3.5 Real Estate Equity Flashcards
Steps in the RE development process
1) Purchasing land/building
2) Estimating projects expected profits and potential interests from buyers/renters
3) Designing the building structure/improvements
4) Getting public approvals/permits
5) Acquiring financing
6) Building/remodeling the structure
7) leasing/selling the property
Real option is what type of option? 3 types of real options?
An option on a real asset.
3 types: option to buy and asset, option to sell a real asset, option to exchange non-cash assets
What is a fair investment?
Investment with an expected value of zero
What is a decision node?
Point in a decision tree when a decision is made
What is an information node
Point when new information is revealed that may affect future decisions
Backward induction?
Start from the final nodes and go to the earlier nodes one step at a time and decide to accept or not accept the project at the first node
5 common approaches to valuing private commercial real estate equity
1) comparable sale price approach
2) profit approach
3) cost approach
4) income (discounted cash flow) approach
5) Multi-factor transaction based approach
When and how is comparable sales price approach used?
Non income producing real estate properties are compared to comparable recently sold properties
When using the comparable sales approach is not viable due to limited recent, comparable real estate transactions, alternative approaches may be used based on one or both of two components:
- The structure’s replacement costs.
- The site’s estimated market value for its most profitable use.
When is cost approach used?
Typically used to value new structures and in market with substantial new construction
CAP Rate formula, description of inputs
NOI / Property Value
NOI = normalized, annual cash flow IGNORING financing cost
Property value = market value
When were CAP rates higher and lower?
Higher: mid 90s & 2002
Lower: pre 2007 GFC and 2021
Pros / cons of income approach valuation?
Pros: value property’s unique characteristics
Cons: needing to estimate a discount rate and exposures to errors in forecasting cash flows
Description of transaction based real estate valuation methods?
Use large data sets of property transaction prices in a specific time period to determine value based on MULTIPLE factors
When transaction-based valuation methods may serve as a reliable basis for real estate valuation?
As long as the following holds:
- They are applied using adequate data and rigorous econometric methods.
- Differences among the properties are modeled well.
- Statistical noise in the data is minimized.
The two main transaction-based valuation methods are
1) repeat-sales
2) hedonic pricing methods
Pros / cons of appraisal over transaction based models?
Pros:
1. They do not suffer from a small sample size bias.
2. All properties can be appraised frequently and by several experts (although this would be costly)
Cons:
1) Appraisals are subjective and backward-looking
2) Properties in appraisal-based real estate price indices are not reappraised as often as the index is reported (appraisals performed annually).
3) Values of appraisal-based indices are smoothed
4) Quality of the appraisal depends on the relevance and quality of available data.
What is stale appraisal effect?
Errors due to using dated appraisals, which contributes to the lagged price changes in appraisal-based indices.
NCREIF Property index (NPI) characteristics?
Popular, large, value weighted index published QUARTERLY based on UNLEVERAGED commercial property appraisals
7500 properties, total value $600 billion
1977 started
How is NPI calculated?
Each quarter the price of property is calculated AS IF it was sold at begging of quarter appraised value and then sold at the end of quarter appraised value
If property is sold, its price is used.
Calculated as if bought for 100% equity and on a PRE-TAX basis
How is NPI total return calculated?
NPI return = income return + capital value return
Income return = NOI / Property value (beginning appraised value adjusted for improvements, reinvestments and sale)
Capital value = change of property value
UK alternative to NPI
Investment Property Databank (IPD) available monthly and annually
NCREIF’s hedonic index that uses transaction data from NCREIF database?
Transaction based index (TBI)
Net operating income formula
NOI= Effective gross income - Operating expenses
OR
[Potential gross income X (1-Vacancy loss rate) ] - (fixed + variable expenses)
Effective gross income formula
Effective gross income = Potential Gross income - Vacancy Loss
OR
Potential gross income - (1 - Vacancy loss rate)
Vacancy loss rate - proportion of unoccupied properties
Pro forma report includes what?
