Chapter 14 CAIA Flashcards - Liquid and Fixed Income Real Estate

Question 1

Five Potential Advantages of Real Estate

Answer 1

Potential to offer absolute returns

Potential to hedge against unexpected inflation

Potential to provide diversification with stocks and bonds

Potential to provide cash inflows

Potential to provide income tax advantages

Question 2

Three Potential Disadvantages of Real Estate

Answer 2

Heterogeneity

Lumpiness

Illiquidity

Question 3

Heterogeneity

Answer 3

Real estate is a highly heterogeneous asset. Not only are the physical features of the individual properties unique in terms of location, use, and design, but varying lease structures can lead to large differences in income streams. This heterogeneity may be particularly burdensome in the initial and ongoing due diligence processes.

Question 4

Lumpiness

Answer 4

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. Listed equities of large companies are not lumpy, because purchases and sales can easily be made in the desired size by altering the number of shares in the transaction.

Question 5

Illiquidity

Answer 5

The final major disadvantage relates to the liquidity of private real estate. As a non-exchange-traded asset with a high unit cost, private real estate can be highly illiquid, especially when compared to stocks and bonds. An important implication of illiquidity is its effect on reported returns as well as its added risk challenges.

Question 6

Styles of Real Estate Investing

Answer 6

Styles of real estate investing refers to the categorization of real estate property characteristics into

Core,

Value Added,

Opportunistic.

Question 7

Core Real Estate

Answer 7

Core real estate includes assets that achieve a relatively high percentage of their returns from income and are expected to have low volatility. Core real estate contains five specific categories: Office, Retail, Industrial, Multi-Family, and Hotels. Core ​properties are the most liquid, most developed, least leveraged, and most recognizable properties in a real estate portfolio.

Question 8

Value Added Real Estate

Answer 8

The value-added real estate style includes hotels, resorts, assisted-care living facilities, low-income housing, outlet malls, hospitals, and the like. These properties tend to require a subspecialty within the real estate market to be managed well and can involve repositioning, renovation, and redevelopment of existing properties.

Question 9

Opportunistic Real Estate Investing

Answer 9

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.

Question 10

Characteristics of Value Added Real Estate

Answer 10

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 11

Fixed Rate Mortgage

Answer 11

A fixed-rate mortgage has interest charges and interest payments based on a single rate established at the initiation of the mortgage.

Question 12

Variable Rate Mortgage

Answer 12

A variable-rate mortgage has interest charges and interest payments based on a rate that is allowed to vary over the life of the mortgage based on terms established at the initiation of the mortgage.

Question 13

Index Rate

Answer 13

An index rate is a variable interest rate used in the determination of the mortgage’s stated interest rate. Index rates fluctuate freely in the money markets and can be based, for example, on the yield of one-year Treasury securities.

Question 14

Margin Rate

Answer 14

A margin rate is the spread by which the stated mortgage rate is set above the index rate.

Question 15

Interest Rate Cap

Answer 15

An interest rate cap is a limit on interest rate adjustments used in mortgages and derivatives with variable interest rates.

Question 16

Option Adjustable Rate Mortgage

Answer 16

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 17

Negative Amortisation

Answer 17

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.

Question 18

Subprime Mortgages

Answer 18

Uninsured mortgages with borrowers of relatively high credit risk are generally known as subprime mortgages.

Question 19

Covenants

Answer 19

document. 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.

Question 20

Recourse

Answer 20

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 21

Cross Collateral Provision

Answer 21

Finally, in order to mitigate the risk to which they are exposed, lenders commonly use a 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 22

Interest Coverage Ratio

Answer 22

interest coverage ratio, which can be defined as the property’s net operating income divided by the loan’s interest payments.

Question 23

Debt Service Coverage Ratio

Answer 23

A related measure is 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 24

Fixed Charges Ratio

Answer 24

A final typically used key ratio with an even broader definition of expenses is the fixed charges ratio. The fixed charges ratio is the ratio of the property’s net operating income to all fixed charges that the borrower pays annually.

Question 25

Mortgage Backed Security

Answer 25

Mortgage-backed securities (MBS) are a type of asset-backed security that is secured by a mortgage or pool of mortgages.

Question 26

Types of MBS

Answer 26

Pass Through MBS

Collateralised Mortgage Backed Obligations

Question 27

Commercial mortgage-backed securities (CMBS)

Answer 27

Commercial mortgage-backed securities (CMBS) are mortgage-backed securities with underlying collateral pools of commercial property loans.

Question 28

REIT

Answer 28

A real estate investment trust (REIT) is an entity structured much like a traditional operating corporation, except that the assets of the entity are almost entirely real estate.

Question 29

Equity REIT

Answer 29

Equity REITs invest predominantly in equity ownership within the private real estate market.

Question 30

Mortgage REIT

Answer 30

Mortgage REITs invest predominantly in real estate–based debt. REITs that invest substantially in both markets have been termed hybrid REITs—a category that has shrunk into very limited use.

Question 31

Two Main REIT restrictions

Answer 31

REITs are subject to the following two main restrictions: 75% of the income they receive must be derived from real estate activities, and they must pay out 90% or more of their taxable income in the form of dividends.