Chap 12 - Real Estate Assets and Debt

Question 1

What are the five especially common categories that can be used to differentiate real estate ?

Answer 1

1. Equity versus debt
2. Domestic versus international
3. Residential versus commercial
4. Private versus public
5. Market size of geographic location

Question 2

What are the 7 challenges to international real estate investing ?

Answer 2

(1) a lack of knowledge and experience regarding foreign real estate markets, (2) a lack of relationships with foreign real estate managers, (3) the time and expense of travel for due diligence, (4) liquidity concerns, (5) political risk (particularly in emerging markets), (6) risk management of foreign currency exposures, and (7) taxation differences.

Question 3

The credit risk of mortgages on residential real estate is typically analyzed with a focus on the creditworthiness of the borrower. Mortgages on commercial real estate tend to focus on the analysis of the net cash flows from the property.

Question 4

What is Private real estate equity ?

Answer 4

Private real estate equity investment involves the direct or indirect acquisition and management of actual physical properties that are not traded on an exchange.

Question 5

What is Public real estate ?

Answer 5

Public real estate investment entails the buying of shares of real estate investment companies and investing in other indirect exchange-traded forms of real estate (including futures and options on real estate indices and exchange-traded funds linked to real estate).

Question 6

What is Private real estate ?

Answer 6

Private real estate is also known as
physical, direct, or non-exchange-traded real estate, and may take the form of
equity through direct ownership of the property or debt via mortgage claims on the property.

Question 7

What is Primary real estate market ?

Answer 7

Primary real estate market if the geographic location of the real estate is in a major metropolitan area of the world, with numerous large real estate properties or a healthy growth rate in real estate projects with easily recognizable names.

Question 8

What are the five common attributes of real estate that can encourage its inclusion in an investment portfolio ?

Answer 8

1. Potential to offer absolute returns
2. Potential to hedge against unexpected inflation
3. Potential to provide diversification with stocks and bonds
4. Potential to provide cash inflows
5. Potential to provide income tax advantages

Question 9

What are the three potential disadvantages of real estate ?

Answer 9

1. Heterogeneity (uniqueness of every proprety)
2. Lumpiness
3. Illiquidity

Question 10

A particular property may experience
dramatic changes in its investment characteristics due to a specific event, such as the signing or termination of a very-long-term, noncancellable lease.

Question 11

What is Lumpiness ?

Answer 11

Lumpiness describes when assets cannot be easily and inexpensively bought and sold in sizes or quantities that meet the preferences of the buyers and sellers.

Question 12

What are the 3 styles of real estate investing defined by National Council of Real Estate Investment Fiduciaries (NCREIF) (2003) ?

Answer 12

1- Core value
2- Added
3- Opportunistic.

Real estate investment styles assist an asset allocator in organizing and evaluating
real estate opportunities, facilitate benchmarking and performance attribution, and help investment managers monitor style drift.

Question 13

The three NCREIF styles divide real estate opportunities from least risky (core) to most risky (opportunistic), with value added in the middle. In terms of risk, core properties are most bond-like, and opportunistic properties are most equity-like. Core properties tend to offer reliable cash flows each year from rents and lease payments, whereas opportunistic properties offer potential capital appreciation and typically have little or no reliable income.

Question 14

What is Core real estate ?

Answer 14

Core real estate includes assets that achieve a relatively high percentage of their returns from income, are expected to have low volatility, are the most liquid, most developed, least leveraged, and most recognizable properties in a real estate portfolio, and include five specific categories: office, retail, industrial, multifamily, and hotels.

Question 15

What are Value-added real estate ?

Answer 15

Value-added real estate includes assets that exhibit one or more of the following characteristics: (1) achieving a substantial portion of their anticipated returns from appreciation in value, (2) exhibiting moderate volatility, and (3) not having the financial reliability of core properties.

Question 16

What are Opportunistic real estate properties ?

Answer 16

Opportunistic real estate properties are expected to derive most or all of their
returns from property appreciation and may exhibit substantial volatility in value
and returns.

Highest volatility because: Exposure to development risk, substantial leasing risk, or high leverage.

Question 17

What are the 8 attributes, developed by NCREIF to distinguish the three types of real estate asset styles ?

Answer 17

1. Property type (purpose of structure, e.g., general office versus specialty retail)
2. Life-cycle phase (e.g., new/developing versus mature/operating)
3. Occupancy (e.g., fully leased versus vacant)
4. Rollover concentration (tendency of assets to trade frequently)
5. Near-term rollover (likelihood that rollover is imminent)
6. Leverage
7. Market recognition (extent that properties are known to institutions)
8. Investment structure/control (extent of control and type of governance)

Question 18

What are the 3 main reasons to introduce the styles into real estate portfolio analysis ?

Answer 18

1- Performance measurement: Investors continually look for tools that can provide them with a better understanding of an investment’s or a sector’s objectives and success in accomplishing those objectives (peer group). In other words, it can help to find a benchmark.

2- Monitoring style drift: Tracking style drift is another benefit of assessing the style of a portfolio.

3- Style diversification: The ability to compare the risk-return profile of a manager relative to the manager’s style may allow for a better diversification of the portfolio, since an investor may be able to construct a portfolio that has a more robust risk-return profile if there is a better understanding of each real estate manager’s style location.

