Last month in this column we presented the factors involved in valuing real estate development companies – through the drivers of their net assets using a multiple that accounted for the reloading adjustment; or alternatively a less direct discounted cash flow analysis. This month, we focus on the single-property owning companies that are so common in our market, and that represent the most often used mechanism for transferring the benefits of owning property rights: how to value the shares of these special purpose vehicles (SPV).
One thing does not change; investors measure the value of a company from its ability to generate cash profits that are potentially distributable as dividends to them. For property owning companies that cash comes from the net operating revenues of the property owned, reduced by the expenses of the legal entity.
Method of Valuation Preferred
As opposed to the property development companies, where management strategy can have a major impact on value, the major input to value for property-owning companies is the cash flow from the project owned. The discounted cash flow technique, applying an appropriate risk-adjusted discount rate to estimate net present value is the standard approach to estimating the value of such companies.
Which Net Income?
So far, so good – but let’s take a closer look and make sure we know how the cash flows for an SPV are calculated and what discount rate applies to them. We easily estimate cash flows of properties (net operating income – NOI) that may flow to direct property owners, and may be subject to income tax along with all other taxable income this owner may receive. We will refer to this as the direct-level of income taxation.
The same property owned through an SPV generates the same NOI that flows to its corporate owner, which then experiences the direct-level of income taxation (24% corporate rate.) The resulting reduced profits are then available to pay dividends to the shareholder or investor. On this basis, the project owned through a corporate entity will flow less cash to the owner and have theoretically less value than the same property owned directly.
The actual amount of taxation as a percentage of the NOI generated is affected by the company’s own operating characteristics as related to the tax laws, for example the amount of (1) asset cost basis (depreciation,) (2) the VAT account, and (3) the amount of business expenses deductible for tax purposes (such as service fees and interest on debt.) But the net income to the investor or shareholder level is reduced by the tax at the direct-level. So where direct ownership benefits from 100% of the NOI flowing to the investor, ownership of shares suffers a 24% reduction (maximum.)
Applications in the Market
In spite of the obvious two levels of taxation on the same income before becoming “net” to the owner, Russian real estate investors commonly choose to use this two-level structure or many reasons: liability protection, tax regulation, convenience of transactions, and others. Estimates are that 95% of commercial real estate transactions take place through shares of SPVs. This is having a significant, but not so obvious effect on how these companies are valued.
Income Estimates and Discount Rate Used
Participants in the commercial property market are besieged with numbers related to the financial performance of income producing projects. Every brokerage company website contains “yield rates,” “capitalization rates,”“pay-back periods,” “income multiples,” and other measures of financial performance – all of them poorly defined, and therefore of limited application. Investment offering materials for real estate projects contain the same measures, applied to incomes calculated in non-standard fashion, and making the resulting pricing and its components subject to significant question.
Most offering information is based on the purported “net operating income” (NOI) of the property. This income stream is the proper measure of the financial performance of the direct ownership of the rights to the property. However, as noted above, it is not the direct property rights being actually transacted in the market; rather it is ownership of the legal entity that owns the rights to that NOI. This produces the dichotomy that one set of information is being freely discussed and offered on the market (the income amounts and capitalization rates for direct ownership of the property,) and another is actually being transacted (the shares of ownership of SPVs with less net income.)
What actually happens is that buyers and sellers negotiate the deal for a property using the readily available information related to NOI and direct ownership, and then assess the deal “off-market” as related to their own individual situations. After due diligence is completed, purchasers end up closing the share transfer of the SPV, and actually receive less than the reported NOI through the dividend flow, as a result of the impact of the legal entity income tax at the direct-level.
Appraisal Method
In estimating value for ownership of property, appraisers in the market are charged to observe, interpret and reflect the perceptions and actions of market participants. Here we consider prices based on the direct ownership of all of the NOI, while the actual property exchanged is SPV shares that provide dividend flow of only a part of the NOI. The textbook tendency of appraisers is to value the income stream from the actual property being exchanged, in this case the reduced SPV dividend flow. However, the market indications for Moscow now strongly indicate that transaction participants are actually negotiating on the theoretical level of 100% NOI and corresponding capitalization rates (as reported by the sellers,) while actually transacting the reduced company dividend levels and future yield expectations.
As a result, when valuing shares of property-owning companies in Russia, appraisers should follow the market and accept the idea that the value of the shares is actually indicated by the present value of the direct-ownership NOI – as capitalized by acceptable rates (yield or direct capitalization) derived from the same relationship. This situation partly comes from the very strong “seller’s” market which right now exists for stabilized income generating properties in Russia. The market is so strong that few sales are occurring in stable income properties, because most owners believe prices are set to continue upward and their interests are served by waiting later to sell.
The Market Lies – Everyone Knows
Those transactions that do occur show the seller setting a price based on direct ownership NOI and a favorably low capitalization rate – and then insisting to sell the SPV shares – rather than the direct ownership to the property. Thus, a price is set on one level of income (NOI,) while offering to actually deliver a lower level (dividends after corporate tax from the SPV.)
The market knows that the actual situation is different from what is offered, and the buyer in the end makes his own decision about whether the resulting dividend flow versus its cost is worthy of making the investment. The actual dividend flows achievable vary greatly depending on each owner’s tolerance for tax ’structuring’ and his ability to support that structure with ways to receive return from the owned shares outside of the dividend flow.
When asked to value the equity of an SPV that is holding property rights, the appraiser is left in the strange position of saying he is appraising one thing (dividend flow from the ownership of SPV shares,) while actually estimating value based on direct ownership (and NOI before corporate tax.) This is actually not a problem, as long as it is explained in the report – and the appraiser is assured that there is a direct relationship in the market between sale price for the shares, and the income and rates applicable to direct ownership of NOI.
Conclusion
From the above discussion, we conclude that currently the proper way to approach valuation of shares of property-owning companies in major Russian markets, is to base the analysis on the net operating income of the property (as if in direct ownership,) and apply market accepted discount (yield) rates as indicated by transactions closed – or as supported by as much other evidence as can be gathered from the market. The stream of dividend income from the ownership of the SPV, which represents the actual financial performance to be received by the investor, is currently of only secondary relevance to the share valuation.
Of course, any appraiser appraising shares of an SPV will also need to account for the debt obligations, working capital adjustments and other potential liabilities of the corporation; things he does not normally account for in appraisal of direct property ownership. In this case make sure your real estate appraiser is also a qualified business appraiser.
As always in an unconventional and fast-moving market like Russia and the CIS countries, we can expect this to change. It will be necessary to closely monitor the actions of buyers and sellers, and to understand the basis on which they are making their transaction decisions. Only in this way can the value of property ownership be measured credibly.