8.4 Real Estate and Infrastructure

Question 1

The characteristics of real estate that make it unique among asset classes are:

Answer 1

High initial investment:

–> The indivisibility of real estate property makes the unit value high and limits the number of potential investors in private transactions.

Unique assets:

–> No two properties are the same. Each has its own unique combination of risk exposures. Buildings differ in terms of size, age, location, construction quality, and leasing arrangements.

Multiple investment alternatives:

–> Investors can choose to access real estate directly or indirectly. Certain real estate investment vehicles are as liquid as large-cap stocks, while other investments are highly illiquid and require long holding periods. There are many different ways to classify various segments of the real estate market.

Limits to diversification:

–> While there are a wide variety of unique properties, it can be difficult to assemble a diversified portfolio of real estate assets due to high cost of individual units.

Lack of investable indexes:

–> Unlike equity or fixed-income indexes, real estate indexes are not investable. They reflect the collective performance of properties that are owned by institutional investors.

Question 2

Additionally, there are several factors that make the price discovery process relatively opaque for private real estate markets:

Answer 2

Price determination:

–> Historical prices are unlikely to be reflective of current market conditions.

High transaction costs:

–> Buying and selling real estate is costly and time-consuming.

Limited transaction activity:

–> Because individual properties are unique and sold relatively infrequently, it is difficult to establish market-based valuations. Additionally, market-wide transaction activity can fluctuate significantly with changes in economic conditions.

Question 3

Residential Property

Answer 3

defined as being owner-occupied, meaning that they are being used to provide shelter for their owners rather than as investments to generate rental income

residential property is defined as owner-occupied single residences, both single-family detached homes and units in multi-family buildings.

Residential property transactions are highly leveraged with borrowed funds providing 80% or more of the purchase price.

The development of active markets for securitized debt instruments, such as residential mortgage-backed securities, has helped homebuyers achieve better borrowing in terms.

Question 4

Commercial Real Estate

Answer 4

appropriate for investors with long-term horizons and relatively low liquidity needs.

However, successful commercial property investing requires experienced professional management.

The lender must consider the creditworthiness of the borrower and the ability of the property to generate sufficient revenue.

Property valuations are critical for lenders in this sector because their loans will be based on a percentage of assessed value and properties are the sole source of collateral.

Question 5

Residential Real Estate

Typical property

Answer 5

• Owner-occupied, single residences
• Single-family residential property

Question 6

Residential Real Estate

Source of equity

Answer 6

• Owners

Question 7

Residential Real Estate

Sources of return

Answer 7

• Directly: Residential mortgages from lenders
• Indirectly: From investors in residential MBS

Question 8

Residential Real Estate

Source of equity

Answer 8

• Enjoyment of the property
• Capital appreciation

Question 9

Commercial Real Estate

Typical property

Answer 9

• Residential properties owned and leased
• Office, retail, industrial, etc.
• Mixed-use properties

Question 10

Commercial Real Estate

Source of equity

Answer 10

• Privately held by owners
• Publicly held through investors

Question 11

Commercial Real Estate

Source of debt

Answer 11

• Directly: Commercial mortgages from lenders
• Indirectly: From investors in commercial MBS

Question 12

Commercial Real Estate

Sources of return

Answer 12

• Rental income
• Capital appreciation

Question 13

Real Estate Investment Structures

Private Debt

Answer 13

• Mortgages
• Construction lending
• Mezzanine debt

Question 14

Real Estate Investment Structures

Private Equity

Answer 14

Direct ownership
- Sole ownership
- Joint ventures
- Limited partnerships

Indirect ownership
- Real estate funds
- Private REITs/UCITS

Question 15

Real Estate Investment Structures

Public Debt

Answer 15

• Mortgage-backed securities
• Collateralized mortgage obligations
• Mortgage REITs
• ETFs owning securitized mortgage debt

Question 16

Real Estate Investment Structures

Public Equity

Answer 16

• Shares in real estate corporations
• Shares in REITs
• Mutual funds, UCITS, ETFs

Question 17

Direct ownership can be free and clear or it may come with liens due to outstanding mortgage obligations.

This type of real estate investing provides several benefits:

Answer 17

Control:

–> Investors who own properties directly have full control over matters such as lease terms, tennents, capital improvements, and property maintenance. Owners enjoy the full benefit of lease payments and capital appreciation.

Tax benefits:

–> Direct real estate owners can also reduce their taxable income by the amount of non-cash depreciation expenses and interest expense on the property.

Diversification:

–> Direct real estate investments have historically exhibited low correlations with returns on traditional asset classes. Investors can improve the risk-return profile of their overall portfolio.

Question 18

The disadvantages of direct real estate investing include:

Answer 18

Complexity:

–> Real estate purchases are complicated transactions. Investors must identify properties to purchase, perform due diligence, and negotiate sale terms with the current owners. Once a sale is completed, the new owner must actively manage their properties, which can be time-consuming.

Need for specialized knowledge:

–> Direct real estate investing requires specialist knowledge about the overall asset class as well as local markets.

