States are self-managed and self-advised. Senior executives are employees of the company itself and report to a board of directors or a board of trustees elected by shareholders. This fully integrated model tends to generate fewer conflicts of interest than the alternative.

An externally managed REIT pays asset management fees to a third-party adviser. If those fees are calculated on total assets, the adviser has a direct financial interest in making the REIT larger, whether or not growth is in the shareholders’ interest. External managers may also arrange for the REIT to pay affiliates of the manager for property management, for acquisition services and for arranging debt. None of this is necessarily abusive, but each fee is a place where the interests of the manager and the interests of the shareholder can separate, and an analyst should price that risk.

How large the listed market is and where it sits

Close to 40 countries now have REITs or REIT-like structures in place, and more are considering them. The asset class reached a symbolic milestone in 2016, when REITs were given their own Global Industry Classification Standard sector in the S&P 500 Index. The tables below show how the developed-market listed real estate equity universe was distributed as of 30 September 2022.

Based on data from the FTSE EPRA Nareit Developed Index. The four regional shares sum to 100.0.

Twelve entries, including the residual, which together account for 100.0 of market value.

The structural split is the more interesting of the two tables. In North America 98% of listed real estate equity value sits inside REITs, against 41% in Europe and 49% in Asia Pacific. The explanation is tax: the REIT regime in North America is more favourable relative to the alternative than it is elsewhere, so almost every company that can qualify does. In Europe and Asia Pacific the REOC structure remains the majority form. Anyone comparing a North American company with a European one is therefore often comparing two different tax animals, and the comparison has to be made after tax, not before it.

Underneath the structural detail, income-producing real estate offers two durable attractions as an asset class. The revenue is contractual, because it comes from leases, which makes it more stable than most corporate earnings. And over long horizons rents tend to move with the general price level, which gives the asset class a measure of inflation protection that fixed nominal cash flows do not have.

Set a REIT share against direct ownership of a building and a clear pattern emerges. The listed vehicle wins on access, information and diversification. It loses on control, on retained capital and, awkwardly, on the very diversification benefit that investors often buy real estate for in the first place.

What the listed structure gives an investor

• Liquidity. Shares in almost any quantity can be bought and sold on a major exchange during trading hours.
• Transparency. Prices and past transactions are published and continuously observable.
• Diversification of the property holdings. A single share buys a spread across property types, geographies and tenant credits that no individual building can offer.
• Portfolio quality. Many listed companies own good assets in leading markets, the kind of buildings that rarely come to a small private buyer.
• Professional management at scale. Executive teams oversee dedicated property management operations, and size brings economies in leasing, purchasing and financing.
• Income that can be steady. Well-occupied buildings on long leases produce predictable property income, and some vehicles distribute it monthly.
• Single taxation. The REIT and passthrough structures avoid tax at the entity level, so only the investor is taxed, on the dividend received.

What it takes away

• Almost no retained earnings. Paying out 90% or more of earnings leaves very little internally generated capital, so growth has to be funded by returning to the capital markets. The faster a REIT wants to expand, the more often it must raise money, and the more its shareholders are exposed to whatever the market will pay on the day.
• The cost of being listed. Maintaining a public corporate structure and satisfying regulatory filing requirements is a permanent overhead.
• Weaker diversification for the overall portfolio. Because the shares trade on a stock exchange, their price is set partly by equity market movements and by market liquidity rather than purely by the value of the buildings. That raises the correlation with the rest of an equity portfolio and reduces the diversification benefit relative to holding private real estate.
• Limits on what may be owned. Qualification rules restrict the asset base. This is why many REITs create taxable REIT subsidiaries, which pay ordinary income tax on earnings from activities that would not qualify, such as merchant development or managing property for third parties.

What an analyst actually examines

Judging the investment merits of a REIT means working at two levels at once. At the macro level the analyst studies the drivers of demand for space: general economic activity, retail sales, job creation, population growth, and the balance between new supply and demand for the specific type of space the company owns. At the company level the questions become concrete: occupancy levels, current leasing activity, rental rates achieved, the remaining term on the lease book, how far in-place rents sit below or above market rents, what it costs to maintain space and to re-let it when a tenant leaves, the financial health of the tenants and how concentrated the rent roll is among a few of them, financial leverage, when debt matures and what it costs, and the quality of management and of governance.

