Real estate investment trusts (REITs) are relatively transparent vehicles. REITs are required by law to hold mainly rental real estate and to distribute most, if not all, of its net income as dividends.
It is because of the transparency that often analysts and investors can calculate a REIT’s Net Asset Value, which is the value of the REIT’s real estate holdings minus the debt and other liability that the REIT has.
What makes a good REIT investment?
In theory, an investment in a REIT should be close to its Net Asset Value, as the real estate assets are what create the cash flow for investors.
However, tracking the long-term trading level of REITs around the world would suggest that not all REITs are equal.
Within any market, there are REITs that trade consistently above their Net Asset Value, while some others that consistently trade below. The rest trade around its Net Asset Value.
This difference in trading levels is often attributed to management value.
In fact, when we model a REIT, we distinguish between a REIT’s Net Asset Value and its Fair Value, the latter incorporating the effects of management on the REIT.
Management value may sound like a fuzzy concept, though analysts typically focus on two issues.
1. Strong corporate governance
At the first level, management value is tied to corporate governance issues. By purchasing a company’s stock, an investor is entrusting his own capital to the company’s manager.
A well-designed regulatory system will help incentivise the manager to act according to his or her fiduciary duty to the investors, and this is why highly regarded financial centres are located in jurisdictions with clear rule of law.
Beyond that, however, many investors, especially fund managers and other institutional investors, also perform a second filter to stay away from companies that are perceived to have weak corporate governance regimes.
In other words, management value is firstly a question of whether investors are comfortable that the managers are properly looking after their capital.
2. Resource allocation
At the second level, an analyst would review a company’s senior management decisions, which are often related to resource allocation.
Given a REIT’s typical business model, resource allocation means that the CEO needs to decide if now is the appropriate time to buy, to hold, or to sell assets, and if it is, to decide on the transaction targets.
He or she would also need to decide when to spend capital to renovate or redevelop existing assets. The senior management will also need to place the appropriate talent into each key position so that the operation will run as expected.
Most decisions taken by the senior management do not have an immediate effect, but these decisions will often shape the company’s prospects over the medium term, say three to five years.
An appropriately executed renovation program, for example, will refresh a company’s mall holdings and increase its competitive advantage.
A bad investment, on the other hand, can potentially reduce the company’s net asset value and its equity position, and the company’s financial position, such as its gearing levels, can deteriorate.
Thus, mathematically, most relevant management decisions will impact a company’s future net asset value.
Analysts express their opinion about a company’s management value by calculating the effects of its management decisions against its Net Asset Value. This modified Net Asset Value is often the basis of the Fair Value.
Looking at it from the other way round, the discount or premium between a company’s fair value and its net asset value is often interpreted as the company’s management value.
A discount means that, in aggregate, the market believes that the management is destroying value, while a premium means that the market believes that the management is continuously creating shareholder value.