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CFA Level II > 32 (AI) - Real Estate > Flashcards

32 (AI) - Real Estate Flashcards

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1
Q

What are the two basic types of real estate ?

A
  1. Residential - single-family homes, apartments/condos, and manufactured housing.
  2. Non-Residential (i.e. commercial) - office, shopping centers, factories, warehouses, agricultural, and other specialty real estate.
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2
Q

What are the four basic forms of real estate investment?

A
  1. Private Equity - Direct ownership in properties
    - Individual ownership of a property
    - Joint ventures
    - Limited partnerships
    - Private REITs or REOCs
    - Forms of commingles funds
  2. Publicly-traded Equity - Indirect ownership of properties (e.g. ETFs, REITs, REOCs, index funds, etc.). These are securities that serve as claims in the underlying assets.
  3. Private Debt - Direct lending to properties. (e.g. mortgages, private debt, bank debt, etc.)
  4. Publicly-traded Debt - Indirect lending to properties. (e.g. mortgage-backed securities, mortgage REITs, unsecured REIT debt, etc.)
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3
Q

What are the key characteristics of real estate investments?

A
  1. Heterogeneity
    2, High unit value
  2. Active management
  3. High transaction costs
  4. Depreciation and desirability
  5. Cost and availability of debt capital
  6. Illiquid
  7. Difficult to determine price/valuation
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4
Q

What are the three different categories of risk in commercial real estate?

A
  1. Supply and demand risk - Business conditions, demographics, and excess supply.
  2. Valuation risk - Cost and availability of capital, availability of information, lack of liquidity, and interest rates,
  3. Operational risk
    - Management expertise
    - Lease terms
    - Leverage
    - ESG considerations
    - Obsolescence
    - Market disruptions
    - Property defects, natural disasters, and terrorism
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5
Q

What happens to real estate prices when interest rates rise?

A

Given high costs to acquire and develop real estate, property values will go down when interest rates rise and the availability of debt capital is more scarce due to higher rates.

Higher rates = lower prices
Lower rates = higher prices

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6
Q

What are the major reasons to invest in real estate?

A
  1. Current income
  2. Capital appreciation
  3. Inflation hedge - rents and property values rise with inflation
  4. Diversification
  5. Tax benefits
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7
Q

Explain real estate’s correlation with traditional asset classes?

A

Real estate (particularly private real estate) is less-than-perfectly correlated with the returns of stocks and bonds.

Adding real estate to a portfolio can reduce risk relative to expected return (i.e. benefits of diversification).

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8
Q

What is the core real estate investing style?

A

A conservative real estate investment strategy that limits investments to high quality and low leverage (<30% LTV), and avoids speculative risks in favor of steady returns.

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9
Q

What are the major macroeconomic factors that affect all sectors of real estate demand and investments?

A
  1. GDP growth (largest driver)
  2. Population growth
  3. Job creation
  4. Wage growth
  5. Regulation
  6. Taxes
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10
Q

Which major macroeconomic factors are specific to the industrial sector?

A
  1. Retail sales growth
  2. Consumer spending
  3. Business formations
  4. Business investment
  5. Business confidence
  6. Industrial production
  7. Trade, transport, and logistics
  8. Changing supply routes
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11
Q

What are the major property types for commercial real estate?

What specific factor drives demand for each property type?

A
  1. Office - Job growth
  2. Industrial - The overall economy
  3. Retail - Consumer spending
  4. Multifamily - Population growth
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12
Q

What is a triple-net lease (NNN)?

A

A type of lease that requires a tenant to pay their share of common area maintenance, repairs, property taxes, and building insurance.

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13
Q

What is a sales-leaseback agreement?

A

A long-term single-tenant lease that requires the tenant to pay all expenses directly, in addition to base rent.

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14
Q

What is the purpose of due diligence in real estate and what does it entail?

A

it involves confirming the facts and conditions that might affect the value of a transaction. It can be costly but it lowers the risk of unexpected legal and physical problems with the real estate asset once acquired.

