5.3/16 Investment Styles, Portfolio Allocation, and Real Estate Derivatives

Question 1

16.1 Demonstrate knowledge of the three NCREIF real estate investment styles.

Answer 1

• List, define, and discuss the investment characteristics of the three NCREIF real estate investment styles

Question 2

16.2 Demonstrate knowledge of eight attributes used to differentiate the NCREIF real estate investment styles.

Answer 2

• Describe individual properties according to the three NCREIF real estate investment styles and the eight attributes developed by NCREIF • Describe real estate portfolios according to the three NCREIF real estate investment styles

Question 3

16.3 Demonstrate knowledge of three purposes of real estate style analysis.

Answer 3

• List and describe three main reasons for introducing styles into real estate portfolio analysis

Question 4

16.4 Demonstrate knowledge of real estate style boxes.

Answer 4

• Describe the basic characteristics of style boxes, and how they can be used in analyzing real estate investments

Question 5

16.5 Demonstrate knowledge of capitalization (cap) rates and the expected returns of real estate.

Answer 5

• Describe and apply cap rates with respect to real estate investments

Question 6

16.6 Demonstrate knowledge of using real estate styles to develop investment risk and return expectations.

Answer 6

• Discuss considerations in the development of risk and return estates for real estate styles. • Describe return estimates for core real estate. • Demonstrate how the true volatility of core real estate risk can be estimated from both the smoothed volatility and from the first order correlation coefficient. • Show how the beta of a true series can be estimated from the beta of a smoothed series and an autocorrelation coefficient. • Discuss how risk-premium methodologies can be applied in estimating expected returns for noncore (i.e., value-added and opportunistic) real estate investments. • Describe methods used by PSERS and CalSTRS to develop absolute target rates of return for noncore real estate assets.

Question 7

16.7 Demonstrate knowledge of the characteristics of real estate derivatives.

Answer 7

• Identify the uses of real estate derivatives by institutional investors. • Identify three potential benefits offered by the existence of derivatives on housing prices. • Identify two critical factors for the effective management of risk using real estate derivatives. • Recognize seven advantages and six disadvantages of property derivatives.

Question 8

16.8 Demonstrate knowledge of the types of tradable real estate derivatives and specialized real estate indices.

Answer 8

• Describe and calculate property total return swaps. • Describe real estate forward, futures, and options contracts. • Describe structured real estate index notes. • Describe traded derivatives of mortgage-backed securities. • Describe stock market-based property return indices (SMPRIs).

Question 9

Three Styles of Commercial RE Investing (According to NCREIF - National Council of RE Investment Fiduciaries)

Answer 9

Core Real Estate Value Add Real Estate Opportunistic Real Estate

Question 10

Core Real Estate

Answer 10

• Least risky category. • More like a fixed-income investment because income, not price appreciation, accounts for the largest part of the return. • Low volatility of returns. • More liquid and developed and uses less leverage than other real estate properties. •Includes the most recognizable properties in a real estate portfolio. • Properties are often held for the long term to fully exploit lease and rental income.

Question 11

Value Add Real Estate

Answer 11

• More risky than core real estate. • Substantial portion of return expected from (uncertain) price appreciation. • Moderate volatility of returns. • Often more leveraged than core real estate. • May require renovation, repositioning, and/or redevelopment to make the property a viable investment. • Properties may include hotels, low-income housing, outlet malls, assisted-care living facilities, and new but not fully leased assets that would otherwise be classified as core properties, such as new apartment buildings and new shopping centers.

Question 12

Opportunistic Real Estate

Answer 12

• A substantial part of the return is derived from property appreciation. • Higher volatility of returns and property values. • More equity-like. • Risks include development risk, leasing risk, and financial (i.e., higher leverage) risk. • The investment horizon is shorter term than for core and value-added properties. • Often accessed through private equity funds that invest in real estate, called PRIVATE EQUITY REAL ESTATE (PERE) funds or real estate opportunity funds. These funds focus on high-return opportunity properties that might require extensive redevelopment but may also invest in value-added and core properties. • Rollover risk, the risk that the property cannot be sold, is substantial because price appreciation is the primary source of returns (rollover in this context refers to changes in ownership but can also mean changes in the nature of the project or in financing, like from a construction loan to a permanent mortgage). • Opportunistic real estate managers are more like traders, because of the shorter-term nature of the investment, while core real estate managers are operators of properties. • Opportunistic funds focus on events to quickly and dramatically revalue properties (for example, opportunistic managers develop raw properties, redevelop properties that have fallen into disrepair, and acquire properties in areas that are expected to see rapid increases in value). •Investments are often cross-border in nature (e.g., German companies have been selling German apartment complexes to U.S. real estate investors).

Question 13

• List and describe three main reasons for introducing styles into real estate portfolio analysis.

