Case 015Sector valuationWarm up
An office REIT owns three buildings at different cap rates. Work out its net asset value per unit, its loan to value, and whether the units trade at a premium or a discount.
1The situation
Kalpit Office Parks, a listed office REIT, owns three buildings. Tower A, a new tower in the business district, earns net operating income of Rs 60 crore a year and comparable buildings sell at a 7.5% cap rate. Tower B earns Rs 40 crore at an 8.0% cap rate. Tower C, older and on the edge of the city, earns Rs 25 crore at 9.0%.
Kalpit has Rs 700 crore of debt and 50 crore units in issue, which trade at Rs 18.
2Your task
What is Kalpit's net asset value per unit, its loan to value, and do the units trade at a premium or a discount to NAV? What happens if cap rates rise half a point?
Quick check
Total NOI is Rs 125 crore. Can you value the portfolio at one blended cap rate of about 8%?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
NAV is about Rs 17.56 a unit, so units at Rs 18 trade at a 2.5% premium, with loan to value of 44.4%. The towers are worth Rs 800, 500 and 278 crore at their own cap rates, Rs 1,578 crore in all. Less Rs 700 crore of debt, NAV is Rs 878 crore over 50 crore units. A half-point rise in cap rates cuts NAV per unit by about 11%.
Step 1How is a property valued?
From the rent it earns and the yield buyers accept. A building's value is its net operating incomeRent and other property income less the costs of running the building, before interest, tax and depreciation. divided by its cap rateThe yield at which comparable buildings change hands: income divided by price.. If a shop rents for Rs 1 lakh a year and shops like it sell for a 5% yield, it is worth Rs 20 lakh. A lower cap rate means buyers pay more for each rupee of rent, because the building is newer, better located or let to safer tenants.
Step 2What is each building worth, and what is left for unitholders?
Value them one at a time. Tower A is Rs 60 crore over 7.5%, Rs 800 crore. Tower B is Rs 40 crore over 8.0%, Rs 500 crore. Tower C is Rs 25 crore over 9.0%, Rs 277.8 crore. Gross asset value is Rs 1,577.8 crore; less Rs 700 crore of debt, net asset value is Rs 877.8 crore, Rs 17.56 a unit. Loan to valueDebt divided by the value of the properties, the property world version of leverage. is Rs 700 crore over Rs 1,578 crore, 44.4%.
| Building | NOI, Rs crore | Cap rate | Value, Rs crore | Value at +0.5% |
|---|---|---|---|---|
| Tower A | 60 | 7.5% | 800.0 | 750.0 |
| Tower B | 40 | 8.0% | 500.0 | 470.6 |
| Tower C | 25 | 9.0% | 277.8 | 263.2 |
| Gross asset value | 125 | 7.92% | 1,577.8 | 1,483.7 |
| Less debt | (700.0) | (700.0) | ||
| NAV per unit, Rs | 17.56 | 15.67 |
Step 3Why does a half-point move in cap rates matter so much?
Because the debt does not move when the buildings do. A half-point rise cuts gross asset value by about 6%, but the whole loss lands on the equity, so NAV per unit falls about 11%, to Rs 15.67, and loan to value rises to 47.2%. At Rs 18 the units would then trade about 15% above NAV. So the premium today is a statement about where cap rates are going: the market is paying slightly more than the buildings are worth now, which only makes sense if it expects rents to grow or yields to stay low.
Close by saying what you would check next: the lease expiry profile of each tower, since a large tenant leaving Tower C would change its NOI more than any cap rate move, and the borrowing limit that applies to listed REITs, which you would confirm from the current regulations rather than quote from memory.
Where candidates lose it
Candidates divide total NOI by an average of the three cap rates, 8.17%, and get about Rs 1,531 crore. That weights a small, risky building the same as a large, safe one and understates value by about Rs 47 crore.
The second miss is forgetting to take the debt off, and comparing gross asset value per unit, Rs 31.56, with the Rs 18 price, which makes the units look absurdly cheap.
What the interviewer asks next
- Tower C's main tenant, half its NOI, leaves next year. What is NAV per unit now?
- Why might a REIT trade at a persistent discount to NAV?
- How would you value a building under construction inside the REIT?
Asked at Morgan Stanley, Investment Banking, London, 2025 (Wall Street Oasis): Real Estate valuation metrics applied to a ad-hoc case study.
Company names and figures are illustrative.