Question

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 $64/share and there are 130 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): $380M Expected next year depreciation: $90M Expected next year interest: $70M Total debt: $1.6B 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 a 7.5% 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 1

Expected next year total revenue: $750M Expected next year total expenses (including interest and depreciation): $380M Expected next year depreciation: $90M Expected next year interest: $70M

Hence, expenses excluding interest and depreciation = total expenses (including interest and depreciation) - Expected next year depreciation -  Expected next year interest = $380M - $90M - $70M = $ 220

Expected NOI = Expected next year total revenue - expenses excluding interest and depreciation = 750 - 220 = 530

Cap rate, r = 4.5% to 6.0%

Since, the REIT holds high quality office buildings in some of the best locations in the US, hence le't use the least (best) cap rate.hence, r = 4.5%

Part (a)

Hence, the estimated value of the asset = Expected NOI / r = 530 / 4.5% = $ 11,777.78 million

Debt = $ 1.6 billion = $ 1,600 million

hence, the equity value = value of the asset - debt = 11,777.78 - 1,600 = 10,177.78

Hence, the estimated fair market value for a share of the REIT described = Equity Value / N = 10,177.78 / 130 = $ 78.29 per share

Part (b)

r = 7.5%; g = 2.5%

hence, desired value of the asset = Expected NOI / (r - g) = 530 / (7.5% - 2.5%) = 10,600.00

Debt = $ 1.6 billion = $ 1,600 million

Hence, the equity value = value of the asset - debt = 10,600 - 1,600 = 9,000.00

Hence, the estimated fair price to pay for a share of the REIT described = Equity Value / N = 9,000 / 130 = $ 69.23 per share

Since the actual share price = 65 < 69.23 = the estimated fair price to pay for a share of the REIT described, the shares are available chepaer, and hence you should buy the shares of the REIT.