Understanding the Discount: Evidence from European Property Shares
Brounen, Dirk, Laak, Martijn ter, Journal of Real Estate Portfolio Management
Executive Summary. This paper investigates why a set of seventy-two European property shares were traded below their net asset values in the year 2002. The findings indicate an average discount to asset value of 36%, which turns out to be highest among the U.K. companies in the sample. When these discounts are related to a wide set of variables, a significantly negative relation can be seen between property share discounts and firm size, liquidity, the level of focus on property types, and indexmembership. The latter two parameters have not been considered before in previous literature and allow the model to explain over half of the observed cross-sectional variation in closed-end discounts.
Being publicly listed yields various benefits, among which easy access to capital and debt reduction are most prominent. For private real estate companies attracting sufficient financial resources is sometimes a mission impossible, which hampers their growth strategy and might spoil valuable business opportunities. The drawback of a public listing is that the stock market does not always value the real estate company according to its fundamental value. Stock market sentiment becomes part of the fund price movement and very often market prices exhibit strong deviations from the net asset values (NAV) of the underlying property portfolio (see Barkham and Ward, 1999). In cases when the stock market is overoptimistic, in that stock prices exceed the NAV and a share price premium emerges, real estate companies can use this window of opportunity to attract 'cheap' equity capital to finance the expansion of their activities. Unfortunately, most of the time the situation is reversed such that the stock value is low compared to the NAV and the resulting discounts are often referred to as a major limitation for future investment plans. Vast discounts to NAV have also triggered a wave of takeovers and delistings, like has been the case for several firms. Examples of such events are the British Compco Holdings, Canary Wharf, Seville Gordon Estates, Citadel and the Dutch Rodamco North America and Rodamco Asia, which have disappeared from the stock exchanges during the last five years.
This discount to NAV is often referred to as the 'closed-end fund puzzle' (see Lee, Shleifer and Thaler, 1991; and Malkiel, 1995) and has been studied on numerous occasions. For real estate companies specifically this issue has been examined more sporadically. Barkham and Ward (1999) studied the discounts of thirty listed property companies in the United Kingdom and linked these discounts to both rational and irrational variables. They document that taxes, firm size, holdings of trading stock and historic monthly returns succeed in explaining about 15% of the cross-sectional variation. But expanding this traditional set of explanatory variables with a noise-trader hypothesis, which incorporates the irrational overreaction of investors, succeeds in boosting the explanatory power of their model towards 33%. Later Bond and Shilling (2003) performed a similar analysis on a panEuropean sample of fifty property companies originating from eight countries and extend the existing literature by considering the impact of company risk on the discount. Their results show that risk is positively related to the discount to NAV and is successful in extending the understanding of why some property companies are undervalued by their stock investors. Although both studies have generated valuable insights, the closed-end puzzle for property companies has not been solved, since much of the cross-sectional variation in discounts is still not accounted for.
This study aims at extending the existing literature by employing a more elaborate sample consisting of seventy-two property companies originating from the U.K., Sweden, France, and the Netherlands and by applying a novel approach, which incorporates portfolio characteristics and the index membership of a firm. …