Be Careful When Using REITs for Valuing an Interest in a Real Estate Entity
Whether using the income approach or the market approach to valuation, the analyst typically relies on empirical data from the marketplace. This data must be applicable to the particular valuation methods being used; i.e., in the market approach, empirical data for market pricing multiples is found in the marketplace where business interests similar to the subject interest trade in arm’s length transactions among willing buyers and sellers.
Similarly, for the income approach, empirical data on rates of return found in the marketplace for comparable companies is identified and applied to the subject company.
When valuing a non-controlling interest in an asset holding company that holds real estate, one of the commonly used sources of rate of return data is the marketplace for real estate investment trusts (“REITs”). Because REITs invest in real estate, and non-controlling interests in them are actively traded, they are sometimes relied upon as proxies for valuing a small, privately held asset holding company. However, the analyst must consider if REITs are truly comparable to the subject interest.
Some of the characteristics of REITs that are similar to those of a typical privately held real estate holding company include:
- They invest at least 75 percent of their total assets in real estate
- They derive at least 75 percent of their gross income from rents from real property, interest on mortgages financing real property or from sales of real estate
- They pay at least 90 percent of their taxable income in the form of shareholder dividends each year. (Although the typical privately held company does not usually have this as a requirement, distribution of available cash flow is often assumed.)
However, there are a number of ways in which REITs differ from the typical subject company. For example, REITs:
- Are managed by independent boards of directors or trustees
- Have no more than 50 percent of their shares held by five or fewer individuals
- Typically own very large portfolios of institutional-grade properties that are well diversified in terms of geographical markets and tenants.
- Are actively followed by many full-time REIT analysts and investors.
- Have full time officers and employees that are devoted full-time to managing the day-to-day affairs of the REIT.
- Are infinite-life corporations, meaning they are never expected to liquidate their assets, as they operate into perpetuity. By law, limited partnerships are finite-life entities with a specified date by which they must be liquidated and dissolved.
- Typically have much greater access to capital, both debt and equity.
- Are growth-oriented entities
Thus, the analyst must carefully weigh both the similarities and differences between REITs and the subject interest in order to determine if REITs are sufficiently comparable for use in the market approach of valuation.