Most of these are not accounting items. They come from supplemental disclosure packages and from the analyst’s own market work, which is one reason listed real estate analysis rewards sector specialists.

Every valuation approach in this reading exists because reported balance sheet values for property are often close to meaningless as a measure of what the property is worth. Whether that is true depends entirely on which accounting model the company applies.

The choice under IFRS

Under International Financial Reporting Standards a company may value investment property using either a cost model or a fair value model.

• The cost model is the same model used for property, plant and equipment: purchase price plus capitalised additions less accumulated depreciation.
• The fair value model carries the asset at fair value and runs every change in that value through net income. A company may only use it if it can determine fair value reliably on a continuing basis.

The choice is meant to be sticky. A company must apply its chosen model consistently across all of its investment property. Once the fair value model is adopted for a property, it must be kept until the property is disposed of or its use changes so that it is no longer investment property, for example because it becomes owner-occupied or moves into inventory. The company must continue with fair value even if comparable transactions used to estimate that value become scarce.

Investment property is shown as a separate balance sheet line, and the company must disclose which model it uses. A fair value reporter must explain how fair value was determined and provide a reconciliation between the opening and closing carrying amounts. A cost reporter must disclose the depreciation method and the useful lives assumed, and must also disclose the fair value of the investment property even though it is not carried at that value.

The position under US GAAP

Most US property owners apply historical cost accounting, which carries an asset at its original purchase price plus capital investment less accumulated depreciation. Where operating income, asset prices or the general price level move significantly, this measure drifts a long way from economic reality. The distortion runs in two directions at once:

1. Carrying values on long-held assets are understated, because buildings held for many years have often appreciated, whether through general inflation or through property-specific improvement in the location.
2. Depreciation is overstated where a company uses accelerated methods, which depresses reported earnings relative to the economic income the property actually generates.

This is the reason the two headline measures of a listed property company diverge so widely. Book value per share, which in this reading means the depreciated real estate value rather than total shareholders’ equity per share, rests on reported accounting numbers. Net asset value per share rests on market values for the assets. Where fair value accounting is used, the two can be close. Where historical cost accounting is used, book value per share is generally not a relevant valuation input at all, and NAVPS is the market-based measure that matters.

Net asset value per share is the difference between a property company’s assets and its liabilities, everything taken at current market values rather than accounting book values, divided by shares outstanding. It is the fundamental benchmark of what a REIT or REOC is worth, and it is a better measure of net worth than historical book value per share. In Europe and Asia the price-to-NAV multiple is the primary tool analysts use on real estate companies; US analysts more often lead with multiples of gross cash flow.

Real estate net asset value is normally the largest single component of the intrinsic value of a REIT or REOC, but it is not the whole of it. A complete NAVPS estimate should also pick up the value of income streams that do not come from owning assets, such as fee or management income; the value of non-property assets, cash included; a deduction for any contingent liabilities; and the value that the management team itself adds.

Starting from net operating income

Where a company reports under IFRS at fair value, appraisals may already exist and the analyst can start from them. Where appraisals are unavailable, or where the analyst disagrees with the assumptions or the methodology behind them, the standard route is to capitalise the rental stream. The rental stream is measured by net operating income.

What is deliberately left out of NOI matters as much as what is included. NOI is struck before interest expense, before income taxes at every level, and before depreciation and amortisation. It is therefore the property equivalent of earnings before interest and taxes: a measure of what the buildings earn, independent of how they happen to be financed.

Capitalising that income gives an asset value. The capitalisation rate is the current required return on income streams of that risk, and it is read out of recent transactions in comparable buildings.

Cleaning the balance sheet

The estimated property value replaces the book value of the buildings on the balance sheet. Related accounting assets, capitalised leases among them, must be adjusted at the same time so that the same economic value is not counted twice. On the asset side, goodwill, deferred financing expenses and deferred tax assets are generally struck out, leaving a hard economic value for total assets. On the liability side, the face value of debt is replaced by market value where the two differ materially, which typically happens after a large move in interest rates, and soft liabilities such as deferred tax liabilities are removed because they are accounting provisions rather than economic obligations.

