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[Straight From MacCrate] Wall Street’s Valuation Methodology Is It Correct?

Jim MacCrate, MAI, CRE, ASA [1], has worn many hats in his career. He taught a number of the appraisal classes I have taken through the Appraisal Institute and I think he is one of the few people who actually understands the “J-Factor [2].” His wife Judy is an SRA and is an accomplished appraiser in her own right, having managed an appraisal panel for a large lending institution throughout its various mergers for a number of years. I can only imagine the riveting conversations at dinnertime.

This week Jim gets a bit DCF’ed about how Wall Street does not fully explain how it values real estate. He believes its a looming problem.
…Jonathan Miller

The Global Equity Research Department of Lehman Brothers [3] recently published the REIT NAV Handbook which summarizes the valuation methodology employed to estimate NAV which is defined as “an estimate of the private market value of a company’s assets.”

Anyone who understands real estate clearly sees the risks inherent in the valuation process that Lehman Brothers has used to estimate the private value of the companies assets. The process does not appear to conform to the Standards of the Appraisal Institute [4] or the American Society of Appraisers [5]. If they use the same procedures to value investments that they have made in real estate companies or real estate investment trusts, they may very well have to take some hits too when they have to “mark to market.”

Consider Lehman’s methodology, outlined as of June 2007:

“We first calculate a forward 12-month cash net operating income (NOI) based on annualized 1Q07 GAAP net operating income (real estate NOI plus joint venture NOI, adjusted for partial contributions, less lease termination fees where included in rental revenue), multiplied by an appropriate growth rate for the next 12 months, minus annualized straight-line rents. In cases in which joint venture NOI was not available, we used the equity in unconsolidated subsidiaries reported on the company’s income statement. (Please note that, for malls and outlets, a rolling four quarters of NOI is used to account for the quarterly fluctuations in revenue driven by percentage rents.)

The resultant cash NOI is then capitalized at an appropriate cap rate (adjusted for the quality of a company’s assets) to determine the implied value of owned properties. We next add capitalized management fee/service income (using between a 12% and 20% cap rate, in most cases), cash and cash equivalents, construction in progress at 110% of cost, any land being held for development, other assets, and, in some cases, the value of tax-exempt debt in order to arrive at the gross market value of a company’s assets.

To determine the net market value of assets, we then subtract all of the company’s liabilities and obligations, including preferred stock at liquidation value and the REIT’s share of joint venture debt.

Our NAV estimates make no adjustment for any mark-to-market on company debt.”

The blog format does not lend itself to an all-inclusive discussion of all the issues and standards. One must remember, however, that Wall Street is not subject to the Uniform Standards of Professional Appraisal Practice (USPAP) [6]. Perhaps they should be to protect the general public. For starters, are the individuals who prepared this analysis competent? According to USPAP, to be competent, the analyst must be familiar with the type of property, the subject market, the geographic area and the appropriate analytical methods for determining value for that type of property. Their qualifications have not been provided.

The second problem deals with scope of work [7] which, according to USPAP, should be clearly delineated so that investors can ascertain the risks associated with this type of analysis. This includes but is not limited too:

* “the extent to which the properties are identified;
* the extent to which tangible properties are inspected;
* the type and extent of data researched; and
* the type and extent of analyses applied to arrive at opinions or conclusions.”

I presume that the information was provided by the individual companies which would tend to be biased, as history and common sense have indicated. The credibility of the results is always measured in the context of the intended use. I will let the individual judge whether the scope of work is adequate to make an investment decision in any of the REITs discussed. In fact, the term “private market value” is not even defined.

While there are many criticisms that will be left unresolved, I would like focus on the second paragraph and specifically the following statement:

“We next add capitalized management fee/service income (using between a 12% and 20% cap rate, in most cases), cash and cash equivalents, construction in progress at 110% of cost, any land being held for development, other assets, and, in some cases, the value of tax-exempt debt in order to arrive at the gross market value of a company’s assets.”

No justification or support has been provided for the 12% to 20% capitalization rates selected for the management fee/service income. They have also added construction in progress at 110% of cost. That could be overstated. Some developers are having trouble selling properties; therefore, the value of construction in progress may be falling and is certainly well below cost. Land values are dropping as construction costs rise, capitalization rates and mortgage interest rates are increasing, thereby reducing the potential value of the finished product. I doubt that the big four accounting firms are making the appropriate adjustments that are required to properly mark the assets and liabilities to market value.

The final sentence is also quite interesting in that Lehman Brothers is not adjusting the debt to market. Many real estate companies have short-term debt and other obligations that will have to be refinanced within the next five years. The cost of the refinancings will most likely be higher over this period, which means the cost of borrowing will increase.

Clearly, anyone involved with real estate knows that real estate investing requires a long term commitment to minimize the cyclical variations occurring in the market place. DCF analysis takes the long term into account, and is regarded as one of the best methods of replicating steps taken to reach investor buy/sell/hold decisions, and is often a part of the exercise of due diligence in the evaluation of an investment.”

Moreover, USPAP states that “DCF (discounted cash flow) analysis [8] is becoming a requirement of advisors, asset managers, fiduciaries, portfolio managers, syndicators, underwriters, and others dealing in investment-grade real estate. These users of appraisal services favor the inclusion of DCF analysis as a management tool in projecting cash flow and return expectations, capital requirements, refinancing opportunities, and timing of future property dispositions. If pension funds and investors apply a discounted cash flow analysis to truly reflect the actions of buyers and sellers in the market place, then, why does Wall Street ignore the same? They too have a fiduciary responsibility, as well as an ethical obligation, to provide investors with meaningful conclusions that are explained, justified and supported by market evidence.

If other Wall Street firms are following similar procedures, expect further hits to some of the REIT shares as interest rates rise, construction costs increase and profits decline as indicated in my previous posting, “Is The Stock Market Signaling A Warning Sign To The Private Commercial Real Estate Market Or Was The Reverse True? [9]Wall Street appears to have forgotten many lessons that were learned in the 1970’s [10].

Thanks to Noreen Whysel [11] who provided some input and assistance.