By Dean Starkman

Is net asset value the most accurate way to value REIT stocks?

For years, Mike Kirby and his associates at Green Street Advisors Inc. have preached that while there may be many ways to value shares of real estate investment trusts, there is only one best way: net asset value (NAV).

That method, as most followers of Kirby and his troupe know, painstakingly calculates the private-market value of a REIT's properties to find its NAV.

REITs, he argues, are basically a collection of buildings, which trade at real prices every day in a huge private market. So, he says, analysts and investors would be foolhardy not to ground REIT valuations in hard, market-based data that is readily available to anyone willing to do the work.

In fact, the real estate stock research firm has been so successful in pushing its NAV-based approach over the last two decades that Kirby is ready to declare the debate over. Green Street's NAV model, he says, has won. But lately, a growing number of REIT analysts, investors and, especially, company executives, have begun to respond: Not so fast.

Led by executives of industrial developer CenterPoint Properties Trust (NYSE: CNT), this camp derides NAV as a static, even backward-looking perspective that doesn't fully take into account the value-creating power that management provides. This cash-flow camp, let's call it, argues that REITs should be valued as operating companies—no less than manufacturers—that create value through buying, selling, developing and redeveloping. Its favored valuation method is a metric known as discounted cash flow, or DCF.

"Real estate has to grow up and look at cash flow," says Paul Fisher, president and chief financial officer of CenterPoint Properties. "It's not about where we were or where we are. It's about where we're going to be." The NAV focus, he adds, "just doesn't work for companies that are dynamic, like CenterPoint."

And that goes for Archstone-Smith (NYSE: ASN), too, says, R. Scot Sellers, chairman and chief executive of the multifamily REIT, an active developer.

"It absolutely shortchanges our value," Sellers says.

Unique Situation for REIT Investors

The target audience of all this wrangling is, of course, investors, especially portfolio managers, for whom the question of how to value REIT shares is more than theoretical but goes right to the grinding task of picking stocks and beating indexes. Many industry figures concede that Green Street's NAV-based approach has gained dominance.

"In general, I side with the CenterPoint side of the argument," says Damon J. Andres, portfolio manager for Delaware REIT Fund. "But lately, the whole industry has started to gravitate to NAV valuations."

This is a debate that only the REIT industry can have. In most industries, the "market," or book, value, of a corporation's assets isn't particularly useful in valuation. General Motors Corp., for instance, is worth far more than the liquidation value of its plant, equipment and inventory. Its manufacturing, branding and marketing skills make up the greater sum of its net worth.

REITs, however, are defined by their ownership of commodity-like assets that trade in relatively liquid markets, like perhaps only the gold or oil-and-gas industries. What's more, calculating REIT NAV has become easier in recent years as REIT disclosure has grown more extensive and now includes average rents, vacancies and other details. So finding the rough value of a REIT's real estate portfolio is possible—even if some argue over whether the exercise is useful.

And to be sure, the debate isn't black and white. Most investors and analysts use a range of metrics and caution against over-reliance on a single one. All investors have their own approach. A popular way to—roughly—measure REITs against each other is to assign a multiple to a company's projected funds from operations (FFO). Critics say the method is dangerously flawed because, like FFO, it fails to measure the amount a REIT spends on capital expenditures. As remedy for that, some portfolio managers compare REITs by their price relative to projected adjusted funds from operations (AFFO). Another popular method applies a discount rate to projected future dividends.

"At some level, valuation of stocks is an art form," says Ross Smotrich, an analyst with Bear Stearns & Co. "There are a number of different approaches. I'm agnostic. We use all these metrics and I try not to be a prisoner of a single one."

And even both CenterPoint and Green Street concede some merit in the method favored by the other. Green Street, in fact, performs detailed DCF analyses on each of the 70 companies in its coverage universe.

Still, Green Street and its followers insist that NAV should take primacy, while those that agree with CenterPoint insist just as firmly that it should be discounted, if not discarded.

Who's right? In a sense, the question boils down to what an investor believes is the most important element of a REIT: Is it the buildings or the people who manage them?

NAV backers believe it's the buildings. "We believe that REITs first and foremost are a collection of real estate that's been securitized," Kirby says. "Management adds a nice kicker, but it's the first part that's most important."

Not surprisingly, Fisher and Sellers argue that the real value comes in how the assets are managed.

"We are real companies," Sellers says. "Like Microsoft is in the software business to make money, we're in the real estate business to make money."