The resulting figure is calculated before any income or capital gains tax that might fall due if the assets were sold. That is a considered choice rather than an oversight. Nobody can predict how a company or its assets would actually be disposed of, and in an acquisition the portfolio may well be kept intact, so investors treat the pre-tax asset value as the primary benchmark. A company that has held assets for a very long time and has almost no remaining depreciable base for tax purposes does present a genuine issue, but quantifying it requires knowledge of the tax position and strategy of a hypothetical buyer, which the analyst does not have.

A number is only as good as the market that produced it. NAVPS can be estimated with confidence when property transactions are frequent enough to supply comparables. Investors observe how similar buildings trade, either on price per square foot or on capitalisation rate, which is simply net operating income divided by total value. Brokers and private research firms track rents by property and the incentives being offered, such as rent-free periods or capital contributions towards fitting out space, and those observations are then applied to the assets of a listed company.

The depth of that observable market varies enormously by country. As of 2022, publicly traded REITs held 12% of commercial real estate in the United States. In Europe only 4% of the commercial market was owned by listed real estate companies, whether REITs or REOCs, while in Singapore the listed share reached 30%.

Three ways NAV is calculated

1. Apply a capitalisation rate to the NOI of a property or of a portfolio.
2. Apply a value per square foot, or per unit, to a property or portfolio.
3. Use appraised values disclosed in the company’s own financial statements, adjusted by the analyst where the underlying assumptions look wrong and where there is enough information to make the adjustment.

The first two methods look like shortcuts, and in a sense they are, but they are shortcuts through someone else’s detailed work. A sophisticated direct buyer of commercial property arrives at a price by forecasting the cash flows expected from owning and operating the building over an intended holding period and discounting them to a present value. Cap rates and values per square foot are what that discounted cash flow process leaves behind once the transaction prints. Divide an estimate of NOI by the cap rate and a value appears; divide the price by rentable area and a value per square foot appears. Both are compressed summaries of a full discounted cash flow exercise. It is worth remembering that the discount rate a private owner-operator applies may not be the discount rate investors apply when buying shares in a REIT.

Trading away from NAV

Listed real estate does not trade at NAV. Over time REITs and REOCs globally have traded at premiums of more than 25% and, in other periods, at discounts exceeding 25%. If a REIT had an NAV of $20 per share, the stock might change hands anywhere between about $15 and about $25 depending on conditions.

Shares priced below NAVPS suggest potential undervaluation, and shares priced above it suggest potential overvaluation. Both readings, though, may be perfectly justified by something the market can see and the NAV calculation cannot: a property development that is going to miss its completion date, or a management team expected to create substantial value. Two further gaps explain much of the difference. Equity markets are forward looking and sometimes apply investment criteria that differ from those used in property markets, while appraisal-based NAV estimates tend to lag changes in market conditions. Property buyers weigh long-term prospects; stock investors concentrate on the near-term outlook for income and asset values.

The price-to-NAV ratio varies by market, by property sector, by outlook and by the perceived quality of management and governance. A discount is not costless for the company. REITs trading below NAVPS, or carrying high leverage, find it harder to raise the new capital that funds acquisitions and development, which can constrain long-term growth relative to REITs trading at or above NAVPS. Issuing equity below NAVPS dilutes existing investors.

Four reasons to hold the number loosely

First, NAV applies a private market valuation tool to a publicly traded security, and the two markets do not always agree. Second, NAV implicitly treats the company as a single asset or a static pool of assets, which contradicts the going-concern assumption under which the company is actually run. Management teams differ in track record and in ability to create value over time, assets are bought and sold, and capital market decisions add or destroy value. An investor has to form a view on how much value the management team will add to or subtract from today’s NAV. This is precisely why an investor might buy REIT A at a 10% premium to NAV in preference to REIT B at a small discount: if the management of REIT A has the stronger record and better opportunities to grow NAV, the premium is the price of that difference.

