In the previous blog titled, “Structural Shift or Mean Reversion: Exploring the NOI Profit Margin Cycle,” we discussed the importance of the profit margin cycle in relation to the pro forma analysis. This piece will expand upon the original idea by including a valuation metric: price-to-sales ratio. A price-to-sales ratio is a common metric used in stock valuation. To derive the ratio, an analyst will divide a company’s price per share by the most recent annual revenue per share and compare the results to peer companies. Similarly, we will apply the same logic to real estate, utilizing NCREIF data with two key distinctions. The price-to-sales ratio used in the stock valuation is based on market values and annual revenue, but the analysis for this blog is based on NCREIF appraised values and quarterly operating revenue.
At the national level, the U.S. apartment sector is valued at 48.1 times the 3rd quarter 2014 revenue figure compared to the long-term average of roughly a 40 multiple. On the surface, this suggests the apartment sector is overvalued relative to the long-term norm. MPF Research believes current valuations are justified given the strength of the structural story driving fundamentals. However, we see short-term risk in the form of weakening profit margins.
Risk exists at the national level, but real estate is purchased at the local level. With that in mind, let’s take a look at how various metros stack up against each other from a relative value perspective in order to evaluate both opportunities and potential pockets of threats.
Based solely on price multiple analysis, the data would suggest most metros are fairly valued. Viewing metros individually, relative value is determined by which metric you give more weight to. For example, a case could be made that relative value is found in Atlanta and Miami because the current profit margin is in line with the national norm, but valuations are cheaper. Conversely, values in New York might be viewed as expensive even though the current profit margin is slightly higher than the national average. In addition, relative value is also contingent on future expectations, which require a good forecast. By understanding both relative value and the future trajectory of the profit margin, investment decisions improve, as money is typically made in real estate by buying the right asset at the right time. With that being said, for this analysis to be useful, it must be extended to the submarket and asset level.