Real estate investment trusts (REITs) cannot be valued by the typical price-to-earnings (P/E) ratio as their earnings are distorted by revaluation of investment properties, change in fair value of derivatives, and so on.
How else can REITs be valued then? Let’s look at some common ways of evaluating them.
The distribution yield shows how much an investor receives in distribution per unit (DPU) for the unit price paid for a REIT. Since REITs are required to distribute at least 90% of their taxable income to their unitholders in order to enjoy tax benefits, many REITs have high distribution yields. As of 6 July 2018, the average distribution yield for Singapore REITs was 6.7%.
Let’s go through a simple example to learn how to calculate a REIT’s distribution yield. Retail REIT Lippo Malls Indonesia Retail Trust (SGX: D5IU) has a DPU of S$0.0322 for the last 12 months. At its unit price of S$0.32 at the time of writing, it has a distribution yield of 10.1% ((S$0.0322/S$0.32) x 100%).
Most investors are usually enticed by a high distribution yield. However, there are many reasons for a REIT’s yield to be higher than that of another REIT. For one, poor economic fundamentals surrounding a REIT could cause its unit price to fall, increasing its distribution yield as a result.
As highlighted in my earlier article here, we should focus on a REIT’s DPU track record instead of its distribution yield alone.
The price-to-book (P/B) ratio is computed by taking a REIT’s current market price and dividing it by the REIT’s latest reported net asset value (NAV) per unit. The NAV of a REIT is calculated with the simple equation of total assets minus total liabilities. A P/B ratio below 1 shows that a REIT is trading at a discount to its NAV.
As of 30 March 2018, Lippo Malls Indonesia Retail Trust had a NAV of S$0.30 per unit. This means that at a unit price of S$0.32, it is trading at a P/B ratio of 1.07 ((S$0.32/S$0.30) x 100%). In other words, it means that investors who invest in Lippo Malls Indonesia Retail Trust are paying S$1.07 for S$1 worth of the REIT’s net assets.
As mentioned in my earlier article, some REITs trade at a massive premium to their NAV as the market perceives them to be safer or to posses strong fundamentals.
Capitalisation rate, or cap rate, is a measure of the return on investment of a property. It is derived by taking the net property income (NPI) of a property and dividing it by its value. For example, in 2017, CapitaLand Mall Trust’s (SGX: C38U) Tampines Mall had a valuation of S$1.05 billion and an NPI of S$58.3 million. Therefore, its cap rate was 5.6%.
The cap rate can also be calculated on a portfolio level and is sometimes known as the property yield. During the same year, CapitaLand Mall Trust had an NPI of S$478.2 million and a portfolio value of S$8.31 billion, giving a capitalisation rate of 5.8%.
Cap rates should be compared between REITs of the same type to give an apple-to-apple comparison.
The Foolish takeaway
The distribution yield, P/B ratio, and cap rate are not the only valuation methods that investors can use. There are other ways of valuing REITs, such as the price-to-funds-from-operations ratio, the replacement cost method, and comparable sales method.
However, investors should not be too hard up on any particular valuation method as valuing a stock or a REIT is more art than science. Sticking to simple valuation methods mentioned in the article should do the trick.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended units of CapitaLand Mall Trust. Motley Fool Singapore contributor Sudhan P owns units in CapitaLand Mall Trust.