Property companies generally make money from investment (owning properties and collecting rent), development (building investment properties) and trading (buying and selling properties, probably after refurbishing them or otherwise adding value).
For this article we will concentrate on property investment. The return on a property investment company’s capital comprises its rental income net of operating costs, and the gain in the value of its properties. This gain is realised when a property is sold, and recorded as an unrealised gain otherwise.
Most UK-listed companies report their investment properties at fair value, which means that unrealised gains and losses flow through the P&L account.
Because rental income is relatively stable (or in technical terms, there is good visibility of earnings) and the trajectory of investment values are arguably foreseeable, property companies can gear their balance sheets very highly, and benefit from (but bear the risks of) high leverage.
Of course, banks regularly fail to judge the trajectory of property values correctly, so property cycles often end in crashes which are then followed by banking crises.
REIT or non-REIT
In 2007 the UK introduced a tax regime for Real Estate Investment Trusts, or REITs. The intention is that investors pay proportionately the same amount of tax from each £1 of rental income irrespective of whether they invest in REITs or directly in land and buildings. REITs do not pay corporation tax on rental income or gains on sale of properties.
To qualify for the REIT regime a company must earn at least 75% of its gross income from rentals, and must distribute 90% of rental profits as dividends. Most of the larger UK property companies have elected to become REITs, but there are many interesting property companies in the non-REIT sector.
We want to measure the three key drivers of value: revenue returns, total returns (which includes capital gains), and net assets.
The standard P/E ratio is a good measure of price relative to total returns. Remember that unrealised gains and losses go through the P&L account, so the E in earnings includes these.
To measure revenue returns, most property companies report something called EPRA Earnings. EPRA, the European Public Real Estate Association, publishes best practice guidelines for financial reporting by its members. EPRA earnings are a standardised measure of earnings which excludes investment property revaluations and gains or losses on disposals, changes in intangible assets and the related tax accruals.
Price/EPRA Earnings — the equivalent to the P/E ratio but using EPRA Earnings — is a useful valuation measure based on the company’s underlying revenue generation.
EPRA also defines a standardised measure of net assets. EPRA NAV excludes deferred tax liabilities and so is a measure of the fair value of assets held as if they are never going to be sold. Price/EPRA NAV is a common valuation yardstick.
But net assets do not tell the whole story. The industry has long used a measure called triple net assets (often written NNNAV). This is NAV adjusted to reflect the current market value of the company’s debt and financial derivatives, and to include the deferred tax which would become payable if the company sold all its property.
It is a rough estimate of the break up value of the company. For companies that are not REITs, the deferred tax adjustment can be substantial.
If you owned property directly, you would want to know what you would get back if you sold it, after paying back your mortgage and paying tax. NNNAV tells you the same thing for listed companies. Thus Price/NNNAV (or Price/EPRA NNNAV using the standardised measure) is a key valuation metric.
Finally, dividend yield is an important valuation measure, especially for REITs.
The gearing of property companies tends to rise and fall in line with property cycles.
Interest cover is a robust measure of whether borrowing is within safe levels. If this drops below two times, alarm bells should ring. Note that dividend cover is not relevant for REITs, as they distribute most of their earnings.
Finally, I would also look at the cash flow generated from rental income, using the ratio of cash flow from operations/EPRA Earnings.