A discount to NAV is a cushion against the appraisals being too high. Leverage makes that cushion thinner than the headline, and it is worth knowing how thin before bidding.
Find the portfolio value at which NAV falls to the price you paid, and convert it to a yield. On an illustrative real estate fund valued at a 5.00 per cent yield with 48 per cent loan to value, a secondary bought at a 15 per cent discount to NAV is fully eroded by a 40.5 basis point rise in valuation yields, to 5.41 per cent. Without the leverage, the same discount would absorb 88 basis points.
Worked in full in The Real Estate Secondaries Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A discount to reported NAV is usually described as the buyer's margin of safety against stale appraisals. It is, but in a geared fund it is a margin against a geared number. Every point that comes off the property values comes entirely off the equity, so a discount that sounds generous may cover a smaller move in yields than the bidding committee has in mind. The calculation takes three lines.
| Input | Value |
|---|---|
| Net operating income | 25.0 |
| Blended valuation yield | 5.00% |
| Gross asset value | 500.0 |
| Debt | 240.0 |
| Loan to value | 48% |
| Other net liabilities | 10.0 |
| Reported NAV | 250.0 |
| Interest offered, 10% of the fund | 25.00 |
| Price at a 15% discount | 21.25 |
Break-even NAV = (1 − discount) × reported NAV = 0.85 × 250.0 = 212.5
Break-even GAV = debt + other liabilities + break-even NAV = 240.0 + 10.0 + 212.5 = 462.5
Break-even yield = NOI ÷ break-even GAV = 25.0 ÷ 462.5 = 5.41%
In Excel, with NOI in B1, debt and other liabilities in B2, NAV in B3 and the discount in B4: =B1/(B2+(1-B4)*B3). Subtract the current yield and multiply by 10,000 for basis points.
Gross asset value only has to fall 7.50 per cent for the 15 per cent discount to be gone. The ratio of the two, 2.00x, is the fund's gearing: GAV of 500.0 over NAV of 250.0. A 25 basis point rise in yields shows it plainly: GAV falls 4.76 per cent to 476.19, NAV falls 9.52 per cent to 226.19.
| View | Break-even yield | Rise, bp |
|---|---|---|
| Unlevered: price = 85% of property value | 5.88% | 88 |
| Fund at 48% loan to value | 5.41% | 40.5 |
The buyer who thinks of the discount as covering a 15 per cent fall in property values is thinking of the unlevered line. The geared fund is covered for less than half of that move in yields. If the buyer's view is that the appraisals are 50 basis points behind the transaction market, the bid at 85 per cent of NAV is already paying more than the assets are worth.
| Loan to value | Discount 10% | 15% | 20% | 25% |
|---|---|---|---|---|
| 30% (NAV 340) | 36.5 | 56.8 | 78.7 | 102.4 |
| 48% (NAV 250) | 26.3 | 40.5 | 55.6 | 71.4 |
| 60% (NAV 190) | 19.8 | 30.2 | 41.1 | 52.5 |
Two patterns are worth remembering. Leverage shrinks the cushion fast: a 20 per cent discount on a 60 per cent geared fund protects less than a 15 per cent discount on a 30 per cent geared one. And the starting yield matters too, because a basis point is a larger share of a low yield. At the same 48 per cent gearing, a 15 per cent discount absorbs 32.7 basis points if the portfolio is valued at 4.0 per cent and 48.2 if it is valued at 6.0 per cent. Low-yielding, highly geared funds are where headline discounts protect least.
The common mistake is comparing the discount to NAV with a view on property values, rather than with a view on NAV. "The market is 10 per cent below the appraisals and we are buying at 15 per cent off" sounds like a 5 point margin. At 48 per cent gearing a 10 per cent fall in GAV is a 20 per cent fall in NAV, and the buyer is underwater before the first distribution. Convert every view on values into NAV through the balance sheet before comparing it with the discount.
The break-even is a floor, not a target. At the break-even yield the buyer gets back exactly what it paid in NAV terms, with no return for the years of holding. The required discount is the break-even plus the return the buyer needs over the remaining life, after fees. The yield cushion tells you how much of the discount is protection and how much is return.
Divide net operating income by debt plus other liabilities plus the price paid for the NAV: that yield is where the discount runs out. Here a 15 per cent discount on a 48 per cent geared fund covers 40.5 basis points, not 88. The free workbooks for the book rebuild a fund interest from its property tape and run the same thresholds on exit yields and rental values, and the GAV to NAV walk shows where the gearing comes from.
Find the gross asset value at which NAV equals the price paid: debt plus other liabilities plus the price as a share of NAV. Divide net operating income by that value. With 25.0m of income, 250.0m of liabilities and a NAV of 250.0m, a 15 per cent discount breaks even at a 462.5m portfolio and a 5.41 per cent yield.
Because a fall in property values comes entirely off the equity. At 48 per cent loan to value, a 25 basis point rise in yields cuts gross value 4.76 per cent and NAV 9.52 per cent. A discount that would absorb 88 basis points on an unlevered building absorbs 40.5 on the geared fund.
At 48 per cent loan to value and a 5.00 per cent valuation yield, a 20 per cent discount absorbs 55.6 basis points and a 15 per cent discount only 40.5. At 60 per cent loan to value even a 20 per cent discount absorbs only 41.1 basis points, so a 50 point view needs a deeper discount.
This article is one calculation from The Real Estate Secondaries Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 681 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.