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CAIA > 3.4 Real Estate Assets and Debt > Flashcards

3.4 Real Estate Assets and Debt Flashcards

1
Q

Real estate investments can be classified in 5 ways:

A

1) Debt vs Equity

2) Domestic vs International

3) Residential vs Commercial

4) Private vs Public

5) Market size of geographic location

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2
Q

What is a mortgage?

A

Debt instrument collateralized by a real estate property, with a value that is more closely associated with the value of the real estate than the profitability of the borrower.

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3
Q

When do mortgages behave like RE equity?

A

Mortgages with considerable credit risk

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4
Q

When may RE Equity behave like debt?

A

When real estate property has long term leases

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5
Q

7 Challenges of International RE investment

A

1) Lack of experience and knowledge with overseas real estate markets

2) Lack of relationships with overseas real estate managers

3) Time and expense of travel (for due diligence)

4) Liquidity concerns

5) Political risk (particularly in emerging markets)

6) Risk management of foreign currency exposures

7) Different taxation.

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6
Q

In the residential real estate sector, institutional investments are primarily in?

A

Pools of mortgages backed by residential real estate.

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7
Q

3 categorizations of RE by market size

A

1) Primary RE market - major metropolitan areas

2) Secondary RE market - medium sized regions (ex: suburban areas of primary markets)

3) tertiary RE market - lesser known regions, smaller populations, smaller RE projects

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8
Q

5 potential advantages to investing in RE

A

s 1-3 are risk-reducing advantages related to portfolio risk. In competitive and efficient markets, these advantages come at the cost of lower expected returns.

  1. Absolute returns
  2. Hedge against unexpected inflation
  3. Diversification (for stocks and bonds)
  4. Cash inflows
  5. Income tax advantages
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9
Q

3 potential disadvantages to investing in RE

A

1) Heterogeneity (diverse offering, numerous categories)

2) lumpiness (indivisible)

3) illiquidity

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10
Q

3 types of RE investment

A

1) Core

2) Value added

3) Opportunistic

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11
Q

Core RE:
- comprises of which categories?
- where does the return come from?
- similar to what financial instrument?

A

1) Office, retail, industrial, multi-family, hotels

2) from rental income, not asset
appreciation

3) bond like with respect to cashflow stability

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12
Q

Value added RE

  • comprises of which categories?
  • where does the return come from?
  • key characteristics?
A

1) hotels, resorts, assisted care living, hospitals, low income housing, shopping malls. May include: new not fully leased properties that if fully leases would be classified as CORE properties & properties that require a new strategy (renovation, etc)

2) mostly from appreciation, and some income

3)
i. Significant portion of expected returns derived from increased property value it.
ii. Moderate volatility
iii. Less financially reliable than core properties

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13
Q

Opportunistic RE

  • comprises of which categories?
  • where does the return come from?
  • key characteristics?
A

1) developing new properties, redeveloping distressed properties, buying properties in areas undergoing improvement

2) value appreciation over a short 3-5 year period

3) equity like, because they currently have no reliable income

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14
Q

3 purposes of real estate investment style analysis

A

1) performance measurement (compare to peers)

2) monitoring style drift

3) style diversification

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15
Q

Amortization is? Then fully amortized means?

A

Repayment of the loan that reduces the principal

Fully amortized = principal is reduced to zero

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16
Q

Fixed rate mortgages risks?

A

Interest rate risk & Inflation risk

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17
Q

Principal payment (PP) formula

A

PP = mortgage payment - interest payment

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18
Q

Exercise! USING CALCULATOR

A) Steve Lipski takes out a 30-year $200,000 mortgage at a 6% annual nominal interest rate. What are the monthly mortgage payments?

B) how much of Lipski’s 61st payment (five years after the loan was originated) is interest and how much is principal? How much is the loan balance after the 61st month?

A

A)

N = 30 * 12 = 360 (to convert to months)
I/Y = 6% / 12 = 0.5% (to convert to months)
PV = -200,000
PMT CPT
FV = 0

B) first calculate loan balance prior to 61st month. N=300, I/Y=0.5, PMT=1199.1, FV=0, PV CPT

  • interest payment in 61st month = loan balance * interest rate
  • principal payment = MP - interest payment
  • loan balance after 61st month = loan balance prior to 61st month - principal payment
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19
Q

When does prepayment favor borrowers or lenders? Why?

A

Favors borrowers when the interest rate is low. Because they can refinance (decrease interest payments) or use extra cash to pay down the mortgage, because the amount they save on their mortgage (if they prepay) exceeds interest they can earn on their cash

Favors lenders when the interest rate is high. Because lenders can reinvest interest cash at a higher rate WHILE the BORROWERS can earn more money by investing

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20
Q

How do interest rate only mortgages work?

