class 6: Equity and Capital Structure Flashcards
which steps of the investment rocess is this?
- Apply decision-making criteria
5. Make an investment decision
equity holder
anyone who has a stake in the ownership of a property
ultimate decision makers
what do equity hold regarding cash flows?
They own the residual rights to all cash flows and liquidation proceeds after the creditors have been paid
how much liability do equity holders have?
they could lose their investment, but they could make infinite profit if possible
as an equity holder, do you have a set maturity date to get your money?
nah bruv
as an equity holder, do you have a set cash flow stream?
nah bruv
how to calculate equity?
asset - debt
Proprietorship and Co-ownership
Property is owned directly by one or more individual
what is the liability of a Proprietorship and Co-ownership?
Unlimited liability which extends to the owners’ other assets
how are Proprietorships and Co-ownerships taxed?
Income of the property is taxed in the hands of the owners
Partnership
formal agreement among a group of people or companies to share ownership
General partners
Unlimited liability which extends to the partners’ other assets
Income of the property is taxed in the hands of the partners’
Limited partners
Only at risk for their investment
Income of the property is taxed in the hands of the partners
are financial partners usually involved in day to day management of the property?
nah bruv
Corporations
Legal entities, owned by shareholders but separate from their owners
who selects the corporation’s board of directors?
shareholders
who selects the corporation’s management?
Board of Directors
what taxes do corporations pay?
Pay corporate taxes
how is corporate income distributed?
through dividends, if declared, which are taxed in the shareholders’ hands
shareholder risk
Shareholders are only at risk for their investment
can corporations be Private or Publicly traded?
yeee
Real Estate Operating Companies (REOC’s)
Corporations whose primary business is investing in or operating real estate projects
Real Estate Investment Trusts (REIT’s)
Legal entities whose primary business is real estate investment
Must be publicly traded (can be private in the U.S.)
how much of the total fair market value of all trust properties that canadian REIT hold must be in canada?
At least 75%
how much do qualified REIT properties account for?
At least 90%
how much of the REIT’s revenue must come from rent or mortgage interest and capital gains from real or immovable properties in Canada?
At least 90%
REIT level of distribution?
High level of distributions (approximately 90%)
what are the The two main financial metrics used in decision making for equity investors ?
Net Present Value (NPV)
Internal Rate of Return (IRR) (we look 90% of the time at this)
what do Net Present Value (NPV) ab¡nd Internal Rate of Return (IRR) have in common?
Both of these use the cash flows we’ve built so far (NOI and Debt service payments)
Both of these metrics use the cash flow model of the property, or real estate investment, developed as part of the financial analysis
The NPV
sum of the present values of the cash flows generated by the investment MINUS the initial investment
Highly dependent on the discount rate
is the rate of return a positive NPV bigger or smaller than the discount rate?
bigger than the discount rate
Hurdle Rate
the rate of return required by the investor
The discount rate applied
The minimum return we are willing to accept
If the NPV returns a value greater than zero, the investment generates a rate of return greater or smaller than the hurdle rate?
greater than the hurdle rate
true or false
The greater the NPV the more attractive the investment.
truuue
The NPV calculated using cash flows before interest
unlevered NPV
you gotta worry about equity holder and the debt holder
will generally use a risk adjusted weighted average cost of capital (WACC)
The NPV calculated using cash flows after interest
levered NPV
you only need to worry about the equity holder now
will generally use a risk adjusted required equity return
is the hurdle rate the same for unlevered NPV and levered NPV?
nah boyyy
The hurdle rate will be different under both scenarios
weighted average cost of capital (WACC)
- Find percentage of the asset that is for debt and equity
- Find multiply the one for debt proportion by interest rate and multiply the equity proportion by the return the equity holders expect to make
the combined proportional cost of the debt and equity used to finance a property or entity
WACC formula
(equity / (equity + debt)) * cost of equity
+
(debt / (equity + debt)) * cost of debt
WACC formula If the entity is subject to tax
(equity / (equity + debt)) * cost of equity
+
(debt / (equity + debt)) * cost of debt * (1 - tax rate)
The IRR
the rate of return of the investment
discount rate which will give an NPV of zero
The IRR is compared to the hurdle rate of the investor
the most widely used investment metric in real estate
then investment is made when the IRR > Hurdle rate or the IRR < Hurdle rate?
IRR > Hurdle rate
The greater the IRR the more attractive the investment
a levered IRR will be compared with a levered or unlevered hurdle rate?
levered hurdle rate
an unlevered IRR will be compared with a levered or unlevered hurdle rate?
unlevered hurdle rate
the most widely used investment metric in real estate
the IRR
Preferred returns
when an investor has first claim on profits (or a specified distribution formula) until he has achieved a certain target IRR
Often given as an incentive for a financial partner to invest
Promote
when an investor earns a disproportionate share of the profits
to whom a promote usually applied?
Often given to the investment manager or operating partner as a form of bonus for achieving a higher IRR
Generally applies to profits after the financial partner has achieved his targeted IRR
Clawback
when an investor gives up a portion of his return to another investor if a certain IRR is not met
to whom is a clawback usually applied?
Applies most often to the operating partner or investment manager
do all investors always want to sell at the same time?
naaah
Not all investors in a project may want to exit (sell) at the same time
strategies that can be used to make the exit of one or more investors easier and less contentious
Right of First Offer
Right of First Refusal
Sale by Appraisal
Shotgun Clause
Right of First Offer
the departing investor sets his selling price but MUST offer the remaining investors the chance to purchase the asset at that price before offering it in the market
Right of First Refusal
the departing investor MUST offer the remaining investors the chance to purchase the asset at any price agreed upon with a third party
Sale by Appraisal
when investors agree to transact, the value will often be set by one or more independent appraisers
Shotgun Clause
an investor offers to buy the share of the other investor at a price he determines
The other investor must either sell his investment at that price OR buy the offering investor’s share at the same price
the capital stack
the hierarchy of who gets money first and who gets the most risk
The lower in the capital stack, the greater or lower the expected return of the investor?
why?
the greater the expected return of the investor
because higher risk
the capital stack hierarchy
Secured debt (mortgage)
Wrap-around (2nd mortgage)
Mezzanine debt (high LTV)
Unsecured debt
Preferred equity
Common equity
Secured debt (mortgage)
guaranteed by a specific asset (mortgage)
Wrap-around (2nd mortgage)
2nd rank on a mortgaged asset
When the first mortgage reaches maturity the new lender will advance additional funds to repay it and becomes the 1st ranked lender on the asset
Mezzanine debt
subordinated to the first and second mortgage
it offers a higher LTV for a higher rate
Unsecured debt
Secured only by the corporate credit and not one specific asset
Preferred Equity
receives dividends and liquidation proceeds before the funds are paid to common equity holders
what is the total cost of capital dependent on?
dependent on the weight of each element and its cost
Sale Leaseback
Property owner sells his asset and then leases it back from the buyer
Ground Lease
Land-owner provides a long-term lease on the land
permits the lessee to build on the land
Pad Sale
The segregation and sale of a small portion of a property (Pad)
Sale of rights
the selling of air, mineral, water, oil and gas rights
