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Kathy Panagopouloskathy.panagopoulos@morningstar.com
Morningstar Moves to Discounted Cash-Flow Model to Analyze REITs

CHICAGO, July 28, 2005 – Almost as hot as the real estate market is the debate on how to value real estate investment trusts (REITs), companies that invest in buildings such as malls, offices, warehouses and apartments.  Should investors determine a REIT’s worth by focusing on the value of the buildings–known as the net-asset value (NAV) model?  Or, should they treat REITs like other stocks–valuing them for their management, earnings and the sum total of future cash flows, discounted to the present–known as the discounted cash-flow (DCF) model?

Which is better–NAV or DCF? Morningstar believes the answer is DCF and just began applying a DCF model for valuing property REITs, replacing the NAV model it previously used. The company believes it is the first independent research firm to use this approach as a primary tool for valuing REITs.  The new DCF model will impact the analysis and fair value estimates for all of the 61 REITs the firm covers.  Before applying the new model, Morningstar considered all REIT stocks it covered overvalued. Under the new DCF model, Morningstar now considers 10 of the 61 stocks undervalued.  Investors can find the new proprietary methodology at Morningstar.com.

“Although buildings add a tremendous amount of intrinsic value to a REIT, the stock market still cares about the company’s management, cash flows and earnings,” said Patrick Dorsey, director of stock analysis for Morningstar.  “Managers can create or destroy value for shareholders as a result of their actions. We think the discounted cash-flow model is the better method for determining the worth of REIT stocks, and for individual investors to make buy/sell decisions.”

Morningstar stock analysts look at cash flow, earnings, buildings’ value, and regulatory constraints as part of their assessment of REIT stocks.  They also consider management decisions and other intangibles, though these typically account for only 15 percent to 20 percent of the overall value of the stock–which indicates the primary importance of the intrinsic value of a REIT’s buildings.

To determine how management can add value, Morningstar analysts look at five key areas when reviewing a REIT stock.  They assess the REIT’s operations to determine if it:

  •  Boosts earnings from existing portfolios.  Is it able to maintain high rents?  Does it look for new, high-margin revenue sources? For example, Simon Property Group (SPG) continues to charge premium prices on new leases, and fills its malls with highly profitable kiosks.
  • Grows the portfolio externally. Does the REIT purchase undervalued properties that can be developed or redeveloped into a more productive asset? Vornado (VNO) is an example of a REIT that often buys buildings at a deep discount, redevelops them and then leases at higher rental rates.
  • Expands into property asset management.  Does the REIT partner with other firms to jointly own property, in a minority stake, to take advantage of the steady stream of high-margin fees, with little capital requirements? Taubman (TCO) generates about one-third of its income from co-owned properties, which reduces expensive capital commitments and boosts returns with lucrative management fees.
  • Seeks “financial engineering” opportunities.  Does the REIT cut debt, seek tax-free property exchanges or undertake other balance sheet maneuvers that are commonly known as “financial engineering”?
  • Retains earnings and reinvests at above-average returns.  Does the REIT use retained funds to invest in private real estate opportunities that could offer investors a market-beating performance?

“Changing to the DCF model requires significantly more work, requiring hundreds of inputs, compared to a NAV model,” Dorsey said.  “While the NAV model is the most common way to value REITs, we think that the added detail that comes from the DCF inputs is crucial–and will help investors better select investments.”

For more information on Morningstar’s new DCF model, please go to:

About Morningstar, Inc.
Morningstar, Inc. (Nasdaq: MORN) is a leading provider of independent investment research in the United States and in major international markets. The company offers an extensive line of Internet, software, and print-based products and services for individuals, financial advisors, and institutions. Morningstar provides data on more than 125,000 investment offerings, including stocks, mutual funds, and similar vehicles.

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This press release contains forward-looking statements. These statements relate to future events or to future financial performance and involve known and unknown risks, uncertainties, and other factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by these forward-looking statements.  In some cases, you can identify forward-looking statements by the use of words such as “may,” “could,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue” or the negative of these terms or other comparable terminology.  You should not place undue reliance on forward-looking statements because they involve known and unknown risks, uncertainties and other factors that are, in some cases, beyond our control and that could materially affect actual results, levels of activity, performance, or achievements.
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©2005 Morningstar Inc..  All rights reserved.


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