Real-Asset Cash Flow vs Asset Valuation Compared

Cash flow is what the assets actually produced. A valuation is what somebody estimates they would fetch. Nilgiri Real Assets Fund I, invented, produced Rs 34,90,00,000 of net operating income on the Rs 3,75,00,00,000 it deployed, being 9.3 per cent on its own cost, or 10.6 per cent on the Rs 3,30,00,00,000 actually producing income. Neither number is a valuation, and quoting either one without naming its denominator says something false.

Everything here turns on one difference, and it is worth sitting with before any arithmetic arrives. One of those two kinds of number arrived. A contract said somebody had to pay it, and somebody paid it, on a date, into an account. Nobody has bought anything, so the other kind did not arrive and cannot arrive. A cash flow is an event that happened and can be counted, and a valuation is an answer to a question that nobody has yet tested with money. On an exchange the price looks like the hard fact and the income looks like the soft one, so a reader who has only ever held listed shares usually carries this the wrong way round. Inside an unlisted property and infrastructure vehicle the order reverses completely, and the reversal governs everything that follows.

What is the one question that separates these two numbers?

Consider a small shop that a neighbour rents out on the ground floor of her house. Two numbers get talked about at every dinner. The first is the rent: eighteen thousand rupees, on the fifth of every month, transferred by a tenant whose name she knows, and if it is late she notices within a day. The second is the shop's value. Her brother thinks one figure, the property agent down the road thinks another, and the man who bought a similar shop two streets away thinks a third. Nobody has put money on the table, so every one of those three is honest and none of them is a fact.

The distinction between an arrival and an estimate survives being scaled up. A cash flowMoney that has actually arrived, traceable to a payer and a date. is money that has already moved from one party to another, so there is a payer, a date, an amount and usually a contract sitting behind it. A valuationAn estimate of what something would fetch, produced by somebody who did not sell it. is somebody's estimate of what an asset would fetch, produced without any money changing hands at all. Ask of any figure on a real-asset schedule whether the money has arrived, and the figure sorts itself into one of those two piles immediately. Everything else that differs between them, who produced the number, what it can be checked against, when it moves, is downstream of that single answer.

Notice how uncomfortable this is. A reader is normally taught the opposite instinct. Rent feels fragile. Tenants leave, roofs leak, a factory shuts and the warehouse it filled empties out. A valuation, printed in a report with a firm's name at the bottom, feels solid. The feeling is backwards, and worth stating plainly. The rent arrived and can be proved from a bank statement in about four minutes. The valuation has never been tested by anybody and cannot be proved at all, only argued with. Neither of those observations makes the rent likely to continue or makes the valuation wrong. Both observations state what kind of number each one is. Whether either number is any good is a different subject.

Run the sorting question across the schedule of Nilgiri Real Assets Fund I and it is startling how lopsided the result is. The fund holds five assets. Its record fixes, to the rupee, what four of them produced in the year and that the fifth produced nothing at all. The record fixes what all five cost. No sale, offer or valuation exists for any of the five, so the record fixes no figure at all for what any of them would fetch. The record is complete on one side and silent on the other, and that silence is not an oversight to be filled in but the honest position of a vehicle whose assets have all been bought and none sold.

What can a cash flow figure actually be checked against?

Against things that exist outside the person stating the number. Nothing else counts as a check. Rs 15,00,00,000 of net operating income from the office property of Nilgiri Real Assets Fund I over one year on its own cost of Rs 1,20,00,00,000, is not a claim floating in a report. The figure is the residue of a set of transfers. Behind it sit rent invoices raised on named tenants, receipts against those invoices, a bank account that grew by those amounts on those dates, leases that say what was due, and a set of operating costs that were paid out to named suppliers. Two people who disagree about that figure can sit down with the statements and settle the disagreement.

Checkability is an unglamorous property and worth naming clearly. A cash flow is the only thing on a real-asset schedule that has it. A cash flow is checkable in the strict sense that an independent person with access to the records can arrive at the same figure without asking the manager's opinion about anything. The word for that is verification, and it is different from assessment. A judgement is assessed by deciding whether the reasoning behind it holds up. A fact is verified by going and looking. A rent receipt is verified. A view about what a building would fetch is assessed, and no amount of care in producing it moves it from the second category into the first.

Two honest qualifications belong here or the point becomes a slogan. The first is that being checkable is not the same as being permanent. Nothing about the Rs 34,90,00,000 that the five assets of Nilgiri Real Assets Fund I produced in one year on its own cost of Rs 3,75,00,00,000 says a single rupee of it arrives again. A tenant can leave. A contracted payment is a contract. Somebody has undertaken to pay it, and the counterparty still has to actually pay. Nothing about next year is established for any of the five. The second qualification is that a cash flow figure is only as checkable as the definition sitting underneath it. Net operating income is a defined line with an agreed shape, built gross to net, and the building of it is covered separately. The definition in use has to be identified before the number is treated as settled, and then the tracing works.