Third, NAV becomes highly subjective when property markets turn illiquid and few transactions can be observed, and when a company owns hundreds of buildings, so that no outsider can say what the portfolio would fetch if sold asset by asset. There may be a large-portfolio premium in strong markets, when a strategic buyer will pay extra to acquire a great deal of desired property in one transaction, or a large-portfolio discount when few buyers exist for that kind of property at all. Fourth, some assets resist the method altogether: undeveloped land, very large properties with no comparables, single-use buildings, service businesses and joint ventures.

NAV as a relative measure

Among institutional investors the most common view is that a REIT or REOC whose management is genuinely creating value should trade at a premium to underlying NAVPS. Two arguments support that view. Investors in listed shares have day-to-day liquidity that a private property investor does not, which justifies a lower required rate of return, and therefore a higher value, on the same assets in the public market than in the private one. And the competitive nature of public markets, together with the size of the organisations involved, should attract above-average management teams, which should in turn produce better property operating performance and better investment decisions than the average private operator.

So although NAV is by nature an absolute valuation metric, in practice it is used mostly as a relative one. If every REIT is trading above NAV, stock selection becomes a matter of buying the one at the smallest premium; if every REIT is trading below NAV, of selling the one at the smallest discount. The same relative logic drives the use of implied cap rates: take the current share price, run the NAV model backwards, and solve for the cap rate that the market price implies. An investor comparing two similar portfolios can then see directly whether the market is valuing them differently.

Net income is a poor description of what a property company earns. The largest single expense on a REIT income statement is usually depreciation, and depreciation on real estate is a bookkeeping convention rather than a description of what happens to the building. The industry therefore built two supplementary measures on top of net income, and both of them are examinable.

Funds from operations

FFO has long been the standard performance measure for REITs, and the National Association of Real Estate Investment Trusts, known as Nareit, has worked to standardise and promote the definition. It is a non-GAAP financial measure accepted by the SEC, as EBITDA is, and under SEC rules and updated Nareit guidance issued in 2018 it must be reconciled to GAAP net income. Companies that report their own adjusted versions of FFO are also encouraged to reconcile those figures back to the Nareit definition, often called Nareit FFO.

A fuller statement of the definition is net income computed under GAAP, plus losses and minus gains from sales of properties, plus depreciation and amortisation related to real estate, plus real estate impairments and write-downs that are unrelated to depreciation.

Why add depreciation back at all? Because investors believe real estate holds its value far better than most business assets and frequently appreciates over long periods, so the depreciation charges permitted under IFRS and US GAAP do not describe economic reality. There is a tax dimension to the same point. A taxable REOC that uses moderate leverage and reinvests most of its income will usually defer a large part of its annual tax liability, because accelerated tax depreciation is permitted in most countries and continued reinvestment keeps adding to the depreciable base.

Gains and losses on sales of previously depreciated operating properties are stripped out on the ground that they are not sustainable, normal income. The amortisation added back covers leasing commissions, tenant improvements and tenant allowances. One warning: despite the name, FFO is not a cash flow measure any more than cash flow from operations is a measure of free cash. It excludes the investment and spending needed to sustain growth in cash flow, and it excludes cash flow from financing activities. It does include FFO from unconsolidated businesses.

Adjusted funds from operations

AFFO refines FFO into something closer to current economic income. Two deductions do the work. The first removes non-cash rent. Straight-line rent is the average contractual rent over a lease term, and IFRS and US GAAP both recognise that average as revenue; the gap between it and the cash rent actually paid in the period is the non-cash rent, or straight-line rent adjustment. Because most long leases contain escalating rents, that gap can be large. The second deduction covers maintenance-type capital expenditure and leasing costs, including leasing agents’ commissions and tenant improvement allowances, all of which are genuinely required to keep the buildings earning.

The purpose of both sets of adjustments, in FFO and again in AFFO, is the same: to arrive at a more tangible, cash-focused measure of sustainable economic income that depends less on non-cash accounting estimates and excludes non-economic charges.

