Alternative Investments Flashcards
Valuation: Highest and Best Use
Choose project with highest implied value (Value on completion - Development costs)
Net Operating Income (NOI)
Rental income at full occupancy
+ Other income (e.g. parking)
Potential gross income (PGI)
- Vacancy and collection losses (X)
Effective gross income (EGI)
- Operating expenses (OE)
Net operating income (NOI)
Capitalization rate
(Market-extraction method)
Used to estimate the investor’s potential return on their investment in the real estate market
Cap rate: R0 = NOI / MV0
Value: MV0 = NOI / R0
All Risks Yield (ARY)
Market Value V0= Rent / ARY
Stabilized NOI example
Term and reversion valuation approach
Total property value: PV of term rent + PV reversion to ERV (estimated rental value)
If current market rents are higher than contract rent, then the rent is likely to be adjusted upward at the next rent review
ERV treated as perpetuity. Rent divided by cap rate > PV back.
Layer method
PV of term rent + PV of incremental rent
2 perpetuities
- Term rent for ever
- Incremental amount for ever
PV the incremental back
Ratio Analysis:
Debt service coverage ratio (DSCR)
Loan to value (LTV)
Equity dividend rate
Two ratios are used by lenders to assess the maximum loan that an investor may obtain:
DSCR = NOI / Debt Servicing
LTV = Loan / Property Value
Return measures:
Div Rate = (NOI – Debt service) / Equity (Value - Debt)
Leveraged / Unleveraged IRR
Leveraged IRR: internal rate of return calculation taking into account the debt used to finance the property purchase and its repayment
Unleveraged IRR: This is an IRR calculation assuming that the property was purchased using pure cash
Max Loan > Div Rate Example
Advantages of Publicly Traded Real Estate Securities
- Greater liquidity
- Lower investment requirements
- Limited liability
- Diversification
-
Taxation: Offers advantages related to dividends compared to REOCs if:
- 75% assets held in real estate, or income from rent or mortgage
- Limited non-rental property assets
- 90% income paid out as distributions
- Tax benefits for shareholders
- Earnings predictability
- High income payout ratios and yields
Disadvantages of Publicly Traded Real Estate Securities
- Control
- Costs
- Stock market valuation (volatile etc.)
- Forced equity issues (dilution)
Economic Value Drivers for real estate type
Net asset valuation per share (NAVPS)
Estimated NOI
/ assumed cap rate
= estimated value of operating real estate
+ cash & accounts receivable
- debt & other liabilities
= net asset value
/ shares outstanding
= NAV / share
Price Multiple Approach: Funds from operations (FFO) / Adjusted funds from operations (AFFO)
Price Multiple Approach: Advantages / Disadvantages
PE: Sources of value creation
- Re-engineering of companies
- Favorable debt financing − Private equity firms are better able to raise higher levels of debt as a result of having better control over management
- Surplus (free) cash is often invested in value destroying projects, thus high leverage reduces this risk as cash is used to service debt
- Greater incentives for management coupled with more direct and intense scrutiny by owners (as compared with stockholders of a public company)
- Effective term sheets − If business plan is not met the equity gets re-allocated away from management and to the private equity owners
Valuation issues in venture capital (VC) transactions
- Pre-money valuation (PRE) is the value of the company before a round of financing
- Post-money valuation (POST) is the value of the company after a financing round thus
- POST = PRE + Finance
- Percentage ownership = Investment / POST
PE Economic Terms
PE Corporate governance terms
PE fund performance
Gross IRR
Net IRR
Gross IRR: return from portfolio companies
Net IRR: Relvant for LP; net of fees & carried interest
PE Perfomance statistics
- Paid-in capital (PIC) – % capital utilized by GP (cum. sum of capital called down)
- Distributed to paid in (DPI) – LP’s realized return: Cumulative distributions (net of fees) / PIC
- Residual value to paid in (RVPI) – value of investor’s shareholding in fund relative to cumulative invested capital, i.e. unrealised return [NAV after distributions / PIC]
- Total value to paid in (TVPI) = DPI + RVPI
Management fees
Annual fee based on amount of committed capitalm (% of PIC)
Carried interest
GP’s share of profits generated from the fund
Carried interest is only paid when NAV before distributions is higher than committed capital (full fund; NOT called up capital)
% CI of Change in NAV before distributions
NAV before distributions
NAV after distributions
NAV before distributions = NAV after distributions from previous year + Called down capital for the year + Operating results – Management fees.
