Case 093Valuing listed securities: IPOs, DCF and REITsCore
A hybrid fund considers units of an office REIT: net operating income Rs 1,200 crore, cap rate 7.5%, debt Rs 4,000 crore, 100 crore units trading at Rs 118. What is NAV per unit, and what does occupancy falling from 90% to 78% do to it?
1The situation
A hybrid fund is considering units of Ambarvan Office REIT, an invented listed trust that owns office parks in three cities. Its portfolio is 90% occupied and earns net operating income, rent less property costs, of Rs 1,200 crore a year. Comparable office sales suggest a cap rateNet operating income divided by property value, the yield a buyer of the building demands. Value is NOI divided by the cap rate. of 7.5%. The REIT carries Rs 4,000 crore of debt at an average cost of 8%, and has 100 crore units outstanding, trading at Rs 118.
Its largest tenant, a technology services firm, is reviewing its office needs. Model the downside as occupancy falling from 90% to 78%, with rents per square foot unchanged and net operating income moving in proportion. REITs must distribute most of their cash flows and follow leverage limits set by the regulator; confirm the current rules.
2Your task
What is NAV per unit today and how does the price compare, what does the occupancy fall do to NAV and to distributions, and would you buy at Rs 118?
Quick check
Occupancy falls from 90% to 78%, cutting NOI by a seventh. Roughly how far does NAV per unit fall?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
NAV is Rs 120 a unit, so Rs 118 is a 1.7% discount, and the occupancy fall takes it to about Rs 98.7. Rs 1,200 crore at 7.5% values the properties at Rs 16,000 crore; less Rs 4,000 crore of debt leaves Rs 120 a unit. At 78% occupancy NOI falls 13.3% and value with it, but debt does not, so NAV falls 17.8% and the distribution yield at Rs 118 drops from 7.5% to 6.1%. Buy only if the tenant risk is priced, which a 1.7% discount does not do.
Step 1How do you get from rent to a value per unit?
The same way you would value a flat you let out: the rent it earns, divided by the yield a buyer wants, less the loan on it. Property value is NOI over the cap rate, Rs 1,200 crore over 7.5% = Rs 16,000 crore; subtract Rs 4,000 crore of debt and divide by 100 crore units, and NAV is Rs 120 a unit. The market price of Rs 118 is a 1.7% discount, close enough to fair that the market is not pricing much bad news. Loan to value is 25%, comfortable against the regulator's leverage limits, which you should confirm.
| NOI | net operating income, Rs 1,200 crore a year |
| c | cap rate, 7.5% |
| Debt | Rs 4,000 crore |
| Units | 100 crore |
Step 2What does the occupancy fall do?
Trace it through the same chain. Occupancy at 78% instead of 90% cuts NOI by a seventh, to Rs 1,040 crore, and at the same cap rate the properties are worth Rs 13,867 crore, down 13.3%. The debt is still Rs 4,000 crore, so the whole Rs 2,133 crore fall lands on the equity: NAV drops to Rs 98.7, 17.8%, about 1.33 times the fall in value. That multiplier is just the inverse of the equity's share of value, and it rises as value falls: loan to value moves from 25% to 29%, so the next fall would be magnified more.
Step 3What happens to the income the fund would actually receive?
The same leverage works on cash. Interest on Rs 4,000 crore at 8% is Rs 320 crore a year whatever the occupancy. Distributable cash falls from about Rs 880 crore to Rs 720 crore, Rs 8.8 to Rs 7.2 a unit, and the yield on a Rs 118 purchase from 7.5% to 6.1%. That is before capital expenditure to refit the vacated floors and before the leasing commissions and rent-free periods needed to fill them, which is why a REIT's reported distribution usually falls by more than NOI in a vacancy.
| Rs crore unless stated | 90% occupancy | 78% occupancy | Change |
|---|---|---|---|
| Net operating income | 1,200 | 1,040 | -13.3% |
| Property value at 7.5% | 16,000 | 13,867 | -13.3% |
| Debt | 4,000 | 4,000 | 0% |
| Equity | 12,000 | 9,867 | -17.8% |
| NAV per unit, Rs | 120.0 | 98.7 | -17.8% |
| Loan to value | 25% | 29% | |
| Distribution per unit, Rs | 8.8 | 7.2 | -18.2% |
Step 4Would you buy at Rs 118?
Not on these numbers without more on the tenant. The price sits a 1.7% below a NAV that assumes 90% occupancy, while the downside case puts NAV at Rs 98.7, 20% below the price. The cap rate is the other lever: if buyers demand 8% instead of 7.5%, the properties are worth Rs 15,000 crore and NAV Rs 110, with occupancy unchanged. The view: a fair price for the REIT as it is, and an expensive one if the tenant leaves, so the fund should want either a wider discount or evidence on the lease, its expiry, its break clauses and the market for the space. The limit of the model is that NOI does not fall exactly in proportion to occupancy, since some costs are fixed and some space may be re-let at different rents, and NAV is a buyer's valuation, not a price anyone must pay.
Where candidates lose it
Candidates divide NOI by the cap rate and stop, quoting Rs 160 a unit. The REIT owes Rs 4,000 crore; the units own only what is left after that, Rs 120.
The second miss is saying NAV falls 13% because NOI fell 13%. The fall in value lands entirely on the equity, so NAV falls 17.8%, and the yield on the units falls by even more once fixed interest is paid first.
What the interviewer asks next
- The REIT could refinance its Rs 4,000 crore at 7% instead of 8%. What does that do to distributions and to the value of the units?
- How would you decide what cap rate to use, and what moves it?
- The REIT trades at a 20% discount to NAV for a year. What are the possible explanations, and which would make you buy?
- Why might a REIT's reported distribution fall by more than its NOI when a tenant leaves?
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Company names and figures are illustrative.