Stanislav Zhukov, head of real estate finance and capital markets services at Ernst & Young, contributed this month’s topical essay. This column has traditionally focused on the valuation and appraisal of real estate assets, but our market operates with legal entities, and most income producing properties are transferred by the sale of shares in the company, rather than shares in the asset itself. For this article, we will shift our focus to consider the important factors driving the value of a company heavily invested in a real estate asset, and how to determine the value of the shares involved.

Types of Real Estate Companies

Where investment real estate is concerned, we typically focus on companies with two functions – either development activity (like PIK or Sistema Gals); or a legal entity set-up for the sole purpose of owning and operating one income producing property – a Special Purpose Vehicle, or SPV. The shares in each of these type of companies have value, but for different reasons.

As always, investors are interested in a flow of income that may return their investment and provide them with a profit. With the high profile initial public offerings (IPO) of real estate companies over the past year – and the visibility of other publicly listed companies operating here – the way their value is finally measured is becoming more evident. A critical driver of value is the potential dividend that may come after payment of operating expenses and taxes by the property development company.

Development Company Value Sources

There are only two basic sources of value for a development company; (1) the completed projects it owns and (2) the projects it will produce in the future. The first category of value is termed ‘net assets’ and is the basic equity (net of debt) that the company owns in its completed real estate projects. The second value source is an aggregate of projects that the company may deliver in the future. Estimating the company’s value is complicated by the following factors of the property, and the development company itself.

Collectively these items are termed the reloading factor. They represent the ability of the company to reinvest its future cash flows in order to create value in new projects. This factor can be worth several times more than a company’s present assets if all the factors are judged positively.

Appraisal Methods: Net Assets vs. Total Present Capital

One way of estimating the value of a development company is to look at how the stock market values similar companies that are trading in the same environment – and make a comparison. The values for listed companies are established in trades every day, and thus their market prices are known and may be compared with the subject company to derive a relative value indication. For asset heavy real estate developers this process is usually done by comparing the relationship of total equity price to net assets, called the ‘net asset multiple.’

When the value of a company’s equity is greater than the value of its net assets, the multiple is greater than 1.0 and the company has a premium for its reloading ability. Reloading premiums are common for companies with a strong presence in growing markets, as they stand to gain the most from sourcing prime development land and implementing new high margin projects. Some companies trade at less than the appraised value of their net assets, meaning a net asset multiple of less than 1.0. This indicates that the market does not have much faith in the future value of those assets, nor in the ability of the company to create successful new ones.

Developers in Russia

By the second half of 2007 there were 11 publicly traded real estate companies operating in Russia, from the oldest publicly traded company (Open Investments – 2004.) to the most recently (PIK Group – 2007.) At the time of IPO, between 2004-2007, the group of companies had net asset multiples ranging from 1.6 to 1.0 and averaging 1.4. At the end of July 2007, the same group of companies showed a range of multiples from 3.0 to 0.7 and averaged 1.3, showing how the market’s impression changed after observing their operations for a time.

The companies with high multiples showed a solid base of operating assets and a strong development track record with an established pipeline of quality projects. The companies with lower net asset values had a smaller quality asset base and a pipeline of proposed projects without full permits or property rights.

Discounted Cash Flow Method

In addition to the pricing indication from the market-based reloading premium, an alternate way of considering the benefits of ownership of development companies is the estimated net present value of future cash flows to be derived from identifiable projects, plus a premium for future execution ability. These cash flows represent free cash potentially available for distribution back to investors. This estimate requires thorough knowledge of the property types and markets involved to correctly project the future potential net revenues. The same market and company knowledge is used to estimate the discount rate for future cash flows, which will account for the development and operational risks associated with the properties involved.

Conclusion

Estimating the value of a development company is not a direct or simple process. The methods described provide a basic framework, but for application to any particular company many more factors are involved and include:

• How well the management structure and processes compare to what is required for operation on the public market;
• the company’s competitive position and any potential strategic value or potential synergy;
• the influence of existing shareholders and perception of potential minority shareholders.

As more companies turn to the public markets for equity capital, we will learn much more about how investors into Russia view this special category of real estate business activity.