NAV before distributions = NAV before distributions – Carried interest – Distributions
PE Accounting for Risk
- Adjust discount rate for probability of failure
- Allow for a variety of scenarios to (realistically) model cash flows
Valuation of Venture Capital Deals
Five-step approach
Valuation of Commodities
- commodities are physical assets (exception: electricity, weather,)
- No future cash flows (no DCF possible)
- Financial instruments on commodities are derivative contracts
- Commodity prices are influenced by the interaction of supply and demand • Stocks and bonds do not incur costs as opposed to commodities that incurs transportation and storage costs − This may result in higher prices for longer period future contracts
Futures
Futures are standardized derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price.
Futures price is the price agreed today to buy or sell a commodity at a future date − Difference between spot and futures price is called basis
Futures price could be higher than the spot price (Contango, negative basis) or lower than the spot price (Backwardation or positive basis)
Contango
Future prices > Spot prices (nagtive basis)
Backwardation
Futures prices < Spot prices (positive Basis)
Theories of Futures Returns
- Insurance theory
- Hedging pressure hypothesis
- Theory of storage
Futures: Insurance perspective
Contract buyers compensated for providing protection to commodity producers. Implies backwardation is normal.
Hedging pressure hypothesis
Theory of storage
- Difference between futures prices and spot prices can be explained by storage costs and convenience yield of holding a stock in inventory
- Holder of a storable commodity has a consumption option that is embedded in the convenience yield
- Difficult-to-store commodities, e.g., heating oil, live cattle and live hogs should have lower inventory levels and higher convenience yield than easyto-store commodities
Total return on fully collateralized long commodity futures
Formula
Roll return
- Roll return – reflects the profit from the convergence of the futures price to the spot price over time and subsequent rolling of the maturing futures contract into another futures contract
- Backwardation market – positive roll yield for the long future position, negative roll yield for the short future position
- Contango market – negative roll yield for the long future position, positive roll yield for the short future position
- Periods of backwardation or Contango do not persist indefinitely
- Roll return has relatively modest impact on overall return when compared to spot return
- Roll return is sector dependent, hence diversification or concentration will have huge impact on overall return on commodities portfolio
Collateral return
– interest paid on the fully collateralized futures position at the U.S. T-bill rate
Commodity Swaps
Commodity swap is a type of OTC derivative contract that allows the users to exchange payments over multiple dates based on specific prices of commodities or commodity indices
- Excess return swap − Payments are made or received based on a return calculated by changes in the level of the index relative to a pre determined benchmark or fixed level
- Total return swap − Similar to the excess return swap in structure with only difference being that a total return swap calculates return inclusive of the collateral return − If the level of the index increases, the swap buyer receives payment net of the fee paid to the seller or vice – versa − Used by large institutional investors as a diversification tool as opposed to excess return swap which is mainly used by consumers or producers of commodities
- Basis Swap − Periodic payments are exchanged based on the values of two related commodities that are similar, but not perfectly correlated − Used when one of the commodities is highly liquid but other is not
- Variance Swaps − Periodically exchange payments based on the differences between observed/actual variance in the price levels of a commodity and some pre defined fixed amount of variance
- Volatility Swaps − Similar to variance swaps − The key difference is that the direction and amount of payments depends on observed/actual versus expected volatility (not pre fixed volatility) for a reference commodity − Parties are speculating on how the volatility of prices will be versus the expected volatility