Who produces a valuation, and what kind of number is it?

Somebody outside the transaction, working to a method, on a timetable, with no money moving at any point. In this vehicle the independent valuation agentA firm outside the manager that values the assets on a fixed timetable. is Palani Valuation Advisors, an invented limited liability partnership (LLP), with the manager marking between those valuations, and the timetable that governs when either of them restates a figure is covered separately. How a valuation is built, how any rate inside it is chosen, and the method that applies to each kind of asset are all covered elsewhere.

The kind of number that comes out at the end matters here, and that kind is a different question from how the number is made. A valuation is a considered opinion about a hypothetical transaction. Every serious valuation says so in its own opening paragraphs, usually in language a reader skims past. The opinion is produced by a professional whose incentive is to be right, using observable inputs where they exist, and it can be very good indeed. The transaction it describes has not taken place and no counterparty has agreed to anything, so the number is still an opinion. Calling it an opinion is not an insult to the valuer any more than calling a weather forecast a forecast is an insult to a meteorologist.

The consequence that matters for reading a schedule is about movement. A cash flow moves when a payment is made or missed, so it changes on the days that things happen. A valuation moves when the valuer restates it, so it changes on the days the timetable comes round, whether or not anything happened in between. Payments and timetables are two completely different clocks, and the difference is why the two numbers can look badly out of step for long stretches without either being wrong.

What happens the moment a cash flow becomes a yield?

A cash flow stops being a fact about money that arrived and becomes a ratio, and a ratio has two ends. Most misreading of a real-asset schedule begins at exactly that point, and it begins so quietly that nobody notices the transition has happened.

Rs 34,90,00,000 arrived. The sentence is complete. The claim needs no context to be true and no denominator to be checked. The statement that the portfolio yields 9.3 per cent is a different kind of thing. The yield statement has smuggled in a second number, and unless it says which one, it has said less than the first sentence did while sounding like it said more. A cash flow becomes a yield the instant somebody divides it by something, and the something is now doing half the work while getting none of the attention. A yield on costA year's income divided by what was paid for the asset, and nothing more. is exactly that: one year's income over what was paid for the asset. Nothing more, and in particular nothing about what the asset would fetch from anybody.

The household version makes the trap obvious in a way the fund version does not. The neighbour with the shop paid twenty two lakh rupees for it and collects two lakh sixteen thousand rupees of rent a year. Her return on what she paid is 9.8 per cent. Her cousin bought an identical shop in the same row for thirty five lakh rupees and collects the same rent, so his is 6.2 per cent. Same building, same street, same tenant covenant, same rent, two completely different yields, and neither of them says what either shop would fetch this afternoon. The yields differ because the purchase prices differ, and the purchase prices are history.

What does Rs 34,90,00,000 look like against everything deployed?

The answer is 9.3 per cent, and deployed capital is the first of the two denominators. Nilgiri Real Assets Fund I put Rs 3,75,00,00,000 into five assets. The Rs 3,75,00,00,000 is the fund's deployed capitalThe money actually put into assets, as against the money committed to the fund.: money actually placed into assets, as distinct from money investors promised the vehicle. Dividing the Rs 34,90,00,000 of net operating income by the Rs 3,75,00,00,000 gives 9.31 per cent, and the record states it as 9.3 per cent. The figure is this fund's own income on its own cost, and the arithmetic is correct.

The shape of the build is the argument, so it is worth laying out as rows rather than prose.

Every one of those five percentages is this fund's own figure on its own cost over one year at the record date, and none of them says anything about what the asset would fetch or what any other asset anywhere produces. Row four is the row the whole guide turns on: Rs 45,00,00,000 has been drawn against the road, it is 12.0 per cent of everything deployed exactly, and it produced not one rupee. The road is not underperforming. There is nothing there to perform yet. A road that is being built has no traffic on it, so the contracted payments have not begun, and the record fixes that they have not begun rather than fixing a figure for when they will.

What does the same Rs 34,90,00,000 look like against the capital producing it?

The answer is 10.6 per cent, and nothing about the assets has changed. The capital drawn against the road is sitting in a construction site and cannot produce income yet. Take the Rs 3,75,00,00,000 and remove that Rs 45,00,00,000. The remainder, Rs 3,30,00,00,000, is the income-producing capitalThe part of deployed capital that is invested in assets currently producing income.. Dividing the same Rs 34,90,00,000 by that figure gives 10.58 per cent, and the record states it as 10.6 per cent. The second reading, too, is this fund's own income on its own cost.

Both divisions are correct. Both use the same numerator. The two divisions differ by Rs 45,00,00,000 in the denominator and by 1.3 percentage points in the answer. How a reader holds the difference matters enormously, so here it is flatly: 10.6 per cent is not a superior result to 9.3 per cent, it is the answer to a different question, and a schedule that quotes one of them without saying which capital it sits on has stated something false. The first asks what the whole pile of money produced. The second asks what the working part of the pile produced. Both are legitimate questions and a reader is entitled to know which one has been answered.