AFFO is the superior measure of economic income and therefore of economic return, because it takes account of the capital spending needed to preserve the earning power of the portfolio, and it better reflects a REIT’s capacity to pay dividends. It is also more error-prone. The annual provision needed to maintain and re-let space is genuinely difficult to predict, and the actual figure in any single year can be far above or far below the norm because capital expenditure programmes and lease expiries are lumpy. As a result FFO estimates are quoted more often, even though analysts tend to base their investment judgements substantially on their AFFO estimates. Methods and assumptions vary from company to company, and firms that compile estimates for publication, such as Bloomberg and Refinitiv, tend not to gather AFFO estimates at all, because there is no universally accepted methodology and corporate reporting of actual AFFO is inconsistent, which makes analyst estimates impossible to corroborate.

Conventional relative valuation transfers to real estate with modest adaptation. The price-to-earnings ratio is replaced by the price-to-FFO ratio and the price-to-AFFO ratio, and enterprise value to EBITDA plays a supporting role. Multiples are typically struck on the current share price against year-ahead estimated FFO or AFFO, which lets an investor compare one REIT with another quickly, or compare a REIT with its own valuation history. Within the sector the comparison is usually made against the average multiple for companies owning similar buildings: an office REIT is measured against the average multiple of office REITs, not against the whole market.

P/FFO is in essence the sector version of P/E. P/AFFO gives a quick cash flow multiple, because the AFFO adjustments turn reported funds from operations into an approximation of cash earnings.

Why EV/EBITDA earns its place

FFO and AFFO are both built on net income available to equity, so both are levered measures. All else equal, a company carrying more debt will show a lower P/FFO multiple simply because leverage magnifies per-share earnings. EBITDA is struck before the leveraging effect of debt, so EV/EBITDA supports like-for-like comparison across companies with different capital structures. It also lines up neatly with how property is actually priced: the inverse of the multiple, EBITDA divided by enterprise value, is a close approximation of the capitalisation rate, which is net operating income divided by market value.

The three drivers of differences in multiples

1. Expected growth in FFO and AFFO. Higher expected growth supports a higher multiple. Growth comes from the business model, since companies that are good at development often produce above-average growth over time; from geography, since a concentration in primary, supply-constrained markets such as New York City or London gives a landlord pricing power that a secondary market does not; and from other factors such as management skill or the structure of the lease book.
2. Risk in the underlying real estate. Cash flow volatility varies with asset type, quality, age, market conditions, lease type and location within a submarket. Apartments are seen as having less variable cash flow than hotels, so apartment-focused REITs tend to trade at relatively high multiples compared with hotel REITs. Similarly, a company with a young, well-maintained portfolio generally trades at a higher multiple than one holding older or dated buildings with deferred maintenance, because the second company faces heavier capital expenditure just to sustain rent growth.
3. Capital structure risk and access to capital. As financial leverage rises, FFO and AFFO multiples fall, because the required return rises with risk. High leverage also eats into incremental borrowing capacity and can create a stock overhang, where investors hold off buying shares because they expect an equity issue to come.

Many other things move the multiple, as with any equity: perceptions of management, whether an asset type or a market is currently in favour, the complexity of the business, the quality of financial disclosure, transparency and governance.

The case for and against multiples

Advantages. Earnings multiples of this kind are accepted across global markets and industries, which lets a portfolio manager place a REIT valuation alongside every other investment alternative on comparable terms. FFO estimates are readily available from market data providers such as Bloomberg and Refinitiv, so P/FFO is easy to compute. And multiples can be combined with expected growth and leverage to deepen the comparison, since FFO and AFFO ignore differences in leverage and leverage ratios can be used to adjust for that.

Disadvantages. A multiple applied to FFO or AFFO may miss the intrinsic value of real estate that does not currently produce income: land held for development, vacant buildings, property under construction, assets whose current use is not their highest and best use, and assets let at below-market rents. P/FFO makes no allowance for the recurring capital expenditure needed to keep buildings operating; P/AFFO is supposed to fix that, but the estimates and assumptions behind AFFO vary widely between preparers. And a growing volume of one-time items, such as gains and accounting charges, together with revenue recognition changes, has made both multiples harder to compute and harder to compare across companies.

Capitol Shopping Center REIT Inc., referred to here as CSC, is a fictitious company that owns and operates retail shopping centres, mostly in the Washington, DC, metropolitan area. Working through its disclosures shows how the measures built up so far behave on a real set of statements.