A closer examination of the competing methods might help clarify the dispute.

Mechanics of NAV

A tool as old as REITs themselves, NAV is based on the idea that since buildings make up the bulk of a REIT's value, REIT shares shouldn't trade too far above or below that value. The method breaks down valuation into two simple questions: 1. What's the value of what the REIT currently owns? 2. How much value is management expected to create or destroy?

To find the first part, the model divides a corporation's projected net operating income (NOI) by an appropriate capitalization rate, the discount rate used to adjust projected future income to its present value. The discount rate must take into account all economic and real estate risks, including risk-free interest rates, property type, location, quality and age, expected demand growth, supply outlook and the like.

As an example, income from a company's suburban office portfolio might warrant an 8.5 percent cap rate because of perceived weakness today in that sector's prospects, and therefore a lower NAV, while NOI from a company that owns high-end shopping malls would merit a 7 percent cap rate, and higher NAV. Even a fraction of a percentage-point difference in cap rates can appreciably change values. The model requires a thorough scrubbing of a REIT's portfolio—time-consuming research that not every investor or Wall Street research department can afford. The trick is deciding which cap rates are right.

NAV proponents argue their model is grounded in reality since buildings trade every day on the private market, which sets cap rates backed by hard cash. Such data, NAV proponents argue, provides a solid foundation for the cap rates that analysts use to value a REIT's portfolio.

"Public-market investors who choose to ignore the information conveyed by these thousands of willing buyers and sellers seem to us to be foolhardy," Green Street wrote in a report that outlined its method in 2003.

Green Street takes its NAV model a step further. In an attempt to capture the value-creating effects of a company's management and strategy, the firm assigns a ranking on a scale of one to 10 for such elements as insider ownership, geographic and property focus, leverage, conflicts of interest and "franchise value," a qualitative measure of management skill. Critics argue that the second part is subjective and arbitrary, "a black box," as one analyst put it.

But even NAV skeptics concede that the model demands at least some attention, especially in setting the outer limits of where a stock should trade.

"It's the reality check that separates what's really happening from the noise of what people are yelling at you," says Steve Brown, managing director and portfolio manager at Neuberger Berman Real Estate Funds. "You're not going to see REITs trade at 16 cents on the dollar, and you're not going to see REITs trade at two times value." The boundaries, Brown says, typically range between 80 percent to 120 percent of NAV.

William E. Hauser, portfolio manager with HVB Capital Management, says that NAV is especially valuable in bear markets, when management's value-creating talents are less of a factor. Then NAV analysis provides solid "buy" signals when discounts get too big.

"When you are in a bear market, the asset value probably takes greater consideration," he says. "That is your safety net."

And it's hard to argue with NAV's impressive record. Green Street boasts that its NAV-backed "buy" recommendations have returned a total of 1,948 percent between January 1993, when the modern REIT era was underway, and January 2005, a compound annualized rate of 29 percent. Its "sell" recommendations have returned a paltry 21.5 percent, or 1.6 percent compounded annually, in the same period. Over the 12-year period from the end of January 1993 to the end of January 2005, the NAREIT Equity REIT Index recorded a 12.8 percent compound annual total return.

Further evidence of NAV's validity comes from a study published in 2003 and revised in 2004 by three finance scholars, William M. Gentry of Williams College, and Charles M. Jones and Christopher J. Mayer, both of the Columbia University Graduate School of Business. The study tracked REIT data since 1990 and found that simply trading REITs mechanically based on their NAVs—buying at a discount and selling short at a premium—produced "large positive excess returns" of about 1.2 percent to 1.8 percent per month, "with little risk." Green Street posts the study on its Web site (www.greenstreetadvisors.com) as evidence of the validity of the NAV model. Case closed? Hardly.

Misses of NAV

David Harris, senior REIT analyst at Lehman Brothers, cautions that NAV analysis alone can be "very misleading." For one thing, NAV calculations themselves can—and often do—differ depending on who's doing the calculating. At the end of third quarter 2004, for instance, when Lehman published its last full NAV analysis, the 65 REITs in its coverage universe traded at a whopping 29 percent average premium; Green Street pegged the premium for its 70-member group at 7.2 percent—a big difference.