A

Only interest payments for the first period, then only principal payments.

Usually: 10/20 or 15/15

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21
Q

How do variable rate mortgages work (adjustable rate)?

A

For some initial period of time the rate is fixed (usually higher to compensate for the risk) and then transitions to a floating rate.

The floating is rate is usually calculated as: index rate + margin rate

Index rate is usually based on money market rates

Margin rate is usually stable and is the compensation for the risk bared by the lender

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22
Q

What is an interest rate cap provision? How does it work?

A

A cap on the interest rate increase for adjustable rate mortgages (ARM).

Ex: no more than 2% per year and 5% over the whole term

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23
Q

Advantages of ARM for borrowers?

A

Initially the interest rate is lower

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24
Q

What is graduated payment loan? Benefits to the lender?

A

Initial interest is fixed and low and then gradually increases.

Benefit to the lender is that the default risk is lower and if default occurs a few years later the property should have appreciated

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25
Q

How does option adjustable rate mortgage (option ARM) work? What are drawbacks?

A

Each month the borrower has the right to choose between a 30-year, fully amortizing payment; a 15-year, fully amortizing payment; an interest-only payment, or a so-called minimum payment which did not cover the monthly interest.

Drawbacks for borrowers: mortgages that allow payments less than interest rate result in NEGATIVE amortization = increase of principal

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26
Q

How does Ballon Payment work? What are drawbacks?

A

Large payment made at some future date

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27
Q

In an interest only mortgage what is the ballon payment?

A

The principal. The monthly payments are only the interest

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28
Q

How to reduce default risk?

A

Examine creditworthiness of borrowers and set limits:
1) front end ratio: housing expenses to monthly income, which is often limited to 28%.
2) Back-end ratio - housing costs and other debt (e.g., credit cards) to monthly income, which is often limited to 36%.

29
Q

Loan to value (LTV) ratio formula? What ratio is considered well collateralized?

A

LTV = mortgage loan / value of property.

80% LTV is well collateralized. Up to 95% is available for insurance

30
Q

Differences of commercial loans

A

1) Commercial mortgages tend to be larger loans, have shorter maturities, and have balloon payments.

2) due to the loan sizes, defaulting commercial mortgages are more likely to be restructured than foreclosed on.

3) Commercial loans for existing properties are drawn immediately and have a longer term (about 5-10 years) compared to development loans that are drawn in phases (i.e., developers draw funds as needed during the construction phase).

31
Q

What is a covenant?

A

Loan requirements that the borrower must meet, otherwise the default of the loan can be triggered

32
Q

Types of covenants?

A

1) Seniority = lender has seniority in event of default

2) resource = actions that the lender can take in case of default

3) restrictions on use of rental income

4) proviso ok managing/operating the property

5) cross collateral provision

33
Q

4 financial ratios used to assess commercial mortgages default risk

A

1) LTV - usually less than 75%

2) interest coverage ratio

3) debt service charge ratio (DSCR)

4) Fixed charges ratio

34
Q

What is the interest coverage ratio formula? What ratio is usually required?

A

Interest coverage ratio = NOI (net operating annual income) / Interest payments

1.2-1.3 ratio is usually required by senior lenders => NOI should be 20-30% higher than interest payments

35
Q

Debt service coverage ratio (DSCR) formula

A

DSCR = NOI / Debtservice payments (interest + principal payments)

36
Q

Fixed charges ratio formula?

A

NOI / Total Annual charges (all fixed charges the borrower pays each year: debt service, lease expenses, etc)

37
Q

When are defaults higher?

A

Its cyclical and defaults are higher during booming markets when the restrictions are less strict

38
Q

2 types of mortgage backed securities

A

1) pass through MBS (interest & principal payments are passed through)

2) Collateralized mortgage obligation (CMO) - tranches that differ in priority for receiving cash flow

39
Q

Residential Mortgage Prepayment options are call and put on what?

A

Call on debt

Put on interest rates

40
Q

What is CPR? Monthly to early formula

A

Conditional prepayment rate - annual % of a mortgage’s principal that is prepaid

Annualized CPR = 1- (1-Monthly CPR)

41
Q

What is the PSA benchmark? What is the assumption and formula? If prepayment rates are in line with PSA, what is the figure?

A

Public securities association benchmark - average benchmark for prepayments based on CPR.

Assumption is that CPR for a 30yr mortgage starts at 0.2% in the first month, grows by 0.2% each month for the next 30 months until reaching 6% and stays at 6%.