Significant capital needs:

–> Investors must raise large amounts of debt and equity to finance direct real estate purchases. Refinancing mortgage loans may be particularly challenging during periods of market stress.

Concentration risk:

–> Only the very largest investors (e.g., endowments) have the financial resources necessary to assemble a diversified portfolio of individual properties. Additionally, real estate may represent an unjustifiably large share of an investor’s overall portfolio.

Illiquidity:

–> Unlike publicly-traded stocks, real estate properties cannot be sold quickly and transaction costs are very high. Owners may need to accept a significant discount from a property’s assessed value in order to complete a sale in a timely manner.

Question 19

Indirect ownership of real estate assets is achieved through a variety of pooled investment vehicles:

Answer 19

can be private (e.g., limited partnerships) or public

joint venture (JV) structure

Examples public real estate investment vehicles include real estate focused exchange-traded funds (ETFs) and public real estate investment trusts (REITs)

Question 20

joint venture (JV) structure

Answer 20

particularly common when one party can uniquely contribute something of value, such as land, while other parties can make other contributions, such as capital, development expertise, debt due diligence, or entrepreneurial talent

Question 21

There are three main types of REITs:

Answer 21

Equity REITs invest in properties either directly or through other vehicles such as limited partnerships or joint ventures. These are professionally managed businesses, seeking to maximize rents and minimize operating expenses.

Mortgage REITs underwrite mortgage loans to other investors seeking capital for their own real estate investments. They may also invest in mortgage-backed securities.

Hybrid REITs have both debt and equity positions.

Question 22

The primary advantage of the REIT structure

Answer 22

it eliminates double taxation. Unitholders are taxed personally on the dividends they receive, but no income taxes are levied on REITs themselves.

REITs originated in the United States but many other countries have subsequently adopted laws that facilitate this structure.

Question 23

a significant disadvantage of REITs

Answer 23

REITs offer fewer diversification benefits because their returns exhibit a relatively high correlation with equity returns.

Question 24

Real estate private equity funds can adopt the following structures:

Answer 24

Infinite-life open-end funds

Finite-life closed-end funds

Question 25

Infinite-life open-end funds

Answer 25

allow investors to make contributions or redemption anytime, and the GP will typically accept them on a quarterly basis

Question 26

Open-end funds tend to focus on the following approaches to real estate investing:

Answer 26

Core real estate consists of well-leased, high-quality commercial and residential properties in the best markets.

They are expected to deliver stable returns, which are typically driven by real estate beta.

Question 27

Finite-life closed-end funds

Answer 27

commonly used to earn higher returns from alpha and beta

Question 28

Investment strategies used by Finite-life closed-end funds include:

Answer 28

Core-plus real estate involves greater risk thana core strategy, with investments in modest redevelopment or upgrades to vacant space and consideration of alternative uses of existing properties.

Value-add investments seek higher returns through larger-scale redevelopment development or repositioning existing properties.

Opportunistic investing accepts the much higher risks of development, major redevelopment, repurposing properties, taking on large vacancies, and speculating on changing market conditions.

Question 29

The benefits of real estate investments include:

Answer 29

Stable, predictable income from rental payments, often over multi-year terms. This component of return is bond-like.

Price appreciation over longer holding periods In addition to rental income, real estate investors generally expect to benefit from increases in property values over their holding period. In this respect, real estate investments are similar to equities.

Inflation hedging due to both rents and price appreciation.

Portfolio diversification due to low correlations with traditional assets.

Tax benefits from writing off the expenses of direct investments or the tax-advantaged status of REITs.

Question 30

Source of Returns

Ranked from safest to most speculative, these strategies are:

Answer 30

1. Senior Debt
2. Core
3. Core Plus
4. Value-add
5. Opportunistic

Question 31

Senior Debt as a source of return

Answer 31

Direct mortgage lending and investment grade commercial MBS make this a low-risk/low-return strategy that generates bond-like cash flows with low credit risk and limited upside potential.

Notice that this strategy can be executed entirely with publicly-traded securities, which significantly reduces exposure to liquidity risk.

Question 32

Core as a source of return

Answer 32

While riskier than secure debt, a core real estate investing strategy is a relatively conservative approach build around high-quality properties with long-term leases and REITs.

Sale-leaseback agreements are among the lowest-risk loans because the tenant is the building’s former owner.

The relationship, and cash flows, will likely continue for many years. Investors can use sale-leasebacks as collateral reduce their borrowing costs.

Returns are bond-like but with the upside potential is greater compared to the lowest-risk strategy.

Question 33

Core-plus as a source of return

Answer 33

This approach invests in the same types of properties as a core strategy, but investors seek to increase returns by making improvements to properties.

This spending is speculative because it is done with the expectation that rents will be increased when current leases expire.

Monthly lease payments provide a bond-like component to returns, but this strategy relies more on capital appreciation than more conservative ones.

Question 34

Value-add as a source of return

Answer 34

This strategy is more speculative than a core-plus approach, with investors willing to own space that is currently vacant.

Also CMBS are used, these are rated below investment grade.

Returns are largely equity-like.

Question 35

Opportunistic

Answer 35

Investors who pursue this strategy have the highest risk tolerance and return expectations.