Exactness is rare here, so the share is worth stating. Rs 3,30,00,00,000 over Rs 3,75,00,00,000 is 88.0 per cent precisely. One warning attaches to that figure and it must be said in the same breath: the office property of this same fund runs at 88.0 per cent occupancy, and the two 88.0 figures have nothing whatsoever to do with each other. One is a share of the fund's money that is invested in income-producing assets. The other is a share of a building's floor area that is let. Their agreeing to a decimal place is a coincidence of this invented case and carries no meaning at all.

What does the denominator do when it moves?

There is something a single worked division cannot show. Reading that 9.3 became 10.6 and filing the change as a small technicality about one road is easy. The change is neither small nor about the road. The control below moves the share of capital described as producing income and holds absolutely everything else still, so a yield travels a very long way while the fund, the assets and the income do not move at all. The direction is worth predicting before the control moves.

Why does a yield on cost never turn into a valuation?

Because it is a fact about one historical purchase, and a valuation is a claim about a transaction in the present that nobody has attempted. The two look joinable because they share units and because the arithmetic connecting them is trivially easy. The ease is exactly the danger.

Which three questions does the cash flow answer, and which three does it refuse?

Setting the two lists side by side is the fastest way to see why a valuation exists at all. The Rs 34,90,00,000 of this invented fund answers, completely and checkably, what arrived, who paid it and what capital it sits on. Ask it anything else and it goes quiet.

The figure cannot say what any of the five assets is worth today. Nor can it say what a buyer would pay for one. And it cannot say what arrives next year. A year that has happened is evidence about a year that has happened and nothing more. The three refusals are not gaps in the cash flow figure but the exact questions a valuation is produced to answer, and both numbers exist for that reason rather than one. Squeezing the second set of answers out of the first number is the single most common thing done to a real-asset schedule, and a reader who understands the split stops trying.

The road asset is the sharpest test of the whole distinction, and it belongs against both lists. The record fixes two things about it and refuses a third. The record fixes that Rs 45,00,00,000 has been drawn against it, being 12.0 per cent of everything deployed. A road being built collects nothing from anybody, and the record fixes that it produced Rs 0. And it fixes no figure at all for what it would fetch. Asset 4 is the asset about which the least is known and the most is usually assumed, and the assumption almost always runs in one direction: that what has been spent on it is a floor under what it is worth. Money spent is money spent. Spending is a cost, it is checkable, and it is not evidence about value in either direction.

When does an estimate stop being an estimate?

On exactly one day, and no earlier: the day somebody actually buys the asset. The word for that event is a realisationThe sale of an asset, which is the moment an estimated value becomes a received amount., and it is the only thing that converts an opinion into an amount received. Until it happens, an estimate can be careful, methodical, produced by an experienced firm and reviewed by two more, and it remains an estimate. After it happens there is nothing to estimate. A number arrived.

None of the five assets of Nilgiri Real Assets Fund I has had that day. Not one has been sold, not one has been part sold, and this record carries no sale, no bid and no realisation for any of them. Having no realisations is the plain state of a property and infrastructure vehicle that has finished buying and has not started selling, and there is nothing unusual or troubling about it. A schedule that talked as though the day had already come would be the troubling one.

There is a version of this everybody has watched happen at close range. A cousin has been saying for four years that the plot outside town is worth a certain figure. Everyone in the household has heard the figure so often that it has stopped feeling like an opinion. Then he actually sells it, and the amount on the cheque is a different number, higher or lower, and on that day the four years of certainty simply stop mattering. Nothing about the plot changed on the day of the sale. The change is that a second party finally had to agree.

What is worth asking of a schedule like this one?

Far more people read a real-asset schedule than ever put money into one. A student reading a fund report, an analyst checking somebody else's summary, a lender sizing a facility against a property portfolio, a person on an investment committee who has ninety seconds before the next item: all of them are reading the same two columns and all of them can apply the same four questions.

First, for every number on the schedule, the question is whether it arrived. The single pass sorts the schedule into the checkable and the assessable faster than any other reading, and it costs nothing. Second, for every yield, ask which denominator it sits on. A line saying 9.3 per cent and a line saying 10.6 per cent can describe the identical portfolio on the identical day, so a yield with no named denominator has not finished being a statement. Third, for every asset producing nothing, the question is why. There is a large difference between an asset that is empty because nobody wants it and one that produces nothing because it has not been built yet, and the schedule will not say which unless it is asked. Fourth, and this is the one people skip, ask what has actually been sold. A sale is the only place an estimate has ever been tested.

A lender reads the same schedule with one extra instinct that is worth borrowing. A loan is repaid out of money that shows up rather than out of a report, so a lender sizing a facility cares first about the arrival pattern of cash and only afterwards about what the security would fetch. Cash first and estimate second is not a lender's peculiarity. A missed payment is felt immediately while a stale valuation is felt years later, and that difference is how a lender arrives at the same ordering.