###### Time Structure Models

Equilibrium Term Structure Models Equilibrium term structure models are built on theories about... **Read More**

An example is better suited here to help candidates understand the concept.

Tysons Limited, a real estate asset management company, is keen on diversifying its portfolio through an office lease REIT investment.

The company needs to value the potential investment as of the end of 2015 based on the data below:

$$ {\begin{array}{l|c} \text{Estimated 12 months cash NOI} & $70,000,000 \\ \hline\text{FFO}&$60,000,000\\\hline\text{Cash and equivalents} & $55,000,000 \\ \hline \text{Accounts receivable}& $25,000,000 \\ \hline\text{Debt and other liabilities}& $300,000,000 \\ \hline\text{Non-cash rents}& $2,500,000 \\ \hline\text{Recurring maintenance-type capital expenditures}& $10,000,000 \\ \hline\text{Shares outstanding}& 10,000,000 \text{ shares} \\ \hline\text{Expected annual dividend 2016}&$5.00 \\\hline\text{Dividend growth rate in 2017 and 2018}& 2\text{%} \\ \hline\text{Dividend growth rate from 2019 to perpetuity}&1 \text{%} \\ \hline\text{Assumed cap rate }& 7\text{%} \\ \hline\text{Office subsector average price-to-FFO multiple}& 10\text{x} \\ \hline\text{Office subsector average price-to-AFFO multiple}&14\text{x} \\ \hline\text{Tysons Limited cost of equity capital}& 9\text{%} \\ \hline\text{Risk-free rate }& 2\text{%} \end{array}}$$

While using each of the approaches below, the amount of a REIT is *closest to:*

- Approach 1: Net asset value.
- Approach 2: Price-to-FFO.
- Approach 3: Price-to-AFFO.
- Approach 4: Discounted cash flow.

**Step 1: Calculate the Estimated Value of Operating the Real Estate as Follows:**

$$ \begin{align*} \text{Estimated Operating Value} & = \frac{\text{Estimated Cash NOI}}{\text{Assumed Cap Rate}} \\

\text{Estimated Operating Value} &= \frac{$70,000,000}{7\%}= $1,000,000,000 \end{align*} $$

**Step 2: Calculate the Net Asset Value as Follows:**

$$ {\begin{array}{l|r} \text{Estimated operating value} & $1,000,000,000 \\ \hline\text{Add: Cash and equivalents} & $55,000,000 \\ \hline \text{Add: Accounts receivable}& $25,000,000 \\ \hline\text{Less: Debt and other liabilities}&($300,000,000)\\ \hline\text{}& \bf $780,000,000 \end{array}}$$

**Step 3: Calculate the NAV/Share as Follows:**

$$ \begin{align*} \frac {\text{NAV}}{\text{share}} &= \frac{\text{NAV}}{\text{Shares outstanding}} \\

\frac {\text{NAV}}{\text{share}} & = \frac{$780,000,00}{10,000,000 \text{ shares}}= $78.00 \end{align*} $$

**Step 1: Calculate the FFO per share:**

$$ \begin{align*} \frac {\text{FFO}}{\text{share}}&= \frac{\text{FFO}}{\text{Shares outstanding}} \\

\frac {\text{FFO}}{\text{share}} & = \frac{$60,000,000}{10,000,000}= $6.00 \end{align*} $$

**Step 2: Apply the office subsector average P/FFO multiple of 10x yields:**

$$ \text{REIT share value}= ($6 \times 10)= $60\text{REIT share value}=($6 \times 10)=$60 $$

**Step 1: Calculate the AFFO value:**

$$ {\begin{array}{l|r} \text{FFO} & $60,000,000 \\ \hline\text{Less: Non-cash rents) rent} & ($2,500,000) \\ \hline \text{Less: Recurring maintenance-type capital expenditures }& ($10,000,000) \\ \hline\text{}& \bf $47,500,000 \end{array}}$$

