Two discounts to NAV, quoted the same way and not comparable: one is diluted by more leverage, the other has no date on which it must close.
Convert each discount to NAV into a discount on the property, by multiplying it by NAV over gross asset value, and then ask whether anything forces it to close. In an illustrative comparison, a REIT at a 25 per cent discount with 35 per cent loan to value buys the buildings 15.75 per cent below appraisal, while a fund interest at a 15 per cent discount with 48 per cent loan to value buys them only 7.50 per cent below. Yet over four years the secondary returns 9.15 per cent, against 6.67 for the REIT if its discount stays where it is, because the fund will sell its assets and the REIT will not.
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 →
Investors who want real estate below appraised value have two obvious routes when listed property trades at a discount: buy REIT shares, or buy a closed-ended fund interest on the secondary market. The two discounts are quoted the same way, as a percentage of NAV, and are not comparable. Each is diluted by its vehicle's leverage, here the fund's more than the REIT's; one is realised by a liquidation the investor can count on, the other by a market re-rating the investor can only hope for.
| Input, per 1,000 of property at appraisal | Listed REIT | Closed-ended fund |
|---|---|---|
| Gross asset value at a 5.00% valuation yield | 1,000 | 1,000 |
| Net operating income, held flat | 50.0 | 50.0 |
| Debt, at 4.00% interest | 350.0 (35%) | 480.0 (48%) |
| Other net liabilities | 20.0 | 20.0 |
| Reported NAV | 630.0 | 500.0 |
| Discount to NAV paid | 25% | 15% |
| Running cost | G&A 0.45% of GAV, forever | Fee 1.00% of NAV, to wind-down |
| Exit | Shares sold in year 4 | Assets sold in year 4, 1.50% costs |
Price paid = NAV × (1 − discount); implied GAV = price + debt + other liabilities
REIT: 630.0 × 75% = 472.5; implied GAV = 472.5 + 350.0 + 20.0 = 842.5, a property discount of 15.75% and an implied yield of 50.0 ÷ 842.5 = 5.93%
Fund: 500.0 × 85% = 425.0; implied GAV = 425.0 + 480.0 + 20.0 = 925.0, a property discount of 7.50% and an implied yield of 5.41%
Shortcut: property discount = NAV discount × NAV ÷ GAV, so 25% × 63.0% and 15% × 50.0%. In Excel: =B1*B2/B3 with the discount in B1, the NAV in B2 and the GAV in B3.
On entry the REIT is much the cheaper way to own the buildings. To match its 15.75 per cent property discount, the fund interest would have to trade at 31.5 per cent below NAV. Even after running costs, 4.5 of G&A against 5.0 of fees, the REIT's yield on implied value is 5.40 per cent against 4.86 for the fund. The method is the same as the one behind a REIT's implied cap rate, applied to both vehicles.
Each year the REIT pays out NOI less 14.0 of interest and 4.5 of G&A, 31.5, a cash yield of 6.67 per cent on 472.5. The fund distributes 50.0 less 19.2 of interest and 5.0 of fees, 25.8, a cash yield of 6.07 per cent on 425.0. In year 4 the fund sells its buildings at appraisal less 15.0 of costs and returns 485.0 to its investors. The REIT holder sells shares at whatever discount the market then applies.
| Route | Price | Annual cash | Year 4 exit | IRR |
|---|---|---|---|---|
| Fund secondary at 15%, realised at NAV less sale costs | 425.0 | 25.8 | 485.0 | 9.15% |
| REIT at 25%, discount unchanged at exit | 472.5 | 31.5 | 472.5 | 6.67% |
| REIT at 25%, discount narrows to 15% | 472.5 | 31.5 | 535.5 | 9.56% |
| REIT at 25%, discount closes | 472.5 | 31.5 | 630.0 | 13.49% |
| REIT exit discount at which the two IRRs match | 16.5% |
The REIT wins only if its discount narrows to about 16.5 per cent within the four years. If it stays at 25 per cent, the shares return their cash yield and nothing else. If it widens to 30 per cent the IRR falls to 5.12 per cent, and at 35 per cent to 3.50.
| Fund discount to NAV | Price | Property discount | Implied yield | Four-year IRR |
|---|---|---|---|---|
| 5% | 475.0 | 2.50% | 5.13% | 5.91% |
| 10% | 450.0 | 5.00% | 5.26% | 7.47% |
| 15% | 425.0 | 7.50% | 5.41% | 9.15% |
| 20% | 400.0 | 10.00% | 5.56% | 10.96% |
Ranking the two by the headline discount, or by the property discount alone. The headline overstates both, the fund's most, because its NAV is the thinner slice of the buildings. The property discount gets the entry price right but ignores the exit: a secondary discount on a fund in its final years is pulled to zero by the sale of the assets, whatever the market thinks, while a REIT discount has no date. Both discounts are measured against appraisals, and if those are stale the true discount is smaller in each case; how much smaller, and how much yield movement a geared discount can absorb, is in how much cap rate expansion a secondary discount absorbs. The REIT, for its part, can be sold tomorrow, and the fund interest cannot.
Translate both discounts to the buildings and then to a dated cash flow. Here the REIT buys property 15.75 per cent below appraisal and the fund interest 7.50 per cent below, yet the fund interest earns 9.15 per cent over four years against 6.67 per cent for a REIT whose discount does not move. The REIT is the better buy only for an investor prepared to bet that its discount narrows below 16.5 per cent by the exit. The discount bridge, from headline to what is actually being paid, is worked in the free workbook for this case.
Multiply the discount by NAV over gross asset value to get the discount on the property itself. A 25 per cent discount on a REIT whose NAV is 63.0 per cent of GAV is a 15.75 per cent discount on the buildings; a 15 per cent discount on a fund whose NAV is 50.0 per cent of GAV is 7.50 per cent. The fund would need a 31.5 per cent discount to match the REIT.
Because a closed-ended fund in wind-down sells its assets and pays out NAV, so the discount is realised on a known timetable. A REIT discount closes only if the market re-rates the shares. In the illustrative case the fund interest bought at 15 per cent below NAV returns 9.15 per cent over four years; the REIT bought at 25 per cent returns 6.67 per cent if its discount stays unchanged.
Solve for the exit discount at which the REIT's IRR equals the secondary's. In the illustrative case the REIT, bought at 25 per cent below NAV, must be sold at no more than about 16.5 per cent below NAV after four years to match the 9.15 per cent return of a fund interest bought at 15 per cent. If its discount widens to 30 per cent, its IRR falls to 5.12 per cent.
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.
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