Answer 13

PERFORMANCE ASSESSMENT: Styles help investors better understand the perf of the portfolio. Benchmarks, risk and return objectives, and perf attribution are better understood in the context of a specific style. - DETECTION OF STYLE DRIFT: Recognizing the style and drifts from that style helps investors apprecitate the riskiness of the portfolio overtime -STYLE DIVERSIFICATION: Understanding the portfolio or manager’s style may allow the investor to create a portfolio with better risk/return tradeoff through the style diversivfication

Question 14

REAL ESTATE STYLE BOX

Answer 14

Offers another way to chracterize RE investments: X or percentage is placed in the box to describe the assets (in a table). Can put any attributes an analyst is interest in on either axis.

Question 15

CAP RATE

Answer 15

cap rate = NOI / Property value can rearrange to find value of property: Property Value = NOI / Cap Rate

Question 16

Equation to unsmooth the volatility of a smoothed return series

Answer 16

Question 17

Beta of the true series formula (measure of systematic risk)

Answer 17

Question 18

Risk Premium Approach (Especially for RE)

Answer 18

Adding a risk premium to a known rate to come to the appropriate return rate.

Value-added and Opportunistic Risks & Returns are difficult to estimate directly and often rely on this approach. E.g. the spreado f the cap rate relative to the 10-year default-free government bonds is known as the cap-rate spread. a typical cap-rate spread for core real estate is 2 to 3%

Question 19

• Identify three potential benefits offered by the existence of derivatives on housing prices

Answer 19

Benefits of housing price derivatives include:

• Enabling of price discovery (i.e., price revelation).
• Improved risk management.
• Ability to obtain short exposure to residential real estate.

Question 20

• Identify two critical factors for the effective management of risk using real estate derivatives.

Answer 20

Two critical factors for effective risk management using real estate derivatives are:

• Index on which the derivative is based should accurately capture the underlying cash market.
• Derivative contracts should have sufficient liquidity.

Question 21

7 Advantages of property derivaties

Answer 21

Advantages of property derivatives include:1

1. Lower transaction cost relative to direct investment in real estate.
2. Derivatives having leveraged exposure without the use of debt.
3. Not being subject to withholding taxes.
4. Obtainable short positions, allowing hedging.
5. Diversified exposure to real estate.
6. Instant access to real estate asset class.
7. Lower management costs relative to direct investment in real estate.

Question 22

6 Disadvantages of Property Derivatives

Answer 22

Disadvantages of property derivatives include:

1. Real estate derivatives are relatively new and the liquidity of many contracts is low.
2. Counterparty credit risk for non-exchange-traded derivatives contracts is a concern.
3. Many markets (e.g., emerging markets) do not have acceptable real estate indices to base derivative contracts on.
4. Real estate derivatives are marked-to-market on a monthly basis (as opposed to daily), creating accounting volatility.
5. Basis risk (the difference in performance of the index versus real estate portfolio) is generally high.
6. There is higher risk due to embedded leverage.

Question 23

Property Total Return Swap (PTRS)

Answer 23

• a swap whereby the buyer of the property exposure pays a fixed price annually (fixed or floating rate) over the life of the swap in exchange for the return on an underlying RE Index.
• Payments are netted at settlement dates with no payment needed at initiation.
• Netting reduces counterparty credit risk of these, OTC Contracts.
• Margin Requirements vary between 5 and 20% of ntional, depending on creditworthiness of counterparties.

Question 24

RE Futures, Forwards, and OptionsContracts

Answer 24

Futures:

• Contracts available on IPD UK All Property Index
  
  • ​priced at par (100) plus total retrun on index.
  • Lag of 3 months on pricing (March 31 pricing of 109.10 means 2015 CY had atotal return of 9.10% for IPD).
• Contracts on S&P/Case-Shiller Home Price Indices (CSI)
  
  • ​CSI is a weighted composite of U.S. housing prices and is available for 10 major cities.
  • Cash-settled contracts have a value of 250 times the index value for that city.
• Options on CSI futures are also traded.

Forward Contracts are generally based on RPX or NCREIF Indices.

Question 25

Real Estate Index Notes (REIN)

Answer 25

structured bonds with coupon rates linked to performance of an underlying RE index.

E.g.: index return was 9% in a year, bond would pay a 9% coupon.

REIN can be considered as a portfolio of a regular bond and a total return swap.

• for the swap, the property exposure buyer would pay the coupon received from the regular bond and in return receive the total return on the specified real estate index.

Question 26

Mortgage- Backed Securities Derivatives

Answer 26

Derivs based on the CMBX, an index of commercial mortgage-backed securities (CMBS) with various rates, allow investors to hedge any credit risk linked to commercial prop’s, or to speculate on the perf of underlying CMBS.

Derivs based on the ABX, an index respresenting subprime residential mortgage-backed securiteis (RMBS). These derivs allow hedging or speculation linked to performance of credit risk of the underlying subprime RMBS.

Question 27

Stock Market-based Property Return Indices (SMPRIs)

Answer 27

• Track stocks that focus on commercial real estate (REITs based on commercial properties).
• FTSE NAREIT PureProperty Index is one example - updated daily.
• Studies show strong correlation betwen SMPRIs and other RE indices (like NPI) with SMPRIs often leading.

Question 28

Rollover Risk

Answer 28

Risk that a property cannot be sold (very high for Opportunistic RE).