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Dividend Stocks: Understanding Net Asset Value

By Bill Stoller - Dec 18, 2013 at 9:01AM

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All net asset values are not created equally at companies like Realty Income and Silver Bay.

If you own a REIT such as Realty Income (O 3.09%) or Silver Bay (NYSE: SBY), chances are you've heard the term: net asset value.

Calculating net asset value, or NAV, usually involves the process of marking assets to market value and subtracting liabilities and obligations in an attempt to give investors timely and accurate information. Knowing what assets are worth today compared to acquisition cost, or book value, can be quite useful in making investment decisions. 

Didn't Enron do that?
Keep in mind Enron marked to market its energy services and wholesale trading operation each day -- but there was no transparency whatsoever -- and we all know how that ended. So how accurate are NAV estimates? I feel that varies depending upon which method is used to calculate them.

Mutual funds and ETFs
At the end of each trading day, most mutual funds mark to market their portfolio of stocks and bonds based upon the closing prices on publicly traded exchanges. This is a highly accurate and transparent way to come up with the NAV of a fund. However, when it comes to real estate funds, it's best to do a bit more digging.

The Vanguard REIT Index ETF (VNQ 2.64%) owns shares of the majority of U.S. REITs -- weighting its holdings by market cap. The top 10 REITs represent 40% of the portfolio. Mall landlord Simon Properties (SPG 1.00%) is the largest REIT and represents the largest holding. However, Simon Properties stock price might reflect a valuation much higher than its NAV because of investor confidence in management's ability to generate exceptional future returns. Conversely, a lack of confidence can result in a stock price below NAV.

So, at any point in time, the entire Vanguard REIT portfolio could be trading above or below the NAV of the underlying REIT stocks. This would be a good thing to be aware of prior to investing.

Asset valuation models
Individual real estate properties are typically valued by looking at net operating income, or NOI, and dividing that by an appropriate capitalization or cap rate. The cap rate for a property can be determined by dividing the NOI by the purchase price.

The basic formula is: Income/Rate = Value, or I/R = V

It sounds simple, but what if you're looking at REITs that own hundreds, or sometimes thousands of properties scattered over many market areas? Plus there is another factor to consider -- arriving at an appropriate cap rate is no walk in the park.

Cap rate 101
The higher the quality of the property and credit worthiness of tenants who pay the rent -- the lower the cap rate and the higher the NAV. High cap rates imply more risk and result in higher returns, but lower values. You would have to perform due diligence to understand how similar properties are being valued in each geographic market to determine an accurate cap rate -- not a particularly easy task.

This is one reason confidence in a REIT management team is so critical. On top of that, different types of REIT business models are easier to evaluate than others. Here are two examples.

Ex. 1: Single-tenant triple-net leases
This is a perfect fit for using the income approach to value the properties. Realty Income owns over 3,800 properties in 49 states and Puerto Rico. It has an overall occupancy of 98% and a long operating history going back 44 years. Each property is leased to a single tenant. The tenant pays the property taxes, insurance, and maintenance. Almost all of the rent from the lease contract falls to the bottom line as income, which can be used to calculate the NAV.

So, the formula is: NOI/cap rate - (debt) = NAV/shares outstanding = NAV per share

The tricky part is selecting or calculating the cap rate. A small change up or down really affects the NAV.

Ex. 2: Single-family homes for rent
One of the newest REIT asset sectors is single-family homes for rent. The first REIT IPO was Silver Bay in December 2012. Fellow Fool Mark Holder recently pointed out that Silver Bay's expenses exceed income -- and calculated that if 100% of the existing portfolio of homes were leased, the company would not break even from operations. So, where's the silver lining for investors? Could it be NAV?

Silver Bay management recently unveiled a proprietary asset valuation model, which basically calculates the value of its single-family portfolio of homes based upon a comparison of sales of similar homes in each market. They referred to it as estimated NAV. As of Sept. 30, 2013, Silver Bay reported this metric to be $19.50 per share -- a significant premium to its stock price.

Why home appreciation does not equal NAV
The Silver Bay valuation model is not based upon the NOI of the current leases. It assumes the highest and best use of each home is as a single-family residence. This would be akin to a liquidation value without taking into account the expenses involved in each sale, or a discount for bulk sales. Remember, NAV has to take into account all of the liabilities and obligations. 

Investor takeaway
Properly calculated, the NAV metric can help investors in publically traded REITs compare the price of each share to the underlying real estate value of each share. Like all metrics, NAV estimates can vary widely depending on the methodology used -- caveat emptor.

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Stocks Mentioned

Realty Income Corporation Stock Quote
Realty Income Corporation
$67.41 (3.09%) $2.02
Vanguard Specialized Funds - Vanguard Real Estate ETF Stock Quote
Vanguard Specialized Funds - Vanguard Real Estate ETF
$96.78 (2.64%) $2.49
Simon Property Group, Inc. Stock Quote
Simon Property Group, Inc.
$116.78 (1.00%) $1.16

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