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Wharton Emeritus Professor Peter Linneman explains the methods by which real estate companies are valued.
BRUCE KIRSCH: When we talk about destruction of value or creation of value naturally there needs to be some method with which we are determining value– calculating value. And so at the company level there is a lot of different approaches, unfortunately. There’s not just one.
There is funds from operations or FFO, discounted cash flow analysis, cap rate analysis, and net asset value, all of which you discuss in the textbook. And each of these methods and approaches has its own nuances and shortcomings. Is there one predominant approach when looking at real estate companies, and does it differ between public companies and private companies?
DR. PETER LINNEMAN: In the old days the answer was that you used cap rate analysis. I think what’s happened is people have gotten more sophisticated as computer power has gotten ubiquitous. It’s everywhere. Everybody now does some variation of discounted cash flow analysis with all its vagaries of what’s the exit valuation, and what’s the right discount rate, and who knows what cash flows will really grow at.
Having said that, people still do cap rate analysis. They do NAV– NAV is if I were to liquidate everything and pay off all my liabilities what do I have? Of course it doesn’t answer how long do you have to liquidate everything.
And really would you ever want to retire all your liabilities? Some of your liabilities aren’t liabilities as long as you keep operating. For example, think of pension liability that I’d have to fund. I don’t view it as a liability because my people are working. I fund as I go. I don’t have to fund it all at once. Anyway, there’s a lot of examples.
Today what people do is all of the above that you mentioned– FFO, and AFFO, adjusting for recurring CapEx, and leasing commissions. They’ll use NAV. They’ll use DCF. They’ll use cap rates. All of the above.
If you said for public companies I would say people tend to focus as a multiple of adjusted funds from operation. Some multiple of AFFO. In Europe on public companies they use more so still NAV and what are you trading at as the discount NAV. But I would say all sophisticated investors use those as starting points and then do more sophisticated analysis.