Mezzanine debt and unrated CMBS are among the riskiest real estate assets.

Investors may be willing to salvage distressed properties or develop new ones, which involves various risk related to regulations, construction timetables, and cost overruns.

Any delays will push the receipt of rental payments further into the future, reducing IRR.

Question 36

Infrastructure investments

Answer 36

backed by real, capital-intensive, long-lived assets that are intended for public use

Question 37

The cash flows received by infrastructure investors are determined by the terms that are negotiated the other parties to the project.

Common arrangements include:

Answer 37

Availability payments that are earned for ensuring that the asset is available to be used

Usage-based payments such as road tolls or facility fees

Take-or-pay agreements that commit the buyer to a minimum purchase price for a specified volume, with the buyer having recourse if deliveries are delayed or fail to meet quality requirements.

Question 38

Public-private partnerships (PPPs)

Answer 38

long-term agreements between governments and private interests to deliver services that have traditionally been provided by governments.

Question 39

development finance institutions

Answer 39

Infrastructure investments may be facilitated by these specialized non-commercial financial intermediaries

these provide and coordinate funding for economic development projects

Examples include the European Bank for Reconstruction and Development (EBRD), which invests in municipal services and infrastructure.

Question 40

Nature of Underlying Assets in Infrastructure investments

Answer 40

can be economic or social in nature

Question 41

Economic infrastructure assets

Answer 41

support economic activity

Question 42

types of assets in Economic infrastructure assets

Answer 42

Transportation:

–> Roads, bridges, tunnels, airports, seaports, and railway systems

Information and communication technology (ICT):

–> Telecommunication towers and data centers

Utility and energy:

–> Power generation assets (including renewables), electricity transmission infrastructure, oil and gas storage and distribution assets, water/solid waste treatment facilities

Question 43

Social infrastructure assets

Answer 43

such as educational and healthcare facilities

provide essential public services

This category may also include social housing, correctional facilities, and government buildings. Income from investments in these assets is typically structured as availability payments, which are are contingent upon the asset being managed and maintained according to contractual terms. T

he facility may be operated by a public agency directly or by a private serviced provided contracted under the agency’s authority.

Question 44

Stages of Infrastructure Development

Answer 44

When classified by stage of development, the basic distinction is between greenfield projects that have yet to be developed and brownfield assets that are already operational.

Question 45

Greenfield infrastructure investments

Answer 45

often follow the build-operate-transfer (BOT) model

During the build stage, investors experience negative cash flows and face exposure to a variety of risks, such as potential construction delays and increases in the cost of materials. Strategic partners with development expertise are typically required.

The operating stage begins when the asset is commissioned and investors begin to receive payments in exchange for making the asset available according to agreed terms.

In the transfer phase, the asset may be transferred to the government on terms agreed in advance, sold to a third party, or decommissioned at the end of its useful life.

Question 46

Brownfield infrastructure investments

Answer 46

involve the acquisition and expansion or renovation of existing assets.

For example, governments may privatize publicly-owned assets or enter into a sale-leaseback arrangement. Some initial investment is required, but risks are lower compared to greenfield projects because the asset has an operating history and is generating cash flows.

Purely financial investors tend to prefer brownfield opportunities, which offer stable, long-term cash flows, while strategic investors may seek to augment returns by improving operations.

Question 47

Secondary-stage investments

Answer 47

are similar to brownfield investments in the sense that a fully operation asset is acquired. However, in this case, no significant capital investments are expected to be needed during the investment horizon.

For example, investors may purchase a greenfield project that has recently been completed. Assets that require significant capital expenditures at regular intervals would not fall into this category.

This is the lowest-risk type of infrastructure investment, suitable for passive investors.

Question 48

Forms of Infrastructure Investment

Answer 48

can either be direct or indirect

Question 49

Direct infrastructure investing

Answer 49

allows investors to control the asset and provides the opportunity to capture its full value.

This type of infrastructure investing is best-suited for large institutions such as pension funds or endowments, which have the ability to tolerate liquidity risk over longer holding periods.

However, even the largest institutions often join with others as part of a consortium in order to mitigate concentration risk.

Partnerships are also needed with strategic investors that are able to undertake specific roles related to the asset’s construction, operation, or maintenance.

Question 50

Indirect infrastructure investing

Answer 50

more common than direct investment because the capital requirements are much lower.

Open-end and closed-end infrastructure funds are structured like private equity funds and operate similarly.

There are also opportunities to invest indirectly through publicly-traded vehicles, such as individual company shares, infrastructure ETFs, and master limited partnerships (MLPs)

Question 51

master limited partnerships (MLPs)

Answer 51

similar to REITs in the sense that they are pass-through entities (i.e., avoid double taxation) and can be traded on public exchanges

They distribute the majority of their free cash flows as dividends, allowing investors to benefit from stable cash flows.

While publicly traded securities provide benefits such as greater liquidity, lower costs, and transparent pricing, they represent a very small segment of the overall market for infrastructure investments and tend to be concentrated in certain sectors. For example, MLPs are largely used for energy transportation, processing, and storage assets.