And while the two analyst teams cover slightly different groups of companies, Lehman's estimate for Prentiss Properties Trust's (NYSE: PP) NAV, for example, was $29.50 per share at the end of the third quarter, while Green Street set it at $34.25, 16 percent higher, at the same time. The stock traded at $37.92 at the end of the period—pricey by Lehman's standards, attractive for Green Street, after factoring Prentiss' value-creating potential.

Differences over what NAV to award a company usually boil down to the use of different cap rates, which, argues Kevin Lampo, an analyst with Edward Jones, can in fact be quite subjective.

"You can spend all day on what cap rate you use," he says. "You'll come up with a number but it may not be the right one."

Harris also argues that pegging NAV becomes especially tricky at "extreme points in the cycle" such as now, with cap rates for many property types at historic lows (meaning prices are quite high). A shift in cap rates could send NAV estimates spinning, he says.

"NAV can be a misleading indicator at the top and bottom of the cycle," Harris says.

Still others worry that NAV models tend to miss the value creating skills of management. "There are certain things that don't fit into the NAV box," Brown says.

CenterPoint's Fisher couldn't agree more. He says that CenterPoint and other activist REITs use properties much in the way manufacturing companies use raw materials, adding value through development, redevelopment, leasing, financing and other methods and selling it when most appropriate. The company churns through about 20 percent of its portfolio a year, he says, which makes NAV analysis a moving target. It also misses an essential element of the company's value, he says, which is to create profits over time through gains on sale.

T. Ritson Ferguson, chief investment officer of ING Clarion Real Estate Securities, agrees that investors are unwise to discount management's role in REITs.

"They're not just the properties," Ferguson says. "They're a collection of properties as managed by a management team. You've got to look at these things."

Fisher dismisses NAV as "liquidation value," a metric that doesn't make sense for going concerns and would never be applied to Boeing Co., General Motors or other companies whose plant and equipment offers few clues to their intrinsic worth.

"Far and away, the dominant driver is the spread between what we sell and what we buy and how much we turn," he says. "The real nub of valuation is cash flow—the green stuff."

The Deal on DCF

The DCF model, which is widely used to value companies in industries across the economy, can also be broken into two main tasks. The first tries to accurately project a company's cash flow growth in perpetuity. The second applies a discount rate to those earnings that captures what the investor could expect from a risk-free investment, plus risks inherent in the enterprise—managers' skill, property type, market characteristics and the like. In theory, if a current share price is trading lower than the warranted per share value produced by a DCF analysis, an investor should buy.

Fisher and others cite as evidence of NAV's problems and DCF's merits the record of CenterPoint itself. The company has confounded Green Street and many other analysts by trading, for years, at a huge premium to NAV. Green Street has been recommending that investors sell CenterPoint since the summer of 2001. Its shares nearly doubled over the next three and a half years and closed the end of 2004 at $48.50. In a report last October, for instance, Green Street pegged the premium at a whopping 49 percent, and continued with its "sell" recommendation.

"They've had a sell on our stock since we traded at $23," Fisher says. "How good can a model be when they've been telling their investors to sell us?"

HVB's Hauser agrees that CenterPoint throws a wrench into NAV theory.

"CenterPoint trades at this absolutely ridiculous premium," Hauser says. "You say, ‘This is really scary.' But it's always traded at this premium, and the market has effectively adjusted. It's a perfect example of how the market has done a good job of moving above and beyond NAV."

ING's Ferguson notes that a number of companies besides CenterPoint have emerged that aggressively manage their assets to add value, making a strict NAV-based analysis problematic. Among these he includes AvalonBay Communities, Inc. (NYSE: AVB), an active apartment developer; ProLogis (NYSE: PLD), the global warehouse company; and SL Green Realty Corporation (NYSE: SLG), a deal-making office company. Others make a similar case for Vornado Realty Trust (NYSE: VNO) and mall giant General Growth Properties, Inc. (NYSE: GGP).

"If you didn't think about management, you'd be pretty off the mark in thinking about those companies," Ferguson says.

Of course, even DCF apostles agree that the model has its flaws. Poorly estimated discount rates—modest errors in guessing future interest rates or a company's risk profile—can wildly affect valuations.

And Kirby has ready answers to all NAV criticism, particularly to the charge that it is "backward looking," which he calls, "a naïve gripe." Cap rates used in deriving NAV by their nature anticipate future earnings of property, he says, and are by their nature forward looking.

And so the debate continues. Which valuation metric is the best approach? Kirby and Fisher have made up their minds, but it is up to investors to decide for themselves which camp to join.