5.1/14 Real Estate as an Investment

Question 1

LO 14.1: Demonstrate knowledge of the attributes of real estate.

Answer 1

• Identify and discuss five potential advantages of real estate that encourage its inclusion in an investment portfolio. • Identify and discuss three potential disadvantages of real estate that discourage its inclusion in an investment Portfolio

Question 2

5 Advantages of RE

Answer 2

1. Real estate has the potential to provide absolute returns. 2. Real estate may act as a hedge against unanticipated inflation. 3. Real estate returns are not perfectly correlated with stock and bond returns, thus real estate offers the risk-reducing benefits of diversification. 4. Many real estate investments provide stable cash inflows. 5. There are potential tax advantages associated with real estate investments.

Question 3

3 Major Disadvantages of RE

Answer 3

1. RE is HETEROGENOUS - characterstics including physical features, location, use, design, and lease structures may be quite different, leading to potentially large differences in returns. 2. RE is Lumpy and not easily divisible - LUMPINESS refers to inability to easily and inexpensively buy and sell assets in saizes/quantities that meed specific needs of buyers and sellers. 3. RE is non-exchnage traded, typically high unit and transaction costs, with long hold periods. tends to be ILLIQUID relative to traditional assets.

Question 4

LO 14.2: Demonstrate knowledge of real estate asset allocation.

Answer 4

• Discuss heterogeneity within real estate subcategories. • Define, describe, and compare the top-down and bottom-up asset allocation approaches

Question 5

Top Down Asset Allocation

Answer 5

Involves big picture approach to allocation decsions, uses macroeconomic approach to asses risk premiums and returns, liquidity, and tax concerns. Use categories such as propertery type, investment management type, risk/reward profile to make allocation decisions

Question 6

Bottom Up Asset Allocation

Answer 6

emphasizes the individual property or subcatecory opportunities rather than characterstics of broad property categories. Individual asset selection drives the descion making - focus is fundamental analysis to estimate specific assets risk return characterstics

Question 7

Hybrid Asset Allocation

Answer 7

uses top-down approach to identify appropriate category allocation wieghts, then uses bottom-up approach to identify subcategories or individual properties for inclusion in portfolio - this approach is most common.

Question 8

LO 14.3: Demonstrate knowledge of methods of categorizing real estate

Answer 8

• Discuss four especially common categories used to differentiate real estate investments given by equity versus debt, domestic versus international, residential versus commercial, and private versus public. • Discuss additional categories used to classify real estate investments (i.e., categorization by market, and classification based on risk and return characteristics)

Question 9

four common categories used to differentiate real estate investments

Answer 9

(1) equity versus debt, (2) domestic versus international, (3) residential versus commercial, and (4) private versus public.

Question 10

Primary versus secondary versus tertiary markets.

Answer 10

Primary real estate markets consist of major metropolitan areas such as Manhattan, New York. Large institutional investors typically focus on primary markets. Secondary real estate markets consist of moderate-size communities such as Louisville, Kentucky. Tertiary real estate markets consist of small communities with smaller projects.

Question 11

LO 14.4: Demonstrate knowledge of the return drivers for real estate.

Answer 11

• Discuss the factors that affect the inflation protection potential of real estate investment.

Question 12

Anticipated (expected) inflation

Answer 12

expected rate of change in the overall price level.

Question 13

Fisher effect

Answer 13

states that nominal interest rates include both expected inflation and the real interest rate. ex ante nominal interest rate = ex ante real interest rate + anticipated inflation

Question 14

unanticipated inflation

Answer 14

The realized rate of inflation minus the anticipated inflation unanticipated inflation = realized inflation – anticipated inflation

Question 15

escalator clauses

Answer 15

allow lease payments to increase over time based on inflation rates. - helps combat inflation

Question 16

LO 14.5: Demonstrate knowledge of the four-quadrant model.

Answer 16

• Describe the components of the four-quadrant model, and its potential uses for analyzing a real estate investment.

Question 17

What is the Four-Quadrant Model?

Answer 17

• created by DiPasquale and Wheaton (1992)1 assesses the long-term equilibrium within the real estate and asset markets and is used as a graphic model of real estate dynamics. - It is a systems dynamics model that accounts for the relationship between all three components of the real estate system: space, market values, and construction.

Question 18

Four Quadrant Model (example)

Answer 18

• The NE quadrant measures rent as a function of demand (D) and supply (S) for real estate. Assuming that supply is fixed in the short term, the rent level (R) is determined where demand is equal to the fixed supply of space. Demand is a function of economic conditions and rent.
• The NW quadrant takes rent (R), a proxy for net operating income, and establishes a property price (P) using a given capitalization rate (i). The capitalization rate is simply the ratio of net operating income to property price and is sensitive to interest rates, economic factors, and taxation.
• The SW quadrant uses the property value we previously determined and establishes the level of construction activity at the equilibrium point where construction costs equal property value. Higher levels of new construction activity would lead to losses (costs exceeding price), whereas lower levels would not maximize profit. Prices (P) equal replacement costs (RCosts), which is a function of the construction level (C).
• The SE quadrant measures how long-term supply changes with changes in construction costs. The change in supply (ΔS) is equal to new construction (C) less the depreciation rate (dS), which is the amount of stock removed from the market. As a result, supply, which we assumed is constant in the short term, is variable in the long ter