Question 19

The ability of the borrower to make or not make unscheduled principal payments is an option to the borrower: the borrower’s prepayment option. The option is a call option in which the mortgage borrower, much like a corporation with a callable bond, can repurchase its debt at a fixed strike price. Therefore, a mortgage borrower benefits from increased interest rate volatility. The lender, on the other hand, has written the call option and suffers from increased interest rate volatility. The key point is that fixed-rate mortgage investing has interest rate risk that includes the interest rate risk of the borrower’s prepayment option. While the prepayment option may be viewed as a call option on the value of the debt, the option may also be viewed as a put option on interest rates.

Answer 19

Borrower’s advantage to refinance the loan, replacing the current high interest-rate, high-priced debt with a new loan at a lower interest rate.

Although the option may not be explicitly priced as part of the loan, it is implicitly priced in the form of a higher interest rate on the mortgage loan or in up-front points, or fees, charged to the borrower.

Question 20

Some fixed-rate mortgages are interest-only mortgages, which means that the monthly payments consist entirely of interest payments for some initial period. The two most widely used interest-only loans are both 30-year mortgages. The first begins with a 10-year interest-only period, followed by a 20-year fully amortizing period; this type of loan is known as 10/20.

In each case, the interest-only payments are equal to the product of the principal balance and the monthly rate. When the mortgage commences amortization, the payments are computed like fixed-payment mortgages except that they are based on the remaining and shorter period of the mortgage’s life.

Answer 20

Consider a $100,000, 25-year mortgage that is structured as a 10/15 interest
only mortgage, with an annual rate of 6%. What would the payments be for
the first 10 and the last 15 years? For the first 10 years, the monthly payments, which are interest only, would be $500 ($100,000 × 6.0%/12). Between years 11 and 25, the monthly fixed payment necessary to fully amortize the mortgage for the remaining
15 years would be $843.86 (using a financial calculator: n=12 × 15=180, i=6%/12=0.5%, PV = +/−$100,000, FV =$0, solve for PMT).

Question 21

Interest-only mortgages have the potential advantage that the monthly payments during the interest-only period are lower than those in the case of a fully amortized loan ($500 versus $644.30). However, during the amortization period the monthly
payments are higher ($843.86 versus $644.30), as the borrower has fewer years to amortize the loan (15 years versus 25 or 30 years).

Question 22

What is an option adjustable-rate mortgage (option ARM) ?

Answer 22

An option adjustable-rate mortgage (option ARM) is an adjustable-rate mortgage that provides borrowers with the flexibility to make one of several possible payments on their mortgage every month.

Question 23

What is a Negative amortization ?

Answer 23

Negative amortization occurs when the interest owed is greater than the payments being made such that the deficit is added to the principal balance on the loan, causing the principal balance to increase through time. This negative amortization can generate higher probabilities of default from borrowers taking on too much debt or failing to prepare for future payments.

Question 24

What is a balloon payment ?

Answer 24

A balloon payment is a large scheduled future payment. Rather than amortizing a mortgage to $0 over its lifetime (e.g., 25 years), the mortgage is amortized to the balloon payment. In other words, at the end of the loan, there is an outstanding principal amount due that is equal to the balloon payment. The balloon payment
allows for a lower monthly payment, given the same mortgage rate, since the mortgage is not fully amortized to $0. Balloon payments due in a relatively short time period (compared to traditional mortgage maturities of 15 to 30 years) may lower the interest rate risk to the lender and permit a lower mortgage rate.

Question 25

What are subprime and prime mortgages ?

Answer 25

Uninsured mortgages with borrowers of relatively high credit risk are generally known as subprime mortgages. Prime mortgages are offered to borrowers with lower levels of credit risk and higher levels of creditworthiness.

Question 26

What is a loan-to-value ratio (LTV ratio) ?

Answer 26

The loan-to-value ratio (LTV ratio) is the ratio of the amount of the loan to the value (either market or appraised) of the property. Residential mortgages with LTV ratios of 80% are often viewed as being very well collateralized. LTV ratios of up to 95% are commonly allowed for insured residential mortgages.

Question 27

What is a convenant ?

Answer 27

Covenants are promises made by the borrower to the lender, such as requirements that the borrower maintain the property in good repair and continue to meet specified financial conditions. Failure to meet the covenants can trigger default and make the full loan amount due immediately. The view that covenants benefit lenders at the expense of borrowers is na¨ıve.

Question 28

What is a recourse ?

Answer 28

Another key element in any commercial debt deal is the recourse that the lender has to the borrowing entity. Recourse is the set of rights or means that an entity such as a lender has in order to protect its investment. Recourse may include how the loan is secured, such as the potential ability of the lender to take possession of the property in the event of a default and the potential ability of the lender to pursue recovery from the borrower’s other assets.

Question 29

What is a Cross-collateral provision ?

Answer 29

Cross-collateral provision, wherein the collateral for one loan is used as collateral for another loan. For example, say a corporation has borrowed twice, securing each loan with a property; with a cross-collateral provision, both properties would be used as collateral for both loans. If the corporation fully pays off one of the loans and wishes to sell the related property, the lender may prevent the sale because the property is still serving as collateral to the other loan.

Question 30

What is the Interest coverage ratio for commercial real estate ?

Answer 30

Interest coverage ratio, which can be defined as the property’s net operating income divided by the loan’s interest payments. The interest coverage ratio allows lenders to analyze the level of protection they have in terms of a borrower’s ability to service a debt from the property’s operating income.

Question 31

What is the debt service coverage ratio (DSCR) ?

Answer 31

The debt service coverage ratio (DSCR), which is the ratio of the property’s net operating income to all loan payments, including the amortization of the loan.

Question 32

What is the fixed charges ratio ?

Answer 32

The fixed charges ratio is the ratio of the property’s net operating income to all fixed charges that the borrower pays annually.