Prepayment rate relative to PSA formula = CPR t / PSA t

If prepayment rates are 100% in line with PSA => 100% PSA, if 1.5 times faster than PSA => 150% PSA

42
Q

3 main prepayment factors UNRELATED to interest rates

A

1) Idiosyncratic prepayment factors (non systematic)

2) Systematic:
- Increased economic activity (new better houses, better jobs)
- Recent path of mortgage rates (have been decreasing for a while)

3) Characteristics of a mortgage pool (some regions are more prone to prepayment)

43
Q

What is refinancing burnout?

A

When rates have been decreasing for some time, the prepayment slows down because of previous refinancing activity (most have already taken advantage of lower rates)

44
Q

Differences between CMBS and RMBS?

A

Commercial Mortgage Backed Securities have:

1) Less prepayment risk - stricter rules

2) More default/credit risk

3) Fewer Mortgages

45
Q

Adequate LTV ratios for CMBSs? Historical ratios?

A

Risky CMBS have average LTV more than 75%

Rating agencies generally allow no kore than 15% of loans to have LTV larger than 75%. And do not assign high ratings to CMBS that have ONE loan more than 5% of the issue

Historically, between 65-80%

46
Q

3 basic types of REITs

A

1) Equity REIT - ownership of properties, also developer, manage, renovate, etc.

2) Mortgage REIT - lend to owners, developers, etc

3) Hybrid REIT - combination of the two (rarely used)

47
Q

How do equity REITs generate revenue?

A

From rent received, increase in property value and increases in rent

48
Q

3 characteristics of REITs?

A

1) Professional Asset Management

2) Independent Board of directors

3) Consistent dividend yield

49
Q

Pros of REIT investing

A

1) management of properties by REIT executives

2) Liquidity

3) No double taxation - paid at individual level

50
Q

Cons of REIT investing

A

1) Management fees

2) Lack of control over management

3) Potential greater price risk (volatility of financial markets)

51
Q

How to qualify for only paying taxes only on retained income for REITs?

A

1) 75% income from RE activites

2) 90% of taxable income to be paid out in form of dividends

52
Q

REIT Ownership restriction

A

5/50 rule = no more than 50% can be owned by 5 or less investors

53
Q

What is platykurtic distribution?

A

Thinner tails = less probability of extreme events than normal distribution

Negative excess kurtosis

54
Q

What is a cross collateral provision?

A

The borrower finances two buildings with the same lender, and the lender can prevent the sale of one building before both are paid off.

55
Q

What is rollover concentration in relation to RE?

A

Trading frequency

56
Q

A 5-year $50,000 mortgage has a 6% annual interest rate. If the borrower of this mortgage loan has a $10,000 balloon payment on the loan’s maturity date, how much of the first monthly payment will be interest?

A

(6% / 12) * 50k = 250

57
Q

An acceptable LTV ratio varies depending on?

A

1) property sector

2) geographic region

3) stage of the real estate cycle.

58
Q

What is Homogeneity? Example?

A

State of being similar or uniform

Ex: homogeneous population = population with very similar characteristics

59
Q

Ilal Development, Inc. is an equity REIT that acquires and manages health-care facilities in the southern United States.
The Western Pension Fund owns shares in Ilal Development, Inc.

What are the tax implications for Ilal Development and the Western Pension Fund?

A

Both dont pay taxes. Because Ilal dev is a REIT and Western is a pension fund (does not pay taxes)

60
Q

Pros / cons of private investment VS public?

A

Pros: investment focus and tax timing benefits

Cons: illiquidity and low transparency

61
Q

How are REIT shareholders taxed?

A

They pay ordinary income tax on dividends received

62
Q

Residential or Commercial mortgages more often have ballon payments?

A

Commercial

63
Q

What is a common risk factor for both residential and commercial types of MBSs that affects them both to a similar extent?

A

Location

64
Q

Borrowers’ creditworthiness affects commercial or insured residential MBSs more?

A

Commercial MBSs, since commercial MBSs are subject to more credit risk due to their non-standardized nature.

65
Q

The prevailing mortgage rate and the path of rates affect residential or commercial MBS more?

A

Residential since they are subject to more prepayment risk than commercial MBSs.

66
Q

Anna Kimmel owns a 100% equity investment in an office complex, where all the tenants have long-term leases.

Why is the value of the property is affected by fluctuating interest rates?

A

Because the property provides a stable income stream, its income is similar to that of a fixed-income (debt) instrument and, like fixed-income instruments, its value will react to changes in interest rates.

67
Q

Do REITs typically have much less default risk than traditional asset classes?

A

There is no evidence for that

68
Q

Mortgage borrowers’ ability to make unscheduled principal mortgage payments gives them a ____ option on the value of the mortgage. It also gives them a _____ option on the mortgage rate. Why?

A

Call option on value of mortgage: since they can essentially buy the mortgage loan

Put option on rate: since they can essentially sell the mortgage rate

CAIA (14 decks)

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