  • Review leases
  • Review of the market
  • Confirm operating expenses
  • Perform inspections
  • Survey the property
  • Examining legal documents
  • Verifying compliance
  • Review cash flow statements
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15
Q

What are the two types of real estate investment indexes?

A
  1. Appraisal-based Index - Indices constructed using appraisals of real estate properties.
  2. Transaction-based Index - Indices constructed based on recent sales of real estate properties.
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16
Q

What is the major flaws of an appraisal-based index?

A

They tend to lag transaction-based indices because actual transactions tend to occur before appraisals are performed.

They also appear to have lower volatility and lower correlation with other asset classes than a transaction-based index.

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17
Q

What is a well-known example of an appraisal-based index?

A

NCREIF Property Index (NPI)

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18
Q

What are the two major types of transaction-based indexes?

A
  1. Repeat-sales Index - Constructed using the value of a property that is sold twice. A regression is then developed to allocate the change in value to each quarter.
  2. Hedonic Index - Requires only one sale of a property. A regression model will control for the differences in property characteristics such as size, age, location, etc. to calculate new values.
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19
Q

What are the three major approaches to valuing real estate properties?

A
  1. Cost approach
  2. Sales comparison approach
  3. Income approach
20
Q

Explain the cost approach to valuing real estate properties?

A

The idea behind this approach is that a buyer is unlikely to pay more for a property than it would cost to purchase land and build a comparable building.

Three steps:
1. Estimate the market value of the land (often using a sales comparison approach)
2. Estimate the building’s replacement cost
3. Make adjustments for estimated depreciation and obsolescence.

Because of the difficulty in measuring depreciation and obsolescence, the cost approach is most useful when the subject property is relatively new.

21
Q

Explain the sales comparison approach to valuing real estate properties?

A

The idea behind this approach is that a buyer would pay no more for a property than others are paying for similar properties in the current market.

Value is derived by taking the sales price of similar/comparable properties and adjusting for differences with the subject property.

22
Q

Explain the income approach to valuing real estate properties? What are the two major methods of the income approach?

A

Value is derived from calculating the present value of the subject property’s future cash flows over the holding period.

  1. Direct capitalization method
  2. Discounted cash flow valuation method
23
Q

What is highest and best use?

A

A concept in determining the value of real estate properties. It’s used to compare how to develop a property (e.g. building an apartment building or shopping center, etc.)

The highest and best use of property is not based on the highest value of a property when a project is completed, rather it’s the highest implied land value.

24
Q

What is the discount rate in real estate?

A

The required rate of return for a real estate property.

25
Q

What is the direct capitalization method?

A

Method in which the value of a property is calculated by capitalizing the first-year NOI of a property using a cap rate.

Value = NOI/Cap Rate

26
Q

Net Operating Income (NOI)

A

The amount of income a property can generate after subtracting vacancy and collection losses, as well as operating expenses from potential gross income. NOI is calculated before subtracting financing costs and income taxes.

27
Q

What is the gross income multiplier method?

A

It’s another form of the direct capitalization method. The gross income multiplier is the ratio of the sales price to the property’s expected gross income in the year after purchase. Multipliers can be extracted from comparable transactions.

A limitation of this method is it ignores vacancy rates and operating expenses.

28
Q

What is the discounted cash flow method?

A

Method to determine a property’s value by projecting NOI for a specific holding period. value and then forecasting a terminal value at the end of the holding period using the direct capitalization method and a terminal value caprate which may be different than the going-on cap rate. One then discounts the NOI over the holding period and the terminal value to the present to calculate a value for the property.

29
Q

How do you forecast a terminal value when using the discounted cash flow method?

A

Calculate the terminal value by using the direct capitalization method.

Terminal Value - NOI in Last Year of Holding Period / Terminal Cap Rate

30
Q

What are the debt service coverage ratio (DSCR) and loan-to-value (LTV) ratio used for?

A

These ratios help determine the maximum loan amount on a specific property.

