Alternative Investments

Question 1

Basic forms of Real Estate Investment

Answer 1

Question 2

Real Estate Characteristics

Answer 2

• Heterogeneity
• High unit value
• Active management
• High transaction costs
• Depreciation and desirability
• Cost and availability of debt capital
• Lack of liquidity
• Difficulty in determining price

Question 3

Reasons o invest in real estate

Answer 3

• Current income
• Capital appreciation
• Inflation hedge
• Diversification
• Tax benefits

Question 4

The role of real estate in a portfolio

Answer 4

The risk/return profile of real estate as an asset class, is usually between the risk/return profiles of stocks and bonds.

Question 5

Gross lease vs. net lease

Answer 5

In a gross lease, the owner is responsible for the operating expenses, and in a net lease, the tenant is responsible. In a net lease, the tenant bears the risk if the actual operating expenses are greater than expected. As a result, rent under a net lease is lower than a gross lease.

Question 6

3 valuation approaches

Answer 6

• Cost approach:
  
  • A buyer would not pay more for a property than it would cost to purchase land and construct a comparable building.
  • Most useful when the subject property is relatively new.
  • Often used for unusual properties or properties where comparable transactions are limited.
• Sales comparison approach:
  
  • A buyer would pay no more for a property than others are paying for similar properties.
  • Most useful when there are a number of properties similar to the subject that have recently sold, such as single-family homes.
• Income approach:
  
  • Value is equal to the present value of the subject’s future cash flows.
  • Most useful in commercial real estate transactions.

Question 7

Highest and best use of vacant site

Answer 7

The highest and best use of a vacant site is the use that produces the highest implied land value, which is equal to the value of the property once construction is completed less the cost of constructing the improvements, including profit to the developer to handle construction and lease-out.

Question 8

2 valuation methods under income approach

Answer 8

• Direct capitalization method
• Discounted cash flow method

Question 9

Gross income multiplier

Answer 9

gross income multiplier = sales price /gross income

A shortfall of the gross income multiplier is that it ignores vacancy rates and operating expenses

Question 10

Cost approach steps

Answer 10

1. Estimate the market value of the land, often use the sales comparison approach
2. Estimate the building’s replacement cost, should include any builder/developer’s profic
3. Deduct depreciation including physical deterioration, functional obsolescence, locational obsolescence, and economic osolescence.
   4.

Question 11

Appraisal-based indices

Answer 11

Pros:

• allows investors to compare performance with other asset classes
• Quarterly returns can be used to measure risk (standard deviation)
• used by investors to benchmark returns

Cons:

• lag actual transactions
• tend to smooth he indexand reduce its volatility
• appraisal lag results in lower correlation with other asset classes

Question 12

Transaction based indices

Answer 12

• Repeat-sales: relies on repeat sales of the same property. A change in market conditions can be measured
• Hedonic index: requires only one sale. A regression is developed to control for differences in property characteristic

Question 13

Categorization of publicly traded real estate securities

Answer 13

Equity

• Equity REITs (Real estate investment trusts)
• REOCs (Real estate operating copanies)

Debt

• Residential or commercial mortgage-backed securities (MBS)
• Mortgage REITs

Question 14

Pros and cons of REIT/REOC Investments

Answer 14

Pros

• Superior liquidity
• Lower minumum investment
• LImited liability
• Access to premium properties
• Active professional management
• Protections accorded to publicly traded securities
• Greater potential for diversification
• REIT-Specific Advantages:
  
  • Exemption from taxation
  • Predictable earnings
  • High yield

Cons

• Taxes versus direct ownership
• Lack of control
• Costs of a publicly traded corporate structure
• Price is determined by the stock market
• When a REIT is structured as an UPREIT or a DOWNREIT, there is the potential for conflict of interest
  
  • UPREIT: “umbrella partnership REIT”, where the REIT is the general partner and holds a controlling interest in a partnership
  • DOWNREIT: the REIT has an ownership interest in more than one partnership and can own at the partnership or REIT level
• REIT specific disadvantage:
  
  • Liited potential for income growth
  • Forced equity issuance
  • Lack of flexibility

Question 15

Investment Characteristics of REITs

Answer 15

• Exemption from corporate-level income taxes
• High dividend yield
• Low income volatility
• Secondary equity offerings

Question 16

Net asset value per share (NAVPS)

Answer 16

NAVPS is the (per-share) amount by which assets exceed liabilities, using current market values rather than accounting book values. NAVPS is generally considered the most appropriate measure of the fundamental value of REITs (and REOCs). If the market price of a REIT varies from NAVPS, this is seen as a sign of over- or undervaluation.

