Alt Investments #39 - Private Real Estate Investments Flashcards
Four basic forms of real estate investment
LOS 39.a
Debt Equity
Private: mortgages direct investments
Public: MBS REITs, REOCs
REOC - real estate operating company
Real estate investment characteristics, and how they differ from other asset classess
LOS 39.b
NOTE: REITs overcome many of these issues
- heterogeneity - no two properties are the same
- high unit value - property is indivisible; difficult to construct a diversified portfolio
- active management - involves, maintenance, lease negotiation, rent collection, etc.
- high transaction costs - involves attorneys, brokers, construction personnel
- cost and availability of debt capital - property values are usually lower when interest rates are high and debt capital is scarce
- illiquid
- difficulty determining prices - due to heterogeneity and low transaction volume, RE market is inefficient
Property classifications
LOS 39.b
- residential
- non-commericial - single-family (owner occupied) homes
- commerical - single (non-owner occupied) and multi-family properties
- commercial - classified by end use:
- residential, office, industrial/warehouse, retail, hospitality, parking facilities, restaurants, recreational properities, or mixed-use
- hotels require the most day-to-day attention; operated more like a business
- unique - farmland, timberland: they can produce a commodity and capital appreciation
Reasons to invest in real estate
LOS 39.c & l
- current income
- capital appreciation
- inflation hedge
- diversification - low correlation to stocks & bonds
- tax benefits - differs by country:
- US - depreciable life shorter than actual
- REITs - tax-free income in some countries
Principal risks of real estate
LOS 39.c & l
NOTE: risks can hedged using insurance or shifted to tenants using lease agreement
- business conditions - affect rental market: GDP, employment, household income, interest rates, inflation
- new property lead time
-
cost and availability of capital - favorability of RE compared to other asset classes
- RE demand higher when debt is easiliy available and interest rates are low
- RE prices can be affected by capital market forces without changes in demand from tenants
-
unexpected inflation
- some leases have inflation clauses to protect owners
- RE values may not keep up with inflation when markets are weak and vacancy rates are high
- demographics - RE demand affected by distribution of: size, age, social class, new household formation
- illiquidity - due diligence takes time
- environmental issues - contamination
- lack of information
- management expertise
- leverage - measured by LTV, DSCR
- other factors - unseen property defects, natural disasters, terrorism
role of real estate in a portfolio
LOS 39.c & l
Risk/return profile is usually between that of stocks and bonds
Has both stock and bond characteristics:
- bond : leases - contractual periodic fixed payments
- stock : risk factors affect asset value, including uncertainty of lease renewal and of future rental rates
role of leverage in real estate investment
LOS 39.c & l
NOTE: debt/equity mix used to finance real estate do NOT affect the property’s value
leverage magnifies positive and negative returns for the investor
Describe commercial property types and their distinctive investment characterisitics
LOS 39.d
low-risk types: office, industrial/warehouse, retail, multi-family, hotels (but riskier than the others because no leases involved and correlated to business cycles
property location is always critical to its value
office
- demand dependent on job growth, especially in finance and insurance
- lease length varies globally
industrial
- demand dependent on overall economy, including import/export activity
- net leases are common
retail
- demand dependent on consumer spendin_g, which is dependent on: j_ob growth, population growth, savings rates
- lease length varies by property quality, size, importance of tenant e.g. anchor tenant gets more favorable lease terms
multi-family
- demand dependent on:
- population growth, especially in the renter demographic, which varies by country, locale, property type
- cost of buying vs. renting
gross lease vs. net lease
LOS 39.d
gross lease - owner responsible for OpEx
net lease - tenant bears risk of unexpected incremental OpEx
types of real estate appraisal values
LOS 39.e
market value - most common; most probable sale price a typical investor is willing to pay
investment value - value that considers a particular investor’s motivations
value in use - value to a particular user e.g. manufacturer or farm
assessed value - used by tax authorities
mortgage lending value - used by lenders; more conservative
Valuation approaches
LOS 39.e
Cost approach:
- cost of land purchase and comparable building construction less estimated depreciation and obsolescence
- depreciation is difficult to measure for existing properties; easier for new properties
- helpful as a maximum potential valuation
Sales comparison:
- sales prices of comparable properties adjusted for differences
- most useful with single-family homes
Income approach:
- direct capitalization method - capitalize first-year NOI using a capitalization rate
- DCF method - PV of future CFs discounted at investor’s required return
- appropriate for commerical RE transactions
- highest and best use - usage of property that maximizes utility i.e. maximum property value
capitalization rate vs. discount rate
LOS 39.f
- discount rate = required rate of return:
r = Rf + ß(Rmkt - Rf) = Rf + ß*Rprem
- cap rate (R0) can be calculated as:
R0 = r - g = NOI1 / value
r = discount rate g = growth rate of NOI NOI<sub>1</sub> = 1st year net operating income value = property value (or recent comparable transactions)
- rearranged to calculate value:
V0 = NOI1 / R0 = NOI1 / (r - g)
(this is a special use of GGM)
- cap rate also called going-in cap rate
- similar to reciprocal of P/E ratio
- when tenant pays all expenses:
V0 = rent1 / ARY
ARY: “all risks yield”
- if rents expected to increase at constant rate, the IRR can be estimated: IRR ≈ R0 + g
how to calculate NOI
LOS 39.f
rental income if fully occupied
+ other income
= potential gross income : “gross sales”
- vacancy and collection loss : “returns”
= effective gross income : “net sales”
- operating expense (insurance, pty tax, utilities, maint, repair)
= net operating income (NOI) : “EBIT”
Income tax & interest are not operating expenses!
property valuation using income approach: direct capitalization
LOS 39.g
If 1st year NOI stable:
V0 = NOI1 / R0 = NOI1 / (r-g)
If 1st year NOI not stable (e.g.renovation costs), use stabilized NOI (calculate NOI1 as if renovation complete) and then subtract lossed value from temporary NOI decline:
V0 = stabilized NOI1 / R0 - PV(temp NOI loss)
Using gross income multiplier:
gross inc multiplier = sales price / gross inc1
gross inc1 = gross inc inthe year after purchase, so:
V0 = gross inc * gross inc multiplier
NOTE: gross inc ignores vancancies and OpEx
property valuation steps using income approach: DCF method
LOS 39.g
- forecast terminal value at end of holding period (use direct capitalization method if NOI growth is constant)
- discount holding period NOI and terminal value to present
FYI: “terminal value” = “reversion” = “resale”
