Real-estate and equity valuation – Opco-Propco analysis

Companies that use property assets in their business may adopt very different real-estate strategies. Ownership versus leasing and the choice of different lease structures can significantly impact key performance and valuation metrics. We show that separating the operating and property components, using ‘Opco-Propoc’ analysis, improves comparability.

Some investors argue that the new IFRS 16 lease accounting reduces comparability. We disagree. In our view IFRS 16 reveals important differences that prior accounting concealed. However, IFRS 16 does increase the relevance of the Opco-Propco analysis that we advocate.

Companies can engage in very different business models in respect of real-estate assets, even though they may occupy and use similar properties in their operating businesses. This can be due to entering into an Opco-Propco type restructuring, sale and leaseback transactions, or simply through an ongoing policy of either leasing or purchasing properties. Furthermore, leasing strategies can themselves differ with varying lease periods and different use of variable lease payments and other lease-flexibility devices.

As a result, similar operating businesses may have very different exposures to the risks and rewards of real-estate investment. Because real-estate performance and valuation metrics, such as return on capital and valuation multiples, are likely to differ from those for operating businesses, combining the operating business with differing real-estate exposures makes comparing metrics for the combination of operating and real-estate activities very difficult. The metrics for these businesses will automatically differ and may be of little use in comparisons with other companies, even if those companies are classified in the same sector and have similar underlying operations.

This issue does not just affect sectors with large scale real-estate requirements, such as retail, hotels or healthcare. Sectors with other ‘big-ticket’ fixed assets, such as airlines or energy companies, where different leasing or ownership strategies are pursued for non-property assets, are also affected.

To illustrate, we show below four companies where the operating business is identical, but where each company has a different real-estate strategy. The companies occupy the same properties and use these in their operating business, but in the first case the properties are owned while, in the others, the same properties are leased with different lease periods.

The long-term and short-term leases are for 20 and 5 years respectively. In both cases the lease liability and lease right-of-use assets are recognised in the balance sheet in accordance with IFRS 16, albeit at different amounts. In the final case the properties are also leased but the lease term is for less than 1 year which means that they are not capitalised under IFRS 16 (and, even if they were, the amounts would likely not be material anyway).

Different real-estate strategies impact on performance and valuation metrics

Note: The figures above reflect various additional assumptions, such as the fair value of the owned properties relative to book value, asset lives, lease discount rates and lease maturity. The full data, including the input assumptions and the additional Opco-Propco analysis shown below, is available in the downloadable interactive model.

Our example illustrates by how much different real-estate strategies can affect performance and valuation metrics. Trying to compare these companies using return on capital and different valuation metrics, without considering the extent of property asset exposure, could lead to incorrect conclusions. For example, the lower valuation multiples arising from a leasing (and particularly short-term leasing), rather than ownership strategy may lead to the incorrect conclusion that this indicates that these stocks might be preferred to those with greater real-estate exposure.

Return on invested capital (ROIC)

Companies that have higher real-estate exposure generally have a lower aggregate return on capital. This is because the ‘return’ that is, in effect, produced by the property investment component of the business is itself low, being driven by the property yield and lease discount rate. As the relative importance of this low return activity increases so the overall return falls. The effect depends on the size of the real-estate exposure and the magnitude of the difference between the returns from real-estate compared with the operating business excluding real-estate.

A lower return on invested capital for the companies with greater property exposure does not mean these are inferior investments; it is merely a consequence of the different composition of the business. However, given the importance many investors attach to return on capital, it is easy to see why some companies prefer the ‘asset-lite’ structure of leasing.

Enterprise value to Invested capital (EV/IC)

The contribution to enterprise value should reflect the fair value of the real-estate investment. This is evidenced by the prices for pure real-estate companies which are closely linked to the underlying property fair value. Even though book value of real-estate assets may differ from fair value.¹Most operating businesses measure real-estate assets at historical cost rather than fair value in the balance sheet. Property investment companies (under IFRS not US GAAP) measure their investment properties at fair value which results in a much closer relationship between book value and market price., the EV/IC for this component of the business is still likely to be close to 1.0. If the EV/IC of the operating business is different, then a different level of property exposure results in the aggregate business having different overall EV/IC metrics.

The use of historical cost measurement for real-estate in financial reporting can make it difficult to identify its contribution to enterprise value. Although permitted, unfortunately most companies do not revalue owned or leased (right-of-use) properties in their financial statements, nor do they provide fair value disclosures. For leases, the lease liability, rather than the right of use asset, is generally a closer approximation of the value of the real-estate interest.²This is because the value of a leased asset tends to decline to reflect ‘annuity’ depreciation not the straight-line depreciation generally applied in practice. The exception is where assets have been impaired. An impaired right-of-use asset written down to fair value (or value in use) should be used as the proxy for the real-estate contribution to EV rather than the lease liability. Even better would be a current value of the lease liability based on updated assumptions, including discount rate. However, unlike other forms of debt finance, IFRS and US GAAP do not require fair value disclosures for lease liabilities.