Question 17

Source o value creation in private equitey

Answer 17

1. The ability to re-engineer the porfolio company and operate it more efficiently.
2. The ability to obtain debt financing on more advantageous terms.
3. Superior alignment of interests between management and private equity ownership.

Question 18

Private Equity Valuation Methodologies

Answer 18

• Discounted cash flow analysis: appropriate for companies with a significant operating history. Typically a terminal value is calculated using a price multiple of the company’s EBITDA
• Relative value or market approach: applies a price multiple, such as the price-earnings ratio, against the company’s earnings to get an estimate of the company’s valuation. This approach requires predictable cash flows and a significant history.
• Real option analysis: applicable for immature companies with flexibility in their future strategies
• Replacement cost: not applicable to mature companies whose historical value added would be hard to estimate
• Venture capital method
• Leveraged buyout method: a method of factoring in the company’s capital structure and other parameters to determine the return. The objective is not to value the company but to determine the maximum price in negotiation that the private equity firm should pay for its stake.

Question 19

4 exit routes for private equity firms

Answer 19

• Initial Public Offering
• Secondary Market Sale
• Management Buyout
• Liquidation

Question 20

Economic Terms of a Private Equity Fund

Answer 20

• Management fees are paid to the GP on an annual basis as a percent of committed capital and are commonly 2%. Management fees could instead be based on NAV or paid-in capital.
• Transaction fees are paid by third parties to the GP in their advisory capacity. These fees are usually split evenly with the LPs and, when received, are deducted from management fees.
• Carried interest/performance fees is the GP’s share of the fund profits and is usually 20% of profits (after management fees).
• Ratchet specifies the allocation of equity between stockholders and management of the portfolio company and allows management to increase their allocation, depending on company performance.
• Hurdle rate is the IRR that the fund must meet before the GP can receive carried interest. It usually varies from 7% to 10% and incentivizes the GP.
• Target fund size stated total maximum size of the PE fund, which signals the GP’s ability to manage and raise capital for a fund. It is a negative signal if actual funds ultimately raised are significantly lower than targeted.
• Vintage is the year the fund was started and facilitates performance comparisons with other funds.
• Term of the fund is the life of the firm and is usually ten years.

Question 21

Popular Multiples (specified by GIPS)

Answer 21

• PIC (paid-in capital). This is the capital utilized by the GP. It can be specified in percentage terms as the paid-in capital to date divided by the committed capital. Alternatively, it can be specified in absolute terms as the cumulative capital utilized or called down.
• DPI (distributed to paid-in capital). This measures the LP’s realized return and is the cumulative distributions paid to the LPs divided by the cumulative invested capital. It is net of management fees and carried interest. DPI is also referred to as the cash-on-cash return.
• RVPI (residual value to paid-in capital). This measures the LP’s unrealized return and is the value of the LP’s holdings in the fund divided by the cumulative invested capital. It is net of management fees and carried interest.
• TVPI (total value to paid-in capital). This measures the LP’s realized and unrealized return and is the sum of DPI and RVPI. It is net of management fees and carried interest.

Question 22

Calendar spread

Answer 22

The difference between th futures price of a nearer maturity and the futures price of a more-distant maturity is known as the calendar spread

Question 23

Basis of a particular commodity contract

Answer 23

The basis is calculated as the spot price minus the futures price and can be positive or negative.

Question 24

Contango and backwardation

Answer 24

• Contango
  
  • Futures prices are higher at dates further in the future
  • Calendar spread and basis are negative
  • Long future position have negativie return because future prices are higher than spot prices
• Backwardation
  
  • Future prices are lower at dates further in the future
  • Basis and calendar spread are positive
  • Long future position have positive return because future prices are lower than spot prices

Question 25

THeories of commodity futures returns

Answer 25

• Insurance Theory states that futures returns compensate contract buyers for providing protection against price risk to futures contract sellers (i.e., the producers). This theory implies that backwardation is a normal condition.
• The Hedging Pressure Hypothesis expands on Insurance Theory by including long hedgers as well as short hedgers. This theory suggests futures markets will be in backwardation when short hedgers dominate and in contango when long hedgers dominate.
• The Theory of Storage states that spot and futures prices are related through storage costs and convenience yield.

Question 26

Return on a commodity derivatives position

Answer 26

Total return on a fully collateralized long futures = collateral return + price return + roll return

where:

• Collateral return (collateral yield) = holding period yiel on the collateral
• Price return (spot yield) = (current price - previous price) / previous price
• Roll return = (price of expiring futures contract - price of new futures contract ) / price of expiring futures contract