DSCR = NOI in Year 1 / Debt Service

LTV = Loan Amount / Appraised Value

31
Q

Debt Service

A

The loan payment that includes interest and principal.

32
Q

When is all-risks-yield (ARY)?

A

When a property’s tenants are required to pay all expenses. Value is determined by applying a cap rate to rent, not NOI.

ARY = Rent / Cap Rate

33
Q

Equity Dividend Rate

A

Known as the cash-on-cash return of an investment in a property.

Equity Dividend Rate - FIrst-year Cash Flow / Equity

34
Q

What is the Equity Dividend Rate, leveraged IRR, and unleveraged IRR used for?

A

Investors use these metrics to evaluate investment performance.

35
Q

What are the two main types of REITs?

A

Equity REITs - RE securities that take ownership stakes in income-producing property.

Mortgage REITs - RE securities that invest primarily in mortgages, mortgage securities, or loans that use real estate as collateral.

36
Q

What are the three main types of publicly-trade real estate investments?

A
  1. REITs
  2. REOCs
    3, Residential or commercial mortgage-based securities (MBS)
37
Q

What is the difference between a REIT and a REOC?

What are the advantages of a REIT over a REOC?

A

REITs are tax-advantaged companies (trusts) that are for for the most part exempt from corporate income tax. To be tax-advantages though, equity REITs are generally required to distribute 90%+ of taxable income to their shareholders.

REOCs are not tax-advantages and are ordinary (i.e. taxable) corporations that own real estate.

Advantages of REITs:
1. Exemption from corporate taxation
2. Predictable earnings
3. Higher yield given distribution requirement

38
Q

What is a mortgage-backed security (MBS)?

A

Publicly traded asset-backed securitized debt obligations that receive cash flows from an underlying pool of mortgage loans. Can be residential (RMBS) or commercial (CMBS)

39
Q

What are the advantages of REITs?

A
  1. Superior liquidity
  2. Transparency
  3. Access to premium properties
  4. Active professional management
  5. Greater potential for diversification
  6. Exemption from taxation
  7. Predictable earnings
  8. High yield.
40
Q

What are the disadvantages of REITs?

A
  1. Limited potential for income growth.
  2. Forced equity issuance.
  3. Lack of flexibility.
  4. Lower diversification benefits relative to direct investment in real estate.
41
Q

What are the different approaches to valuing REITs?

A
  1. Net Asset Value per Share (NAVPS)
  2. Price-to-FFO
  3. Price-to-AFFO
  4. Discounted cash flow
42
Q

What are the advantages of investing in private real estate?

A
  1. Direct exposure to the real estate asset class
  2. Returns dictated by property performance
  3. Tax benefits
  4. Inflation hedge
  5. Illiquidity premium
  6. Control and ability to pursue diverse strategies
  7. Lower correlation with other asset classes
43
Q

What are the disadvantages of investing in private real estate?

A
  1. Illiquidity
  2. High fees and expenses
  3. high minimum investment
  4. Low transparency
  5. fewer regulatory protections for investors
  6. Appraisals lag actual market values
  7. Higher risk due to the use of leverage (but also higher returns).
44
Q

What are the advantages of investing in publicly-traded real estate?

A
  1. Tracks real estate asset class fundamentals over the long term
  2. High liquidity
  3. Professional management
  4. Inflation hedge
  5. Tax efficiency (REITs)
  6. Access to a diversified pool of assets
  7. Access to special sectors
  8. Low minimum investment
  9. Low entry/exit costs
  10. Regulatory protections for investors
  11. High transparency
  12. Limited liability
45
Q

What are the disadvantages of investing in publicly-traded real estate?

A
  1. Higher volatility
  2. Higher correlation with stocks
  3. Dividends are taxed at high current income tax rates
  4. Poor governance/agency conflict
  5. Equity markets penalize high leverage
  6. market prices differ from NAV
  7. REIT structure limits possible activities
  8. Compliance costs may be prohibitive for smaller companies

CFA Level II (12 decks)

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