A Primer On Real Estate Equities

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Right now, there’s an anomaly in certain real estate stocks in Asia …

The anomaly is the share prices of these companies in relation to their underlying net asset value (NAV).

You see, in many parts of the region, shares of real estate companies trade at a substantial discount to their underlying NAV.

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This means that an investor in these shares is buying US$100 worth of property assets for, say, US$60 (that is, a 40 percent discount to NAV).

You cannot buy bricks and mortar assets at discounts like this. No one says, the market value of this building is $1 million, but I’ll sell it to you for $600,000. So it’s no surprise that investors are interested in this proposition.

But before you jump into real estate stocks trading below their NAV, you need to consider whether these stocks are actually a good deal…

A primer on NAV

In simple terms, NAV is the value of the company’s assets (the value of the real estate, plus any other businesses that the company may hold), less the debt and other liabilities that are owed by the company.

Under accounting rules, all investment properties (properties held in the portfolio for rental income) should be revalued each year with the new valuation reflected in the company’s accounts. This takes into account any increases or declines in property values over the course of the past year.

But properties that are under development do not need to be revalued. They are held on the books at cost (which normally includes land cost and any construction costs already incurred), or at a figure reflecting realisable value, whichever is lower.

In most cases, the value of the completed development properties is likely to be considerably higher than the values held in the accounts. Hence, the reported book value of the company will likely underestimate the full realisable value of the portfolio of development properties.

So for companies with large development portfolios, the book value of the company as shown in the company’s accounts is likely to understate the true NAV of the company.

For real estate investment trusts (REITs) and investment property companies that don’t have many development properties, the stated book value is likely to be a much closer measure of underlying NAV, if those investment properties are revalued each year.

So why do Asian real estate companies routinely trade at deep discounts to NAV?

Why aren’t investors prepared to pay to pay a price for Asian real estate shares that reflect the underlying value of the company’s assets?

There are several reasons:

First, there may be a difference between REITs and other types of property companies, such as developers. REITs often trade at prices much closer to NAV and sometimes in excess of NAV. That may be because of the stable nature of the company’s portfolio and its income. The rules that govern REITs mean that they must pay 90 percent of income to shareholders as dividends. And the amount of more uncertain, risky development that REITs can do is often limited by the rules. Sometimes debt limits are also imposed, and in most cases, REITs attract certain tax benefits that other companies don’t get.

Developers take bigger risks simply because they buy land, often expensive, up front, and spend years developing it. The pricing of the finished product at the end of the development period is uncertain. This is especially the case in volatile markets like Hong Kong, China and some other parts of Asia. The returns on investment may be very good, but the rewards are normally achieved at greater risk.

In short, REITs often enjoy lower volatility than the market as a whole and lower volatility than developer stocks.

So they are perceived as carrying lower risk and therefore less uncertainty. Investors pay a higher price for that lower perceived risk.


Then there’s the “management discount factor.” You see, many listed real estate companies in Asia, especially Hong Kong, are controlled by family groups that have maintained a vice-like grip on the company, sometimes for generations. Investors sometimes believe that the controlling shareholders are really running the company for their own benefit and not for the benefit of shareholders. In short, investors feel that they’re not focused on creating shareholder value.

For example, a company I have followed for many years owns a portfolio of high-end hotels. The family patriarch who controls the company is a keen helicopter pilot. The company has spent large amounts of money (shareholder money) building helicopter landing pads on the top of some of its hotels. This can in no way be profitable for the company, and some investors think this is done to satisfy the controlling shareholder’s private hobby.

There have also been examples of changes in family management that has brought radical changes in tactics, strategy, gearing and risk taking.

For example, many years ago, the son of a company founder took over the reins of the company from his father. The son immediately cranked up the debt and embarked on a splurge of asset buying in various markets around the world. Shareholders were not impressed, and the company has consistently traded at a discount to its peers pretty much ever since.

And then there are transparency and policy risks that investors will often take into account. For example, China-based listed companies are widely believed to have lower corporate governance standards than those in more developed, longer established markets. Disclosure and transparency in Chinese companies is often much less than it is for companies elsewhere. These companies are having to learn what is expected of them when they enter international markets.

Government policy is another big factor in some countries, and certainly in China. The authorities exercise huge control over most aspects of the economy and financial conditions in China. This is not a free market in the way that most western people think of markets. The Chinese government is constantly tweaking the rules and pulling lots of levers to control and direct companies, their businesses and financial outcomes. The real estate sector is a classic case in point. New rules seem to emerge onto the stage on a weekly basis.

This all places a climate of uncertainty and risk on companies. Investors know that the companies can be hit with any number of new rules, regulations or requirements at any time. Share prices often reflect that risk and uncertainty.

Now, in some circumstances, real estate stocks may trade at a premium to NAV. This can happen if the market believes that real estate values and rentals are set to rise in the future and the NAV will expand. Investors may reflect that into share prices now.

Some REITs may also often trade at premiums to NAV. This can reflect a view that valuations, as given in the company’s accounts, are below what could realistically be achieved in the open market if assets were to be sold.

So how can you tell if a stock is cheap or not?

It’s all well and good to say that a certain stock (or market) is cheap because it is trading at, say, a 50 percent discount to its NAV.

But before we jump to that conclusion it is worth quickly checking the following:

  • What discount (or premium) to NAV has this company traded at over time?
  • What is the relative valuation of this company compared to its peers over time?
  • Is there any good reason why this stock is cheaper (or more expensive) than it has been in the past or relative to its peers?

I know investors who have bought a particular stock because it is trading at, say, a 55 percent discount to NAV. But sometimes that stock has traded at around this valuation for many years. So relative to its own history, it is not cheap.

Then the question becomes, “Is there a catalyst that is likely to make this stock trade closer to its NAV?”

For example, some investors look at Chinese property stocks, many of which were up at least 30 percent in 2017, and conclude that they must be expensive. But, in fact, the sector as a whole is trading at a discount to NAV of around 33 percent. That’s been about the average for the past 12 years.

But listed property companies have been enjoying record sales and strong sales growth in the past year. Those sales will reflect in earnings in the coming year or two. So given that the stocks are not overly expensive relative to their historical NAV, the strong earnings growth can also help underpin share prices.

Similarly, Hong Kong real estate stocks were up around 30 percent in 2017. But the property companies (not including the REITs) are still trading at a discount of close to 40 percent to their NAV. Companies that have sometimes traded at prices close to NAV are now trading at 40 percent to 50 percent discounts. And these are big blue chip, bellwether stocks in the sector. So despite having risen strongly, share prices are not expensive against their history on a NAV basis.

For Singapore, where a greater proportion of listed real estate companies are REITs— which often trade at higher valuations than property developers – the picture is very different. Here, property stocks are trading, on average, at a premium to longer-term averages and at a premium to underlying NAV. Therefore, they appear more expensive.

However, the Singapore real estate market is crawling out of a trough where property prices fell over the previous three years. Property prices are starting to recover, which will likely push NAVs higher in the coming year. Stocks have reflected that expectation to some extent already.

So as investors, we should always look at the relative valuation of individual property stocks or the overall sector (relative to its own history and its peers) and try to understand the catalysts for why the current situation exists. Then we can understand what might make it change going forward… and whether or not we should invest.

Good investing,

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