What is Net Asset Value in Private Real Estate Investing?
Net asset value (NAV) in private real estate investing is the total value of an asset, minus any outstanding debt and the cost of other any fixed or planned capital expenses. It’s critical for real estate investors to understand NAV because asset prices are what drives current and future investor returns. For example, an increase in NAV typically correlates with an increase in cash distributed to investors from the underlying asset.
Net asset value also demonstrates an investment firms’ performance and ability to generate value for investors over time. NAV in private real estate is calculated at the individual asset level and the fund level and can also be provided to investors as a share value, depending on the investment structure. At Origin, we calculate the total value of each of our assets on a monthly basis using the most up-to-date market and operational data.
Let’s walk through an example of how to calculate NAV for an asset that was purchased within the last quarter for $50 million. At the time of the acquisition, the total value of the asset clearly agreed upon by the market is $50 million. To calculate the NAV at the time of the acquisition, we subtract the debt of $25 million and the planned capital and fixed expenses of $5 million from the $50 million total asset value, to arrive at the NAV of $20 million. See Chart 1 below for more detail. However, net asset value changes over the following months, quarters and years of ownership. Chart 2 below demonstrates what the NAV of an investment that has been improving operations could look like a year into ownership.
|At Acquisition||1 Year Later|
|Less: Capital & Fixed Expenses||($5,000,000)||($5,000,000)|
|Net Asset Value||$20,000,000||$22,000,000|
As explained earlier, because NAV is a function of total asset value, any underlying factors that change the valuation of an asset also change the net asset value. NAV changes largely fit into two categories: a change in net operating income (NOI) that is expected to continue over time and changes in capital markets.
How Net Operating Income Impacts Net Asset Value
NOI is all the revenue generated by a property, minus operating expenses. Property-level revenue changes along with shifts in supply and demand which impacts renters’ ability and willingness to pay. This can include a wide range of factors from new properties nearby offering concessions to renters (implying low demand), to the addition of new employment opportunities near the property (positive momentum for demand). However, although these changes certainly impact NOI in the short term, they only impact NAV if the impact to the property’s income is perceived as sustained (expected to continue over time).
For example, let’s consider a well-located asset with a strong and diverse tenant base and Class A construction that is currently operating below projected occupancy. Although the income for the next quarter or so will be negatively impacted from the lack of occupancy, the underlying strengths of the asset and its tenant base mean that it will be a stable investment in the long-term. If the market believes an asset has long-term viability, short-term changes in revenue and expenses at the property will have minimal impact on NAV. You can see this reflected in the chart below labeled Asset X.
How Capital Market Changes Impact Net Asset Value
Capital markets, or the pricing and availability of capital, has the greatest impact on NAV. For most real estate investments, annual property income only accounts for 10-20% of the total return; the remaining 80%-90% is driven by the “capped NOI” or the residual value of the property. Because the cap rate acts as a multiplier on net operating income, when supply or demand changes that affect entire asset classes or markets become permanent, these changes impact implied growth, exit cap rates and therefore have the greatest impact on net asset values.
For example, let’s look at Asset Y in the chart below, another Class A multifamily property at which 20% of the tenants work for a large company whose headquarters are nearby. At acquisition, this property’s NAV was $20 million, and it was 100% occupied, however, what happens if one year into ownership the nearby company decides to relocate its headquarters to a different city? In contrast to the diverse tenant base of Asset X referenced above, Asset Y will likely lose many of its residents and therefore a large percentage of its revenue as a result of this change. Because the loss of employment in this area is a permanent change, the negative impact on demand and revenue at the property will be perceived as sustained by the market. This in turn means that the lower occupancy will become part of the “capped NOI” and have a serious impact on NAV. See the chart below contrasting the effects of short-term NOI loss (Asset X in the chart below) and long-term NOI loss (Asset Y in the chart below) on net asset value.
A great example of the strength of cap rates is the West Loop neighborhood in Chicago. Over the last 10 years, this submarket has seen consistently increasing demand and has absorbed new supply at record rates. As a result of this perceived cash flow security and expected continued growth, cap rates in the West Loop have continued to compress. Therefore, regardless of actual fluctuations in NOI of the underlying assets there, NAV’s have continued to rise.
When Net Asset Value Changes
Unlike the stock market, private real estate net asset values do not react instantly to market events. Factors and trends that affect NAV’s often take longer to come to fruition and impact supply and demand for the underlying asset. These adjustments to value often lag the public equities market by at least a quarter and often much longer. Sometimes, fluctuations that impact the stock market may not affect revenue streams at the real estate level at all. For example, in the fourth quarter of 2018, amid global trade and growth concerns, the public markets corrected and dropped more than 15% but real estate values and growth projections remained unchanged. This resilience is why private real estate is recommended as a necessary and stabilizing component of portfolios for all types of investors.
Why Understanding Net Asset Value Matters
For private real estate investors, it’s crucial to understand how an investment firm or partner calculates and reports on NAV so that you can better understand projected returns. Responsible and transparent firms will report NAV’s on a consistent basis and explain the factors that caused any changes in NAV from prior reporting. Investors should beware of firms that never adjust NAV’s or continue increasing NAV’s even when sustained market conditions indicate that they should have changed.