Enterprise value profit multiples

Valuation multiples based on profit measures are also impacted by real-estate strategy. This applies to all of the commonly used multiples such as EBIT, EBITDA and EBITDAR. In each case, a higher level of real-estate exposure is likely to increase the reported multiple.³The only exception is in the case of EV/EBITDA multiples where companies with very short-term leases, or leases with variable lease payments that are not capitalised, would likely have a higher multiple than companies with a higher real-estate exposure from leasing if those leases are capitalised (8.0 versus 5.9 in the table above). This is because in the case of very short-term leases§ the property cost is reported as a rent expense rather than depreciation. The reason is that the multiple applicable to the real-estate portion of the business would generally be higher than that applicable to the pure operating component. This is because real-estate risk would usually be lower than the risk of the pure operating business and also because, in the case of an ownership real-estate business model, a portion of the return (the potential for increase in fair value) is missing from profit and loss due to historical cost accounting. 

The higher multiples that arise from higher real-estate exposure does not mean that these stocks are more expensive investments, it is merely a consequence of the differing nature of the business. As with the EV/IC multiple, the overall profit multiple for the business, including the real-estate exposure, is a weighted average of the multiple for the real-estate and for the operating business. Because the applicable multiple for the real-estate component is usually higher⁴In effect, the pure real-estate profit multiple is the reciprocal of property yield (less depreciation) for owned properties and the lease interest rate for leased properties. than that for an operating business, the overall multiple shows a positive relationship to real-estate exposure.

Opco–Propco based analysis

As we illustrate above, companies that are real-estate ‘asset-lite’ tend to deserve a lower overall value relative to reported profit compared with companies with more significant real-estate exposure. If investors do not realise this or apply adjustments before making stock comparisons, then stocks may potentially be mis-priced.

Making comparisons of aggregate metrics is not easy, even with awareness of the different effects of real-estate. Much better would be to make adjustments so that returns and valuation multiples are more comparable. This involves splitting a company into a real-estate component (Propco) and a residual (Opco) containing the operating business excluding the real-estate asset contribution.

A property expense still needs to be recognised for Opco, but this is based on a hypothetical short-term (less than 1 year) lease in all cases. This, in effect, removes any risks and rewards from property ownership which remain in Propco.

The approach is relatively simple:

• Assign any real-estate assets and the related depreciation expense to Propco.

• Apply a notional charge by Propco to Opco for the short-term lease rentals. In the case of owned properties this should reflect the estimated rental yield (applicable to a short-term lease) for the asset. The same amount should apply to a right-of-use asset; however, this can usually be approximated by the lease rent payment made for the actual longer-term lease.

• Allocate part of the total enterprise value to Propco to reflect the estimated fair value of the real-estate interest. The remainder of the total enterprise value relates to Opco.

Here is our application of the analysis to the example above.

Opco-Propco analysis

Note: The short-term rental expense applied in the analysing the aggregate business into Opco and Propco components reflects an assumed property yield of 5%. This, and other inputs, can be changed in the downloadable model (see link above).

The key observation regarding this table is that the performance and valuation metrics for the Opco component of each company are the same, even though, as we explain above, the metrics for the aggregate business combining Opco and Propco are very different. This is not surprising since we started with the premise that the four companies were identical, except that the real-estate used in their businesses is accessed in different ways. In practice, applying the Opco-Propco analysis to different businesses with different underlying operations would result in varying metrics for Opco. However, these metrics would be more comparable and more useful in analysis than those reflecting the aggregate operations before removing the differing investment in real-estate.

Has IFRS 16 made analysis more difficult?

Some investors have suggested to us that IFRS 16 has had a negative impact for investors because it has introduced a lack of comparability between companies that use leases of different terms. Under the previous accounting all operating leases were excluded from the balance sheet, resulting in supposedly more comparable metrics. Of course, there was still the difference between ownership and leasing and also the potential for some property leases to be classified as finance leases and therefore capitalised. However, all operating leases produced comparable metrics.

We disagree with this negative view of IFRS 16. We think it is important that investors get a clear picture of the extent to which companies are exposed to real-estate assets. Only by capitalising all (material) leases, taking into account the lease term, is this achieved. However, it is also important that your analysis does not disregard differences in real-estate exposure, which is why, where the effect is material, an Opco-Propco type analysis is important.

Some may argue that the Opco-Propco analysis is actually undoing the new lease accounting. This is partly true but it is also important to consider the extent of real-estate exposure and the leverage resulting from lease obligations. Only by applying IFRS 16 is this clearly presented. The application of Opco-Propco analysis merely separates the two components of the business to aid analysis.

One of the key messages arising from our analysis is the importance of fair value. To successfully do an Opco-Propco analysis, investors need fair value disclosures for owned and leased real-estate assets. Under IFRS, fair value is currently only required for investment properties. We do not necessarily believe that fair value should be applied in the primary financial statements, but we believe that fair value disclosures would benefit investors.

We suggest that the IASB considers the need for such disclosures in their current review of IFRS disclosure requirements.

Insights for investors

• Return and valuation metrics of companies that have significant and differing exposure to real-estate assets are unlikely to be comparable.

• High real-estate exposure generally results in a lower rate of return on capital and lower value relative to the book value of assets, but higher profit-based valuation multiples.

• Use Opco-Propco analysis to obtain comparable performance and valuation metrics.

• Adjust for the fair value of real-estate assets where available. For lease right-of-use assets the lease liability may be a better estimate of fair value than the book value of the asset itself.

• New lease accounting under IFRS 16 provides a better measure of real-estate exposure but increases the importance of Opco-Propco type analysis.

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