Chapter 14 CAIA Flashcards - Liquid and Fixed Income Real Estate
Five Potential Advantages of Real Estate
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
Three Potential Disadvantages of Real Estate
Heterogeneity
Lumpiness
Illiquidity
Heterogeneity
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.
Lumpiness
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.
Illiquidity
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.
Styles of Real Estate Investing
Styles of real estate investing refers to the categorization of real estate property characteristics into
Core,
Value Added,
Opportunistic.
Core Real Estate
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.
Value Added Real Estate
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.
Opportunistic Real Estate Investing
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.
Characteristics of Value Added Real Estate
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.
Fixed Rate Mortgage
A fixed-rate mortgage has interest charges and interest payments based on a single rate established at the initiation of the mortgage.
Variable Rate Mortgage
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.
Index Rate
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.
Margin Rate
A margin rate is the spread by which the stated mortgage rate is set above the index rate.
Interest Rate Cap
An interest rate cap is a limit on interest rate adjustments used in mortgages and derivatives with variable interest rates.
Option Adjustable Rate Mortgage
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.
Negative Amortisation
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.
Subprime Mortgages
Uninsured mortgages with borrowers of relatively high credit risk are generally known as subprime mortgages.
Covenants
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.
Recourse
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.
Cross Collateral Provision
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
Interest Coverage Ratio
interest coverage ratio, which can be defined as the property’s net operating income divided by the loan’s interest payments.
Debt Service Coverage Ratio
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.
Fixed Charges Ratio
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.
Mortgage Backed Security
Mortgage-backed securities (MBS) are a type of asset-backed security that is secured by a mortgage or pool of mortgages.
Types of MBS
Pass Through MBS
Collateralised Mortgage Backed Obligations
Commercial mortgage-backed securities (CMBS)
Commercial mortgage-backed securities (CMBS) are mortgage-backed securities with underlying collateral pools of commercial property loans.
REIT
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.
Equity REIT
Equity REITs invest predominantly in equity ownership within the private real estate market.
Mortgage REIT
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.
Two Main REIT restrictions
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.
