3. Real Assets Flashcards
Real Asset
Physical economic resource, direct creator of consumption opportunity.
Undeveloped Land
Real asset that is not currently being used. Value of undeveloped land lies in the future consumption.
Land Banking
Investors purchase undeveloped land for the purpose of developing the land in the future. Key, is they plan on selling it to home-builders in the future.
Paper Lots
Lots are vacant, but zoned for development.
Blue Top Lots
Process of development has begun, rough grading and temporary drainage. Some development and building permit fees have not been paid.
Finished Lots
Lots are ready for construction and all developmental fees paid. Only remaining, payment of building permit fees and property inspection.
Key Risks of Undeveloped Residential Land
- Type: more uses for a property, higher value. Thus, single use property risky.
- Location: lots in path of development or near cities, high value. Thus, rural lots risky.
Land as a Call Option
Strike: construction and other costs incurred for development.
Time to Exp: generally unlimited
Underlying Asset: combination of land and improvements
Option Payoff: diff. between value of completed project and all costs of development& construction
Binomial Option Pricing Model to Evaluate Land
current value of improved property=
(UpVal x UpProb) + [DownVal x (1-UpProb)]
Timberland
- long term investments in wood via existing forestland
- returns exhibit low correlation to with stock and bond returns
Advantages of Timberland Investing
- low correlation with stocks and bonds
- may act as hedge against inflation
- invest in real asset, land
- renewable resource although long growth cycle
- flexibility of harvesting
- timber used for variety of products
Disadvantages of Timberland Investing
- trees destroyed by fire
- value tied to cyclical industries
- supply not fixed
- tech and recycling may reduce need
- investment horizon long
Farmland
- real asset that generates crop income
- more closely related to commodity prices than rent
Farmland Benefits
- renewable annual cash flow
- steady cash stream
- short growth cycle
- multi-purpose option
- expected increase in world population
- not dependent on local economies, listed on international futures
- scalable: strong competition to lease farmland
Farmland Disadvantages
- agency risks
- political risks
- less harvest flexibility
- natural forces can destroy
- farm specific inefficiencies
- revenues driven by market factors
Option to Produce Alternative Crop
Based on
- correlation
- volatility
- current closeness to profitability
Farmland Exposure
- best way is to own
- two indices: DAX Global Agribusiness Index & Thomson Reuters in the Ground Global Equity Index
- ETF: MOO
Infrastructure
broadly defined as the underlying foundation of basic services, facilities, and institutions upon which society depends
Greenfield Projects
infrastructure investments that must be constructed
Brownfield Projects
infrastructure projects that may already exist and could be transferred from public to private sector
Government Influence on Infrastructure Projects
Positive: - significant need - economic growth tied - proceeds from sale can be used for other things Risks: - regulatory risk - continued government influence - right to revoke a lease
Types of Infrastructure Investments
- Listed Stocks and Listed Funds
- Closed End Funds: structured like private equity
- Unlisted (evergreen) Open End Funds
Intellectual Property
intangible asset that can be owned
Intellectual Property Modeling
- discounted cash flow model
V = (p x CF1)/(r-g)
Smoothing
- results in lower price and return volatility, which makes assets look less risky than they might be
Historical Performance of Timber and Farmland (January 2000- December 2010)
- returns were generally positive and volatility low
- strong Sharpe ratio
- returns based on appraisal
- tendency to smooth
- based on quarterly
Fixed Rate Constant Payment, Fully Amortized Mortgage
- requires the borrower to pay a constant periodic amount, usually monthly, that will completely pay off the loan amount with the last payment
- over time larger amount becomes principal repayment, less interest
Monthly Mortgage Payment Calculation
MP = MB x [i/ (1 -i)^-n)] where: MP= constant monthly payment MB= mortgage balance at beginning of loan i = monthly interest rate n = number of months in the loan term
Calculating Monthly Interest, Principal and the Outstanding Balance
Book One, Page 290
Unscheduled Principal Payments
- borrowers may make additional payment
- cause balance to decline more rapidly
- benefit borrowers in a falling interest rate environment
Interest Only Mortgages
calls for interest only payments during the first part of the loan , and fully amortized payments during the second part of the loan
Variable Rate Mortgages (ARMs)
generally originate at one interest rate, after which, the interest rate fluctuates up or down during the loan term based on the movement of a published index
Interest Rate Caps
limit the amount the interest rate may increase in any one adjustment period
Graduated Payment Mortgage
allows borrowers to make lower monthly payments for the first few years of the loan (typically first 5 years) and larger payments for the remainder of the term
Option Adjustable-Rate Mortgage Loans (option ARMs)
specialized version of adjustable rate mortgages that are structured to provide borrowers payment flexibility
Balloon Payment Loan
when a mortgage requires periodic payment that will not fully amortize the amount of the loan by the end of the loan term, the final payment is an amount that is larger
Debt to Income Ratio
- sums the total housing expenses and divides the sum by the monthly income of the borrower
- front end ratio: borrower may limit housing costs to gross income to 28%
- back end ratio: borrower may limit housing costs and other debt such as auto and credit loans to 36% of gross income
Loan to Value
- the amount of the loan relative to the market or appraised value of the property
- loan considered well collateralized is LTV 80% or less
LTV = balance of the loan/ market value of the property
Commercial Mortgage Characteristics
- borrowers: companies
- income generation
- balloon payment: generally not fully amortized
- usage: long term invest prop, short term dev prop
- covenant: usually several
- cross collateral provisions: allow banks to pool to reduce risk
Default Risk
more important in commercial than residential
Interest Coverage Ratio
calculated as the property’s net operating income (NOI) divided by the amount of annual interest payable
