Don’t Discount Discounted Cash Flows
Time value for money in simplistic terms means that a dollar earned today is worth more than a dollar earned in the future. A theory we can all certainly relate to, through our own bank accounts and the interest we receive on these accounts.
REITs appear fairly valued
Our DCF analysis suggests that REITs are currently trading below our DCF estimates. Our DCF analysis involves using a 2-stage, 5-year dividend and earnings discount, a fairly conservative long discount rate with no perpetual growth rate, the current 10 year bond rate and a market risk premium of 5.0%.
Our DCF analysis supports our other valuation metrics and confirms that REITs are not overvalued (refer Part 1 “Value in AREITs” white paper). In fact, our discounted cash flow analysis suggests that REITs are somewhat more attractively priced. The driving factor behind this is how global interest rates have fallen materially in the past year, and domestically, the cash rate is at a historic low of 2%.
Strengths of DCF analysis for REITs
We believe Discounted Cash Flow analysis is a fundamentally sound valuation approach, as it measures the value of a business’s future expected cash flow, discounted at a rate that reflects its riskiness. As a result, when utilising DCF method, the entity’s ability to grow cash flow, given the riskiness of its assets and its balance sheet capacity is equally important. Due to the particular characteristics of commercial real estate (rental streams secured by virtue of the lease contract) and the REIT structure, most of a REIT’s cash flow is reliable and may be predicted with a relatively higher level of confidence than many other industries. We therefore believe accurately valuing REITs by discounting its future cash flow is appropriate.
1. Captures firm value, not just asset value
The main advantage DCF has over Net Asset Value (NAV) assessment is that it values the entire cash flow available to shareholders, both current and in future periods. While we find NAV is a useful measure in measuring a REIT’s market value relative to its break-up value, the majority of REITs are growing, going-concern entities and are not likely to sell all of their assets in the near future. Another shortcoming of most NAV calculations is that they do not account for costs that may vary by entity, such as the cost of debt and general and administrative (G&A) expense.
2. “Cash flow is king”
The cash flow is king rule applies to entities in all industries and stages, and we believe is particularly relevant for the REIT industry. Investors are attracted to commercial real estate as an investment primarily due to the reliable cash flow characteristics. The reliability of a REIT’s dividend payment, as well as its potential for future dividend earnings growth, is an attractive characteristic for REIT investors.
3. Main inputs are transparent and not reliant on capitalisation rates
The primary inputs of DCF are fairly straightforward: entity cash flow, cost of capital and terminal growth are the essential items. Each of these has components that incorporate some subjectivity, although we have tried to narrow that subjectivity and will discuss them in detail below.
Disadvantages – and how we address them
1. Results may vary widely with input changes
One of the disadvantages of the DCF model is that relatively minor changes in a couple of inputs (namely the discount rate and terminal value) may dramatically change the value. This is also true for other types of analyses. Our methodology is based on relative consistency and an unaltered calculation of the Capital Asset Pricing Model (CAPM) to derive the cost of equity. Accordingly, by being consistent in our approach to all AREIT valuations we remove much of the risk from input variance.
We believe a certain amount of subjective decisions may be applied to any valuation model in order to address entity-specific issues. In our DCF assessment, however, we have limited the subjectivity to our specific entity cash flow projections and the terminal value process.
3. Magnitude of the terminal value
While the terminal value in our DCF analysis is discounted by five years (at which point we apply a perpetuity growth rate on cash flows) empirical studies have shown that terminal values can have a valuation impact of (45%-85%) on the DCF.
As a result, we have used two costs of capital, calculated using the Capital Asset Pricing Model (CAPM), to differentiate between the next five years and the long-term outlook of each entity. Our current cost of equity uses a running 10 year bond rate and includes the assumptions described above for the equity risk premium, entity-specific current betas, and market-cap and free float related issues.
The long-term cost of capital used in discounting the terminal value is derived from a property valuation perspective. Property valuers, when determining the terminal cap rate of an asset; take into account the depreciation of the asset over the period and typically apply a higher terminal discount rate relative to the initial discount rate.
Factoring in the traditional DCF growth model of deducting the perpetual growth rate from the CAPM derived discount rate, we have negated the subjectivity in deriving the perpetual growth rate for each unique REIT with not applying one, erring on the side of a valuer’s conservatism.
Second, the terminal value is based on cash flow in our terminal year. This cash flow is a reflection of our earnings projections of each of the previous five years and certainly carries a higher dispersion risk when compared to the one year’s cash flow projection. Again, we remain comfortable with these projections due to the inherent conservatism in our forecasting approach (ie, we avoid “heroic” growth assumptions).
Whilst we have limited the subjectivity of our analysis to distribution growth, based on our REIT earnings models and each REIT’s expected long-term growth rate, we characterise our DCF models as works in progress and constantly revisit various aspects over time.
What about the NAV methodology?
Up to this point, we have primarily utilised estimated DCFs and NAVs to value REITs. Unfortunately, each has drawbacks. NAVs are highly sensitive to small movements in market capitalisation rates and do not fully capture intrinsic firm value or changing multiyear growth prospects. Moreover, NAV analysis for REITs makes one simplifying assumption – mainly that the market is correct. Earnings multiples are quite useful in assessing relative value between similar REITs, but determining the appropriate absolute multiple at which a stock, property type, or the industry should trade is complex.
To be clear, we are not suggesting abandoning the NAV valuation methodology in favour of a DCF valuation framework. Rather, we believe that the best approach is to utilise what we’d refer to as an “all of the above” approach in valuing REITs. In an ideal world, these two valuation methodologies will produce the same answer – making it simple to determine whether a stock appears overvalued or undervalued. However, the reality is that there will be numerous cases where our valuation work produces a range of values.
This is where equity valuation can be as much of an art as it is a science. In our view, the best approach is to utilise our experience and to evaluate the quantitative and qualitative factors, and focus on the valuation measure that simply seems to make the most sense at the time.
Key variables of the discounted cash flow model
Because we are valuing the equity, the discount rate we utilise is the cost of equity, and not the cost of capital, which calculates the weighted averages of the costs of equity and debt.
The risk and return model that is utilised in most real-world analysis is the capital asset pricing model (CAPM). We discuss our assumptions in further detail below.
The CAPM employs the rate of a riskless asset in its calculation. We use the 10 year Australian Government Bond Rate as a proxy, and while it may fluctuate in price, it essentially has no default risk. Because we are valuing REITs as going-concern companies, we are using the longest-horizon Australian Government Bond rate possible.
The beta we employ comes from an asset valuation perspective in which we derive asset betas based on a vast array of data that helps describe the relative risk and quality of an asset. This is applied consistently on the granular level on each asset in a REIT’s portfolio. The weighted average asset beta is then overlayed with both quantitative and qualitative factors that are unique to the REIT and is adjusted on a relative basis. Key determinants include gearing levels, liquidity, management and corporate governance.
Equity risk premium
The equity risk premium represents the required additional return one would expect to get from an equity investment over a riskfree investment, such as the 10 year Bond Rate. We utilized a 5% premium as this is the average implied equity risk premium utilised in the investment community and realistically take into consideration the market’s expectations today with regard to equity spreads over bonds.
Current and long-term cost of equity
We have used two costs of capital, calculated using the Capital Asset Pricing Model (CAPM), to differentiate between the next five years and the long-term outlook of each company. Our current cost of equity uses a running 10 year Bond rate and includes the assumptions described above for the equity risk premium, company-specific current betas and company-specific size premium. The long-term cost of capital is adjusted using a relevant property and entity valuation metric and is used only in discounting back the terminal value in the DCF model.