How do private market participants understand the value of their interest in an asset at a given point in time? In the commercial real estate realm, many people look to net asset value (“NAV”) as a measure of the value of that investment today. In this article, we’ll explore how NAV — sometimes referred to as “marked value” — is determined and how investors can use it to evaluate the current value of an asset in which they hold an interest, or to evaluate a potential investment in a secondary market.
How is NAV determined?
NAV is determined by a General Partner as a way to communicate an investment’s value to Limited Partners. While there is no universal method for calculating NAV, one of the most common ways is based on a discounted cash flow (“DCF”) analysis. The DCF analysis draws on a foundational investment concept: In general, the value of an asset is determined by the future cash flows the asset generates and its residual value upon sale of the asset. The asset’s determined value is then discounted back by applying a “discount rate” to reflect what an investor’s expected internal rate of return (“IRR”) should be, adjusting for the risk or volatility associated with the projected cash flows. All else equal, the higher the level and growth of the cash flows and its expected residual value, and the lower the risk associated with the cash flows, the greater the NAV will be.
To use DCF analysis to value a real estate asset, we would begin by forecasting all of the property’s future cash flows including its residual value, and then calculate what they are worth today. Here’s an example:
Let’s assume we make an investment in a hotel and we are going to execute a five-year business plan. During that time, we will gather revenues from the property in the form of daily revenue received from our guests. Then we will pay out operating expenses plus interest expense on the debt secured for that particular investment. The amount left over will be used to make distributions to investors over time. At the end of our investment horizon, we will sell the asset and distribute the sales proceeds net of debt and other transaction costs including third-party costs (e.g., broker costs and carried interest paid out to sponsor partners). The residual value will be derived by applying a market capitalization rate (“cap rate”) to the property-level cash flow or net operating income (“NOI”) in the final year of the investment period.
If we are two years into the plan today, we can estimate the present value of the property’s future cash flows by projecting the net levered (after debt) cash flow to the investors for the next three years and applying a discount rate to derive the present value, or NAV. Here’s how the math would look with simple numbers:
If we apply a discount rate of 12%, the current value of the future cash flows would equal $963.07. We would then adjust the present value of those levered cash flows by the net cash position and any material assets or liabilities on the partnership’s balance sheet.
Let’s take a closer look at the key components of this valuation method:
- Cash flows: The goal is to estimate the amount of cash produced by the asset after paying for operating expenses, debt service, and capital expenditures. To determine this, it’s necessary to make a series of assumptions about how the property will perform in the future, then forecast how this performance translates into cash flow. Commonly considered variables from the revenue side include average daily rate (“ADR”) and occupancy for a hotel investment, rent and lease payments for other commercial real estate assets, and market growth rates. Deductions include normal operating expenses such as repairs and maintenance, utilities, management fees, property taxes, and insurance in addition to interest expense and renovation costs. Perhaps the most important assumption is the price that we will sell the property for at the end of the hold period, also known as its residual value. The residual value is determined by applying a market cap rate to the final year’s NOI. The cap rate is reflective of the current yield, or return on investment, the next buyer would expect to generate from acquiring that asset.
- Discount rate: Is a proxy for an investor’s expected rate of return for a particular investment, factoring in the relative risk of a particular investment. Riskier cash flow streams are discounted at higher rates, while more certain cash flows are discounted at lower rates. For the same set of cash flows, higher discount rates will generate a lower net present value (“NPV”). The discount rate is also affected by the risk of the business plan (the investment strategy for the property). For example, when considering a multifamily apartment building with relatively steady cash flows, we may use an 8-10% levered discount rate. With a riskier hotel that could require renovations and capital expenditures, we may assign a higher discount rate of 15% to reflect the increased volatility associated with the projected cash flows. Other variables we adjust for when considering the appropriate discount rate are market (primary, secondary or tertiary), asset quality or vintage, and the amount of debt or leverage on the asset.
As part of performing the DCF analysis highlighted above and deriving the NAV, the General Partner also uses comparable sales and other market benchmarks to help determine the appropriate cap rate to apply. This not only determines the residual value of the asset, but insures that the derived NAV is relatively in line with today’s market value for an asset of similar quality and profile.
Do NAV calculations change over time?
The marked value of an asset can change over time. If assumptions about the asset and results change, so will the NAV. And even if assumptions remain the same, the NAV will change as time goes by and the investment moves closer to its exit.
It’s also important to recognize that private asset valuation isn’t an exact science. While DCF analysis is a comprehensive valuation methodology, it is based on a variety of assumptions and inherently involves an element of forecasting and evaluation of risk factors. At Cadre, we put a substantial amount of time and effort into modeling asset valuations — and our NAVs are audited by a third-party firm two times each year to ensure we are adhering to industry standards. Our analysis is rigorous and benefits from proprietary data and the extensive experience of our investment team, which has more than $45 billion in transaction experience and are actively participating in these markets on a daily basis.
How is NAV used throughout the lifecycle of an investment?
By deriving the value of a given asset’s future cash flows, the NAV helps investors track changes in the value of the asset from its initial purchase price. The reforecasted cash flows and the NAV quantify updates to the original business plan and help to quantify the changes to risk and projected returns. Importantly, the NAV is forward looking and does not reflect the cash flows received by the current investor in the asset life-to-date for the investment, which will factor into that investor’s total return for the investment.
Given NAV is an assessment of an asset’s value at a given point in time, it is often used as a benchmark in secondary markets to determine asset pricing between buyers and sellers. In fact, “discount to NAV” is a commonly quoted metric to describe pricing of investments on the Cadre Secondary Market — and entering a deal at a discount to NAV means an investor has the opportunity to buy into a particular deal at a value that may be slightly below its current marked value.
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