Rental income per lease, other income, and unexpected vacancy allowance
i.e. provides a projection of property’s future cash flows
In practice what does RE property valuation include?
Info on properties:
- cash flows
- expenditures (capital & tenant improvements, leasing commissions)
- accounts for depreciation
- income tax
- financing costs
How to find APPRAISED VALUE using discounted cash flow analysis?
Find the cash flows for each year, the discount rate and calculate the NPV or PV
2 types of private RE investment vehicles?
1) Private Equity RE funds
2) limited partnerships
PE RE Funds investment strategies
Collect funds from investors and invest in the equity or debt of private real estate
Active management approach
Long term, hold to liquidation funds
Lifespan about 10 yrs, first 2-3 yrs are called investment years
Private equity RE Funds 3 disadvantages?
1) Investors do not have direct control over the underlying portfolio
2) Often lack a liquid exit strategy.
3) Unreliable reporting of values
3 types of PE RE Funds
1) commingled RE funds (CREFs)
2) syndications
3) joint ventures
Main advantage of PE RE Funds?
Access to real estate properties that are too large to be held by one institution
OR
Access to a portfolio that small funds could not create on their own
Commingled RE funds (CREFs) characteristics?
- structured as Close ended funds.
- investors receive negotiable ownership certificate = proportional claim to underlying RE asset
- unit prices are determined using regular appraisals
- main difference to other PE RE funds - negotiability
RE Syndications characteristics
A syndicators (general manager) receive a fee for pooling and actively managing RE investments
Allows smaller investors to access investments outside of their expertise
Passes depreciation deductions = avoids double taxation
Joint ventures in RE
When 2 or more parties each bringing unique expertise.
Usually small number of individual or institutional investors
Limited partnerships in private RE investment characteristics?
Have a Fund sponsor (GP) responsible for raising capital from investors (LPs, typically institutional investors
Often use aggressive levels of debt (around 75%)
Have a 1-2% management fee and 20% performance fee
Capital is drawn when suitable investments are identified
What is GEARING? How is it expressed?
gearing = Using leverage
Expressed using LTV or Debt / Equity ratio
5 public RE investment vehicles?
1) Open ended mutual funds
2) Options and futures on RE indices
3) Exchange rated funds on RE indices
4) Close ended RE mutual funds
5) REITs
Open ended RE funds characteristics
Investors can redeem their shares daily at the NAV (net asset value)
Some investors arbitrage Stale prices by entering at specific times
Difficulties of options and futures on RE Indices
The difficulty of pricing the options/futures because of the illiquidity and heterogenous (dissimilar) qualities of RE
How are ETFs based on RE Indices issued and redeemed?
At about the same price as the NAV
Closed ended RE mutual funds characteristics
No redemption issues, shares are traded on secondary market
Usually trade at a premium or discount to the NAV
Typically liquidate portfolio after 15 years
Majority of equity REIT holdings represent?
Equity claims on RE
Equity REIT characteristics
Main income from rent, some degree from increases in property values
Potential hedge against inflation
Market returns correlated to small and mid cap stocks = suggests more reflective of stock market fluctuations than RE market prices
Correlation level of NCREIF Property Index compared to REIT index is?
Less correlated with the stock market
Each step in the development process is equivalent to buying a…? Why?
Call option
Because the developer has the option of either scrapping the project or moving on to the next step.
What most accurately reflects the risk-adjusted return and risk (measured by standard deviation) of equity REITs over the past 18 years compared to global equities? Which measurement reflects this?
Slightly higher risk-adjusted return and higher risk.
Sharpe ratio = risk adjusted return
Which real estate investment imposes the LEAST capital constraints on small investors?
Open ended RE funds
Characteristics of equity REIT returns VS global equities from 2000 to 2020?
- Larger volatility than global equities
- Moderate Sharpe ratio (> global equities)
- Moderately negatively skewed (similar to global equities)
- Large excess kurtosis (> global equities)
- Very large maximum drawdown (> global equities)
