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Homework answers / question archive / Consider a REIT that holds high quality office buildings in some of the best locations in the US
Consider a REIT that holds high quality office buildings in some of the best locations in the US. The REIT is currently traded at a price of $68/share and there are 120 million shares outstanding. Using the information below answer the following questions: Expected next year total revenue: $750M Expected next year total expenses (including interest and depreciation): $360M Expected next year depreciation: $90M Expected next year interest: $70M Total debt: $1.8B Current office CAP in the US: 4.5% to 6.0% depending on quality and location. a. What is your estimation for a fair market value for a share of the REIT described? Show your work! b. What is your estimation for a fair price to pay for a share of the REIT described, if you require an 8.0% rate of return on an unlevered basis and expect the REIT to increase NOI at an average rate of 2.5%? Should you buy shares of that REIT?
Answer:
Total Expenses = $ 750 million, Total Expenses = $ 360 million, Depreciation = $ 90 million and Interest Expenses = $ 70 million
Operating Expenses = Total Expenses - Depreciation - Interest Expense = 360 - 90 - 70 = $ 200 million
Net Operating Income (NOI) = 750 - 200 = $ 550 million
Levered Cash Flow (LCF) = NOI - Interest Expense = 550 - 70 = $ 480 million
(a) CAP Rate Range: 4.5 % to 6 %
Therefore, Property Value Range: V1 = (480 / 0.045) = $ 10666.67 million to V2 = (480 / 0.06) = $ 8000 million
V1 = $ 10.67 billion and V2 = $ 8 billion
Total Debt = $ 1.8 billion
Range of Equity Values: E1 = 10.67 - 1.8 = $ 8.87 billion and E2 = 8 - 1.8 = $ 6.2 billion
Number of Shares Outstanding = 120 million shares
Therefore, REIT Share Fair Price Range: P1 = (8.87/0.12) = $ 73.92 and P2 = (6.2/0.12) = $ 51.67
REIT Fair Price Range is between $ 51.67 and $ 73.92
(b) If the property is valued on an unlevered basis the NOI is used without being reduced by the interest expense, however the CAP rate becomes 8% and the perpetual constant NOI growth rate becomes 2.5 %
Unlevered Cash Flow = NOI = $ 550 million
Therefore, Property Value = [550 x 1.025] / [0.08 - 0.025] = $ 10250 million or $ 10.25 billion
Equity Value = 10.25 - 1.8 = $ 8.45 billion
Number of Shares Outstanding = 120 million or 0.12 billion
Therefore, Fair Price per Share = 8.45 / 0.12 = $ 70.41667 ~ $ 70.42
As the current REIT market price of $ 68 per share is below its intrinsic fair market price of $ 70.42, the REIT shares are undervalued and hence a good buy.Therefore, they should be bought.