What the company is

• The portfolio is defensive by the standards of commercial real estate, because a large share of the space is let to retailers of basic necessities such as grocery stores and drug stores.
• The Washington, DC, location is viewed favourably for two reasons. The city is the capital of the United States, and government is the largest employer and has historically been a steadier source of jobs than the private sector. The area is also fairly dense with strict zoning restrictions, which makes building new shopping centres difficult and limits competing new supply.
• Over the past decade CSC has raised rents and net operating income by an average of 2% to 3% a year.
• Year 1 and Year 2 were difficult years for commercial real estate generally. CSC still delivered growth while many peers saw FFO and AFFO fall. That cuts both ways: because CSC never suffered the decline in occupancy and rents that others did, its portfolio may have less recovery upside now that forecasts point to improving property fundamentals.
• In the middle of Year 2 the company bought three shopping centres from a local developer for $111.2 million, on which the first-year return is estimated at 6.75%. That is a better going-in cap rate than the market average of 6.0% to 6.25%, achieved through relationships and reputation with tenants, brokers and competitors and through the ability to move quickly from a strong balance sheet. The property is not fully leased, so there is scope to raise NOI further by attracting tenants. The purchase was funded with a $54.6 million mortgage at 6%, a common stock offering of 1 million shares and cash on hand.
• Further acquisitions are planned, funded by a mix of debt, common equity and internally generated cash. The company requires acquisitions to deliver an unleveraged internal rate of return of 9.5% from current yield and capital appreciation combined.
• Balance sheet policy is to stay below 50% debt to market capitalisation, preferably nearer 40%. The in-place average cost of debt is 5.7%.
• Dividend policy targets a payout of roughly 80% of AFFO. That level pays an attractive dividend, retains some cash flow, leaves a cushion for a downturn, and stays comfortably inside the US payout requirement, which is based on taxable net income measured after depreciation. Management has noted that the dividend has run well above taxable net income.
• Over the past decade CSC has traded between 9 and 19 times FFO, its peers between 8 and 18 times, and all REITs between 7 and 20 times. On AFFO the ranges are 10 to 21 times for CSC, 9 to 19 times for peers and 9 to 24 times for all REITs.
• Shopping centre REITs are currently estimated to trade 7.6% above analyst estimates of NAV, while the REIT sector overall trades at a 14.8% premium to estimated NAV.
• The historical beta of the shares against the broad equity market is 0.80. The risk-free rate is 4.0% and the market risk premium is estimated at 5.0%.

The reported statements

Two lines on that balance sheet deserve attention before any valuation begins. Accumulated depreciation of $938,097 thousand against gross real estate of $3,761,361 thousand means roughly a quarter of the recorded cost of the portfolio has already been written off, which is exactly the distortion that makes NAVPS necessary. And deferred rent receivable of $38,165 thousand is the accumulated straight-line rent asset. It has no market value of its own and must not be added into a NAV calculation that has already removed non-cash rent from NOI, or the same economics would be counted twice.

Non-cash rents reflect the straight lining of contractual rent increases; the change in deferred rents in the cash flow statement often reveals the same amount. Recurring capital expenditures are the costs of maintaining the earning capacity of existing assets, including leasing commissions, roof and car park repairs and basic fitting out of space to attract tenants.

Analysts covering CSC publish estimates of FFO, AFFO and dividends per share for the coming three years. Combining the consensus of those estimates with reported results gives the picture below. Yr1A and Yr2A are actual; Yr3E, Yr4E and Yr5E are estimated.

Read the growth rows carefully, because they contain the whole story of the case. In Yr2A, when peers and the wider sector were shrinking their AFFO and their dividends, CSC grew AFFO by 5.4% and lifted the dividend by 1.8%. From Yr3E onwards the position reverses: all REITs are forecast to grow AFFO per share by 8.1%, 9.7% and 10.8%, against 6.2%, 8.8% and 5.4% for CSC. The defensive portfolio that protected the company on the way down gives up ground on the way back up. Meanwhile the payout on AFFO stays within a narrow band of 78.9% to 81.8% across all five years, which is a management team running the policy it says it runs.

