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Is PE Relevant with REITs?

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By JimLuckett
December 4, 2003

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How useful can P/E be if E is not useful? The Empire State Building, if still owned by its original owner, would be fully depreciated; so all of its net operating income would contribute to the owner's earnings, unreduced by depreciation charges (leaving aside improvements and replacements that are more recent and still being depreciated). But a new owner who paid a lot for the building, taking in the same net operating income from it, would be seen to be earning much less from it, because of high depreciation charges. Same building, same rents, same operating costs, same physical and market forces of appreciation and depreciation acting upon the asset, same actual cash flow being derived, but very different bottom line "E", due to an artifact of ownership. And how do we reconcile the fact that the fully depreciated components of the Empire State Building still have a lot of economic value? We subtract 1/40 of their cost every year from earnings for 40 years, then discover that instead of being worthless, all those bricks and steel girders are worth millions more than historic cost. Where did that value come from?

Another example to make E seem even sillier -- Two REITs, each with one fully depreciated building from which they derive positive earnings. Let each sell their building to the other for a high price. Stipulate the prices paid for the two buildings are equal, the buildings are identical, and so are their net operating incomes. Suddenly each company is earnings much less, due to high depreciation charges, where before there were none. Yet their cash flow and the net worth of their real estate holdings is unchanged. Should their stock prices drop?

I recently saw a Business Week article that introduced to readers the novel idea of calculating net enterprise value and using that instead of P/E to guide stock valuation. There was no reference to real estate stocks or to NAV (but that would have been useful context that would have improved the article, in my opinion). The point of that article was that leverage can be used to hype earnings without enhancing net enterprise value. So, why would you pay more for a company just because it was more leveraged, if the net enterprise value was not enhanced? Yet P/e analysis would lead you to make that mistake. The same has been said in favor of NAV analysis -- a REIT can hype FFO or AFFO by leveraging up, but not NAV, unless it truly creates value with the incremental debt proceeds.* I highly recommend the article. I can give you my dentist's name and address -- I'm sure the magazine is still there.

*(You can, however, increase NAV growth over time by leveraging up -- and you can decrease it too if things go badly. You also decrease the accuracy with which NAV can be estimated by leveraging up).

Greenstreet Research works tirelessly to educate readers about why NAV analysis is better than P/AFFO. They only give away out-of-date research, but it is still instructive methodologically. Download and read all their sample industry reports and sample issue of Real Estate Securities Monthly.


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