- typical required 1.2 or greater
interest coverage ratio = NOI/ annual interest payment
Debt Service Coverage Ratio (DSCR)
DSCR = NOI/ total loan payment
Fixed Charges Ratio
fixed charges ratio = NOI/ all fixed payments
Mortgage Backed Securities (MBS)
is an investment structure that promises payments that are secured by a pool of mortgages
Collaterized Mortgage Obligations
are different from MBS in that investors self select into tranches that have different terms of principal and interest payments
Prepayment Option
residential loan option that allows part of full payment early
Conditional Payment Rate
annual reduction in the mortgage principal if the same percentage is repaid each month for an entire year
PSA Prepayment Benchmark
Public Securities Association studied prepayments
Assumes:
- CPR of 30 year loan is .2% per month
- increased by .2 % by month until month 30
- at that pt, remains constant at 6% for the rest of the mortgage life
Commercial Mortgage Backed Securities
- backed by commercial real estate
- key risk: default risk
- LTV btw 65-80%
- LTV > 75%, higher risk
Exhibit following characteristics: - tranches
- credit rating differ across tranches
- tranche char- senior tranch, fixed income, junior based on underlying commercial loan risk
- narrow tranches
Collateralized Mortgage Obligations
- structured product
- ## different tranches to investors
Sequential Pay CMOs
- simplest form of a CMO
- pays predetermined share of the interest to each tranche
- principal payment receipts based on tranche seniority
- many if not most of the underlying mortgages are insured
- more effected by interest rate and prepayment risk than default risk
Contraction Risk
as mortgage rates fall, prepayment increases and the average life of the pass-through security decreases
Extension Risk
as mortgage rates rise, prepayment rates slow and the average life of the pass through security increases
Other CMO Structures and Tranches
- Accrual tranches or Z bonds- receive no interest payment
- Principal only and interest only CMOs
- Floating rate tranches
- Planned amortization class (PAC) tranches - formed to provide a group of investors a more predictable cash flow stream
- Targeted Amortization Class (TAC) tranches: like PAC, but with more complexity
CMO Financial Crisis
- 1994: crisis as prepayments fell as interest rates rose
Real Estate Investment Trust (REITs)
- trade on exchanges
- 75% income must be from RE investments
- liquid
Benefits of Investing in REITs
- No corporate taxes
- Liquidity
- May be margined
- Asset allocation
- Professional management
- Income: REITs have to distribute 90% income
- Corporate governance: no more 50% held by 5 or fewer
Risk and Return of Mortgage REITs
- solid 12.8% return
- high standard deviation (22.4%), next commodities
- negative skewness and leptokurtosis
- min return -24.1%, max drawdown -69.1%
- positive correlation with global equity and bond
- zero correlation with commodities
- neg corr with VIX, i.e. greater uncertainty in equity market is negatively related to mortgage returns
Backward Induction Process
working backwards on a decision tree from the final nodes
Profit Approach
if valuing a real estate firm rather than a property
Equity Residual Approach
valuation approach for real estate
- subtracting interest and other cash flowed owed and discounting remaining cash flows
Discounted Cash Flow Approach for Real Estate Investments (Income Approach)
- most common method used for appraising
Potential Gross Income
income if all offices and space are occupied
Effective Gross Income
potential gross income less the vacancy loss
DCF Decision Outcomes
- if NPV greater than zero, project should go forward
- if IRR is greater than the discount rate, project should move forward
Real Estate Investment Risk Factors
- Financial Risk
- Business Risk
- Operational Risk
- Liquidity Risk
- Inflation Risk: may be good inflation hedge
- Legal Risk
Private Equity Real Estate Funds
- invest pooled capital in private real estate
- 10 year with 2-3 years investment period\
Advantages: - access
- access to fund management
Disadvantages: - lose direct control
- lack liquidity
- performance difficult to measure
Commingled Real Estate Funds (CREFs)
- specific type of private equity RE fund
- first type
Syndications
- financing mechanisms that allow investors to raise capital and hire expert
- limited partnerships or REITS or corporations
- if limited, depreciation tax deductions may be passed directly
Open Ended RE Mutual Funds
Advantages: - gain access with limited amount of capital - funds generally buy and sell - more liquidity - regulated by SEC Disadvantages: - right to defer redemptions - stale prices - fees - tax inefficient compared to ETF
ETF
- tradable investment that track a particular index
- Do Jones U.S. Real Estate Index
Closed End RE Mutual Funds
- exchange traded mutual funds Advantages: - liquidity - purchased on margin - can take long or short position - increased transparency - regulated by SEC Disadvantages: - difficult to get exposure to what you want - tax inefficient
Equity REITs
- must have 75% or more underlying RE holding claims to RE
- highly correlated with over market
- more highly correlated with small cap than large cap
Depreciation
reduction in value of an asset with the passage of time
Principals of Depreciation
- when depreciation is not allowed, the after tax IRR will be less than the pre-tax IRR reduced by the tax rate
- the effective tax rate is equal to the stated tax rate when tax deductible depreciation equals economic depreciation
- after tax IRR is slightly higher in the accelerated depreciation than in nonaccelerated
- when outlays can be fully expensed for tax accounting purposes, the after tax return will generally be approximately equal to the before tax
Accelerated Depreciation
allows a firm to write off the value of an asset more quickly than the true economic decline in the asset
Real Indices Based on Appraisal
National Council of RE Investment Fiduciaries
NPI calculated:
- appraised
-unleveraged basis
- before tax
- value weighted
NPI used as proxy for commercial RE investment
Hedonic Price Index
uses the underlying characteristic of an asset to estimate prices of the assets in the index
Equity REIT Performance
- strong 14.5% return
- largest max gain 31%
- max drawdown -68.3%
- negative skewness and leptokurtosis
- high positive correlation with global equity and high yield bond
- neg corr with VIX
- low positive correlation with commodities
