Alternative Investments

Question 1

Valuation: Highest and Best Use

Answer 1

Choose project with highest implied value (Value on completion - Development costs)

Question 2

Net Operating Income (NOI)

Answer 2

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)

Question 3

Capitalization rate

(Market-extraction method)

Answer 3

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

Question 4

All Risks Yield (ARY)

Answer 4

Market Value V₀= Rent / ARY

Question 5

Stabilized NOI example

Answer 5

Question 6

Term and reversion valuation approach

Answer 6

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.

Question 7

Layer method

Answer 7

PV of term rent + PV of incremental rent

2 perpetuities

1. Term rent for ever
2. Incremental amount for ever

PV the incremental back

Question 8

Ratio Analysis:

Debt service coverage ratio (DSCR)

Loan to value (LTV)

Equity dividend rate

Answer 8

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)

Question 9

Leveraged / Unleveraged IRR

Answer 9

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

Question 10

Max Loan > Div Rate Example

Answer 10

Question 11

Advantages of Publicly Traded Real Estate Securities

Answer 11

1. Greater liquidity
2. Lower investment requirements
3. Limited liability
4. Diversification
5. Taxation: Offers advantages related to dividends compared to REOCs if:
   
   1. 75% assets held in real estate, or income from rent or mortgage
   2. Limited non-rental property assets
   3. 90% income paid out as distributions
   4. Tax benefits for shareholders
6. Earnings predictability
7. High income payout ratios and yields

Question 12

Disadvantages of Publicly Traded Real Estate Securities

Answer 12

1. Control
2. Costs
3. Stock market valuation (volatile etc.)
4. Forced equity issues (dilution)

Question 13

Economic Value Drivers for real estate type

Answer 13

Question 14

Net asset valuation per share (NAVPS)

Answer 14

Estimated NOI
/ assumed cap rate

= estimated value of operating real estate

+ cash & accounts receivable
- debt & other liabilities

= net asset value
/ shares outstanding

= NAV / share

Question 15

Price Multiple Approach: Funds from operations (FFO) / Adjusted funds from operations (AFFO)​

Answer 15

Question 16

Price Multiple Approach: Advantages / Disadvantages

Answer 16

Question 17

PE: Sources of value creation

Answer 17

1. Re-engineering of companies
2. Favorable debt financing − Private equity firms are better able to raise higher levels of debt as a result of having better control over management
3. Surplus (free) cash is often invested in value destroying projects, thus high leverage reduces this risk as cash is used to service debt
4. Greater incentives for management coupled with more direct and intense scrutiny by owners (as compared with stockholders of a public company)
5. Effective term sheets − If business plan is not met the equity gets re-allocated away from management and to the private equity owners

Question 18

Valuation issues in venture capital (VC) transactions

Answer 18

• 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

Question 19

PE Economic Terms

Answer 19

Question 20

PE Corporate governance terms

Answer 20

Question 21

PE fund performance

Gross IRR

Net IRR

Answer 21

Gross IRR: return from portfolio companies

Net IRR: Relvant for LP; net of fees & carried interest

Question 22

PE Perfomance statistics

Answer 22

1. Paid-in capital (PIC) – % capital utilized by GP (cum. sum of capital called down)
2. Distributed to paid in (DPI) – LP’s realized return: Cumulative distributions (net of fees) / PIC
3. 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]
4. Total value to paid in (TVPI) = DPI + RVPI

Question 23

Management fees

Answer 23

Annual fee based on amount of committed capitalm (% of PIC)

Question 24

Carried interest

Answer 24

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

Question 26

**NAV _before_ distributions** **NAV _after_ distributions**

Answer 26

**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

Question 27

**PE Accounting for Risk**

Answer 27

1. Adjust discount rate for probability of failure 2. Allow for a variety of scenarios to (realistically) model cash flows

Question 28

**Valuation of Venture Capital Deals** Five-step approach

Answer 28

Question 29

**Valuation of Commodities**

Answer 29

* 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

Question 30

Futures

Answer 30

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)

Question 31

**Contango**

Answer 31

Future prices \> Spot prices (nagtive basis)

Question 32

**Backwardation**

Answer 32

Futures prices \< Spot prices (positive Basis)

Question 33

Theories of Futures Returns

Answer 33

1. **Insurance theory** 2. **Hedging pressure hypothesis** 3. **Theory of storage**

Question 34

Futures: **Insurance perspective**

Answer 34

Contract buyers compensated for providing protection to commodity producers. Implies backwardation is normal.

Question 35

Hedging pressure hypothesis

Question 36

**Theory of storage**

Answer 36

* 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

Question 37

**Total return** on fully collateralized long commodity futures Formula

Answer 37

Question 38

**Roll return​**

Answer 38

* **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

Question 39

Collateral return

Answer 39

– interest paid on the fully collateralized futures position at the U.S. T-bill rate

Question 40

Commodity Swaps

Answer 40

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 1. **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 2. **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 3. **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 4. **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 5. **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