**Step 2: Calculate AFFO per share:**

$$ \begin{align*} \frac {\text{AFO}}{\text{share}} &= \frac{\text{AFO}}{\text{Shares Outstanding}} \\

\frac {\text{AFO}}{\text{share}} &= \frac{$47,500,000}{10,000,000 \text{ Shares}}= $4.75 \end{align*} $$

**Step 3: Apply the office subsector average P/AFFO of 14x yields:**

$$ \text{REIT share value}= ($4.75 \times 14)= $66.50 $$

**Step 1: Calculate the annual dividend per share (DPS):**

$$ DPS=\text{Prior year DPS}+ \left(\frac{\text{Prior}-\text{year DPS}}{100\%} \times \text{Growth Rate} \right) $$

$$ {\begin{array}{l|c|c|c|c|c} \textbf{Year}&{\textbf{2015} }&{\textbf{2016} }&{\textbf{2017} }&{\textbf{2018}}&{\textbf{2019}} \\ \hline\text{Dividend Per Share (DPS)} & & $5 & $5.10 & $5.20 & $5.25 \\ \hline {\text{Terminal value at the} \\ \text{end of 2018*}} & & & & $65.63 & \\ \hline \text{Present Values} & $63.57 & 4.59 & 4.29 & 54.69 &\\ \end{array}}$$

**Step 2: Determine the terminal value at the end of 2018:**

$$\text{Terminal value}= \frac{$5.25}{(9\%-1\%)}= $65.63$$

Calculate the value of a REIT per share by discounting the dividends at a rate of 9% as follows:

REIT value per share = $ 63.57

* Note: *The resulting amount of a REIT share is likely to vary, sometimes significantly, depending on which approaches are used.

## Question

Consider the following selected REIT financial data concerning an investment in an industrial building at the end of 2013:

$$ {\begin{array}{l|c} \text{Estimated 12 months cash NOI} & $35,000,000 \\ \hline\text{FFO}&$30,000,000\\\hline\text{Cash and equivalents} & $20,000,000 \\ \hline \text{Accounts receivable}& $20,000,000 \\ \hline\text{Debt and other liabilities}& $220,000,000 \\ \hline\text{Non-cash rents}& $4,000,000 \\ \hline {\text{Recurring maintenance-type capital} \\ \text{expenditures}}& $8,000,000 \\ \hline\text{Shares outstanding}& 10,000,000 \text{ shares} \\ \hline\text{Expected annual dividend 2014}&$6.00 \\\hline\text{Dividend growth rate in 2015 and 2016}& 7\% \\ \hline {\text{Dividend growth rate from 2017 to} \\ \text{perpetuity}} & 5\% \\ \hline\text{Assumed cap rate }& 8\% \\ \hline {\text{Office subsector average price-to-FFO} \\ \text{multiple}} & {12x} \\ \hline {\text{Office subsector average price-to-AFFO} \\ \text{multiple}} & {20x} \\ \hline\text{Tysons Limited cost of equity capital}& {11\%} \\ \hline\text{Risk-free rate }& {2\%} \end{array}}$$

The value of the investor’s potential investment using a price-to-FFO approach is

closest to:

- $25.75.
- $36.
- $30.
## Solution

The correct answer is B.This is computed as follows:

$$ \begin{align*} \frac {\text{FFO}}{\text{share}} &= \frac{\text{FFO}}{\text{Shares outstanding}} \\

\frac {\text{FFO}}{\text{share}} &= \frac{$30,000,000}{10,000,000 \text{ Shares}}= $3.00 \end{align*} $$Applying the office subsector average price-to-FFO:

$$ \text{REIT share value}= ($3.00 \times 12)= $36 $$

A is incorrect.The amount reflects the REIT per share value using the NAV approach.

C is incorrect.The amount reflects the price-to-AFFO applying the office subsector, elaborated in the workings below.

Reading 37: Investments in Real Estate Through Publicly Traded Securities

*LOS 37 (d) Calculate and interpret the value of a REIT share using the net asset value, relative value (price-to-FFO and price-to-AFFO), and discounted cash flow approaches.*