Key Takeaways
- Many open-ended private equity real estate funds must calculate, or strike, net asset value (NAV) on a recurring basis for any number of reasons, including to allow new investors to initiate positions, to allow existing investors to exit positions, to satisfy limited partner reporting requirements, and to comply with audit requirements.
- In basic terms, NAV is the net worth of a private equity real estate fund and is calculated as the assets of the fund less the liabilities.
- Investor management platforms are excellent tools that bring benefits to sponsors and limited partners; however, these software tools tend to fall short in assisting sponsors with calculating NAV.
- An experienced fund administrator understands the nuances involved in gathering the data required to strike NAV, performing the NAV calculation, and mitigating risks associated with the incorrect application of the metric.
Net Asset Value: The Basics
Private equity real estate offerings qualify as securities, but they are not publicly traded and do not have observable market prices. In place of an observable market price, fund sponsors may calculate and report NAV. It is usually reported on a per share or per unit basis, but it can also be expressed on an overall basis. The NAV metric provides investors with an estimate of the value of their position at a specific point in time and facilitates a few important activities:
- Personal financial assessments: NAV helps investors gauge the value of their stake in the fund, which is important for investors who need to submit personal financial assessments for other transactions or to satisfy financial responsibilities.
- Benchmarking fund performance: NAV provides a metric to compare the fund’s performance against market benchmarks or other funds in the same asset class. While not always conclusive, this comparison can help investors to evaluate whether the fund is meeting expectations.
- Establishing transaction prices: NAV serves as the basis for determining fair transaction prices for buying or selling shares or units in the fund.
NAV represents the total value of a real estate portfolio after accounting for liabilities. In simpler terms, it’s the difference between the fair market value of the assets held within the fund and all debts and obligations tied to the investing entity. In the context of private equity CRE, total assets typically include the fair market value of all properties held within the entity as well as non-real estate assets such as working capital. Liabilities include mortgages, business loans, and all other obligations.
Here is the NAV formula:
NAV = Total Assets (Fair Market Value) − Total Liabilities
NAV per share (NAVPS) can be calculated by dividing the overall NAV by the number of shares or units outstanding.
NAVPS = (Total Assets − Total Liabilities) / Number of Shares Outstanding
Challenges When Calculating NAV in Private Equity Commercial Real Estate
The illiquidity inherent to real estate coupled with the intricate structures of some private equity funds introduces challenges for sponsors when calculating NAV. Each of these factors adds complexity to the process of aggregating and valuing assets, accounting for liabilities, and ensuring that NAV reflects a fair and accurate picture of the fund’s financial health. In our experience, two factors deserve additional consideration.
Market Illiquidity
Every sponsor and astute investor, whether focused on equity or debt investments, understands that illiquidity is a common trait across the commercial real estate industry. Thin trading volumes define many commercial real estate markets, and this leaves market participants without rich data to facilitate price discovery.
Given the limitations that stem from illiquid market conditions, NAV calculations typically rely on appraised or estimated values, which involve a degree of judgment. These valuations often depend on comparable property sales to the extent they are available, pro forma projections, and the application of capitalization (cap) rates, all of which introduce uncertainty into the NAV calculation.
One of the risks that CRE sponsors face in participating in an illiquid asset class is that it can cause valuation lags, where NAV may not accurately reflect current market conditions. This can become especially problematic during periods of market volatility or economic distress where transaction volumes decrease, and price discovery becomes particularly difficult. Situations like this test the confidence of investors in the NAV assertions issued by the sponsor. Over the last several years, this has created newsworthy issues for private equity firms offering open-ended funds.
Special Considerations for Debt Funds
Debt funds that extend credit to CRE sponsors face even more difficulty in striking NAV because the underlying credit assets may be classified as Level 3 assets, which means the assets do not trade on an observable market. In other words, there may be little or no opportunity to conduct traditional price discovery. Under these circumstances, financial models must be used to value the credit assets. The most common approach is to construct a discounted cash flow model that relies on a series of assumptions specific to the portfolio as well as external factors, such as a Treasury yield curve.
Lexcraft Advisors is equipped to support debt fund sponsors facing challenges in calculating NAV, but many fund administrators are not. Debt fund sponsors are advised to probe a prospective administrator about their experience building and managing credit valuation models prior to forming a partnership.
Investor Management Platforms Fall Short in Calculating NAV
Investor management platforms, while valuable for tracking investor relationships and capital flows, are not designed to handle the complexities of NAV calculations. Two feature limitations prevent these software products from automating the NAV calculation and leave fund sponsors seeking alternatives.
First, these platforms often lack the tools to aggregate and analyze data from diverse sources. At the time of this writing, none of the investor management products on the market are capable of aggregating data from multiple, external sources, which precludes the automation of the data gathering process necessary to support the NAV calculation.
Second, while many investor management platforms allow for the user to manually input an overall or per-share NAV figure, these tools lack the functionality to perform the NAV calculation. Even after the sponsor has gathered the data necessary to perform the NAV calculation, it must be done outside of the investor management platform and subsequently keyed in.
The Role of a Fund Administrator in Calculating NAV
A fund administrator is uniquely positioned to handle NAV calculations because the administrator is typically responsible for fund-level accounting and bookkeeping. Having access to this information allows the administrator to quickly gather much of the data necessary to strike NAV, including working capital balances and loan balances. An experienced administrator will typically rely on a standardized methodology and calculation templates to streamline NAV calculations and mitigate the risk of errors.
By retaining a fund administrator, the sponsor can take a significant step toward boosting credibility and investor confidence. Administrators function as impartial third parties and handle NAV calculations according to industry standards, investor agreements, and relevant accounting principles. Further, an administrator will be able to deliver auditable NAV calculation working papers at any time, which is critical for funds subject to audits or special reporting stipulated by limited partners.
Final Thoughts
Depending on the fund structure and the requirements stipulated in foundational documents, private equity real estate funds may need to strike NAV on a recurring basis. In these instances, the sponsor is charged with providing a clear and standardized measure of the fund’s net worth at a given point in time. NAV serves as the foundation for essential fund operations, including investor reporting, compliance with foundational documents, and individual limited partner requirements. Accurate and timely NAV calculations are also critical for managing subscriptions and redemptions.
Unfortunately, investor management platforms fall short when it comes to calculating NAV. They lack features to allow for automated data gathering and calculations. Instead, sponsors must perform these tasks on their own or seek assistance from a third party. Fund administrators are the most common vendors sought out by sponsors to support recurring NAV calculations because administrators have experience with the data and the steps that must be completed. Some administrators specialize in commercial real estate and understand the nuances of illiquid CRE assets as well as the common challenges that real estate sponsors face throughout the NAV calculation process.
Lexcraft Advisors is a fund administration provider that serves middle market real estate investment funds and syndications, typically with equity under management between $15 million and $150 million. Our team takes pride in providing general partners with reliable fund administration solutions often reserved for large, global investment firms. To learn more about our services, schedule a complimentary meeting with one of our Managing Partners.