Approach one: relative value against peers

At a recent share price of $69.85 the multiples work out as follows, with the analyst convention of focusing on the next two forecast years.

The multiples follow directly from the estimates: $69.85 ÷ $4.23 = 16.5 times on Yr3E FFO, and $69.85 ÷ $3.76 = 18.6 times on Yr3E AFFO. The premiums follow from the multiples: 16.5 ÷ 14.5 − 1 = 13.8% against shopping centre peers on Yr3E FFO. CSC trades at a premium on all four measures against both comparison groups, and the premium is in the low to high teens throughout. The historical trading ranges give context: 9 to 19 times FFO for CSC over the past decade, against 8 to 18 times for peers, so a premium is normal for this company, and the current 16.5 times sits in the upper part of its own range rather than outside it.

Approach two: net asset value

The NAV build for CSC follows Figure 2 exactly. The source figures are the Year 2 statements; the cap rate and the growth rate are assumptions, and they are stated so that their effect can be seen.

Approach three: a two-step dividend discount model

REITs pay out most of their income by law, which makes a dividend discount model unusually well suited to them: the dividend is close to the whole of the distributable cash flow, so little judgement is needed about payout policy. The usual practice is a two-step or three-step model, with near-term, intermediate-term and long-term growth assumptions. Discounted cash flow models applied to REITs typically use intermediate-term cash flow projections and a terminal value derived from historical cash flow multiples.

Historically the two markets served different clienteles. Large institutions and wealthy individuals reached real estate through direct ownership, joint ventures and private funds, while individual investors, lacking the resources to buy buildings, bought shares in listed property companies. That separation has broken down. As more property companies listed and kept issuing equity to fund acquisitions, developments and mergers, the market capitalisation of the listed sector grew substantially, and the resulting float and liquidity made it practical for institutions to add public real estate allocations alongside their private ones.

Should an investor able to access both choose one? The honest answer is that it depends on objectives: total return requirement, tolerance for volatility, diversification goals and the expected return from each route. Many institutional investors, pension funds and endowments among them, allocate to both. Public and private real estate equity share the same core attractions: exposure to property, a potential inflation hedge, attractive risk-adjusted returns and some diversification benefit against stocks and bonds.

How the two markets interact

Listed real estate plays a complementary role rather than a substitute one. Its liquidity makes it the natural place to express a short-term view: when sentiment towards retail property turns unusually negative and drives listed shares below net asset value, that view can be acted on in a day. Sustained valuation differences between the public and private markets create opportunities that managers on both sides can capture. If listed companies trade well below net asset value, they may go private or sell themselves to private real estate funds. When property values are high, listed companies can sell buildings to realise gains and private funds may look for exits through the initial public offering market. The gap between public and private pricing is therefore self-correcting over long horizons, but the correction runs through corporate transactions rather than through arbitrage.

The two routes also reach different opportunity sets. Private investors can pursue strategies that are heavily restricted for REITs, merchant development of property built for sale being the clearest example. Running the other way, REITs were in some countries the first movers into specialty sectors such as self-storage and data centres, so investors wanting exposure to those niches had to buy listed companies until private funds followed, often in search of higher yield.

Matching the vehicle to the objective

Two practical rules fall out of all this. An investor whose primary objective is liquidity should prefer listed REITs and REOCs, because their shares trade on exchanges, while direct investment in income-producing property is generally illiquid. An investor whose primary objective is maximum growth or capital gain should prefer REOCs or direct ownership, because both are free to invest in any kind of real estate or related activity and to retain and reinvest as much income as they judge appropriate, which creates value through development and through trading property. REIT payout requirements prevent that retention, so REIT growth opportunities are structurally more limited.

Both rules carry caveats. Shares in a closely held listed company with a small free float that trades infrequently may not deliver the liquidity an investor expects. And management quality, corporate governance, balance sheet capacity, leverage and the availability of attractive reinvestment opportunities matter greatly when choosing a specific vehicle and a specific company, whatever the structure says on paper. Expertise requirements also differ sharply: buying a single building directly demands a great deal of property expertise from the investor, whereas buying a listed REIT or REOC share demands much less, because the property interests are managed by professionals and the business is overseen by a board.