CRE Technicals Flashcards
What are the different types of real estate firms?
REPE (RE Priv Equity)
REIT (RE Investment Trust)
RE Development Firm
RE Investment Management
REOCs (RE Operating Companies)
RE Brokerage Firms
Real Estate Private Equity
-Raise capital from investors
-Acquiring and developing commercial properties (buildings), managing the properties, and selling the improved properties to realize a profit
Real Estate Investment Trust
-Own a portfolio of income-generating real estate assets over various sectors
-Exempt from corporate-level income taxes
-Ex. the obligation to issue 90% of their taxable income as shareholder dividends
-Most are publicly traded & must follow SEC guidelines
Real Estate Development Firm
-Build properties from scratch
Real Estate Investment Management
-Raise funding from limited partners to acquire, develop, and manage commercial properties to sell them at a profit later
-Different from REPE because REIMs usually have no end date (open-end funds)
Real Estate Operating Companies
-Purchase and manage real estate, like REITs, but REOCs re-invest their earnings rather than the mandatory distribution to shareholders
-“Double taxation”: income taxation occurs at the entity and shareholder levels – contrary to REITs.
Real Estate Brokerage Firms
-Intermediaries to facilitate transactions on both sides
*Protect the interests of their clients in transactions involving the purchase, sale, or leasing of real estate assets
*Help clients identify a new property to purchase or market and sell a property on behalf of the client or even negotiate the terms of a lease
Property Classes in RE investing
Class A: Class A premium properties in prime locations with top-of-the-line amenities. Low risk, low reward investing
Class B: More outdated, yet are built and renovated with high-quality construction material and maintained well. Offer higher yields with upside potential from the value-add opportunities
Class C: more outdated in infrastructure and located in bad areas regarding the outlook on rent pricing and market demand. More upside in returns on Class C properties to compensate investors
Class D: distressed assets because of their poor condition. Class D properties are located in areas with collapsing market demand. Investors tend to avoid Class D properties
What are the four main real estate investment strategies?
Core: Lowest risk. Modern properties in prime locations occupied by creditworthy people
Core-plus: Necessity for capital improvements, marginally riskier (low-to-moderate risk)
Value-add: growth-oriented and carry a moderate-to-high risk profile
Opportunistic: involve the most complicated, time-consuming projects – such as new development or redevelopment. No CFs on date of acquisition though has potential to have large returns in the future.
What is the real estate capital stack?
Common Equity: highest risk/reward. Equity claims are last in priority in the event of default.
Preferred Equity: blends features of debt and common equity but is only senior to common equity and subordinate to all debt.
Junior (mezzanine) debt: Bridges gap between equity + senior debt. The interest rate is higher than senior debt because it’s unsecured and of lower priority. Possess the right to take control of a property in the event of default.
Senior Debt: Highest priority. It can be the standard mortgage loan. Return is lowest as the borrower pledges collateral as part of the financing arrangement.
Senior debt lenders, such as banks, are first in priority of repayment
What are the four stages of the real estate cycle?
Recovery: Market coming out of the trough, low occupancy rates with no demand, construction, etc.
Expansion: the economy and real estate market show improvements (ex. unemployment rate)
Hyper-supply: prices of properties initially retain their upward momentum before starting to descend downward from the oversupply in inventory. Buyers have power.
Recession: Ex. high unemployment
What influences the real estate cycle?
Interest rates, economy, government intervention, consumer income, etc.
What are vacancy and credit losses?
Vacancy loss: percentage of units available for rent that were left unoccupied in a given period (opportunity cost)
Credit loss: inability to collect rent from tenants
How do you calculate Effective Gross Income?
Effective Gross Income (EGI) = Potential Gross Income (PGI) – Vacancy and Credit Losses
How do you calculate vacancy rate?
Vacancy Rate (%) = Number of Vacant Units/Total Number of Units
What is NOI in real estate?
Profit potential of income-generating properties before subtracting non-operating costs.
Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses
Ancillary Income: parking passes, ammenities, etc.
Direct Operating Expenses: property management fees, property taxes, property insurance, utilities, and maintenance work.
How is the cap rate used to value a property?
Expected rate of return on an income-generating investment property.
Cap Rate (%) = Net Operating Income (NOI) + Property Value
Income is the Forward NOI which is subject to error (projected 12 months).
Income Approach (appraisal)
Property Value = Net Operating Income (NOI) ÷ Market Cap Rate
Cap rate is estimated through research of similar properties/transactions
Why is the cap rate the inverse of a multiple?
The net income multiplier (NIM) is the reciprocal of the cap rate.
Property Value = Net Operating Income (NOI) × Net Income Multiplier (NIM)
Why is the cap rate the inverse of a multiple? (Part 2)
Estimate the value of a commercial building expected to generate $200k in NOI at stabilization.
Given a market cap rate of 10.0%:
Implied Property Value = $200k ÷ 10.0% = $2 million
Given the NOI and net income multiplier (NIM):
Implied Property Value = 10.0x × $200k = $2 million
Compare the cap rates for the main property types?
Hospitality (hotels): highest cap rates because demand fluctuates based on external factors (state of the economy and the income of consumers). Bookings are on a short-term basis.
Retail: risky because of the shifts disrupting the broader market (eCommerce)
Industrial: top performer in the CRE market because trends such as eCommerce, cloud computing, and big data
Multifamily: the most stable in terms of consistent demand (i.e., consumers will always need a home to live in), but economy still has an effect on occupancy rates
Office: Exhibits cyclicality based on the conditions of the broader economy. Crucial to establish long-term leases
What is the relationship between the cap rate and risk?
Higher cap rate = higher risk, but higher potential returns
Lower cap rate = lower risk
Ideal scenario is the mispricing of property values relative to their income potential.
What is cash-on-cash or “cash yield” return?
measures the annual pre-tax cash flow received per dollar of equity invested.
Suppose the return on a property investment is centered around value appreciation instead of income generation (e.g., lease-up, renovations). In that case, the cash-on-cash returns should be expected to be on the lower end.
What is the difference between the cap rate and cash-on-cash return?
The cap rate measures the return expected on a rental property investment. (Formula in another flash card)
The cash-on-cash return, or “cash yield,” measures the annual pre-tax cash flow received per dollar of equity invested. It’s a levered metric because the numerator is the annual pre-tax cash flow.
Cash-on-Cash Return (%) = Annual Pre-Tax Cash Flow ÷ Equity Contribution
How are property values and NOI multiples affected if the market cap rate rises?
Higher Cap Rate: Lower Property Value + Lower NOI Multiple
Lower Cap Rate: Higher Property Value + Higher NOI Multiple
What does funds from operations (FFO) measure?
Measures the operating performance of REITs by estimating its capacity to continue generating sufficient cash.
Funds from Operations (FFO) = Net Income + Depreciation – Gain on Sale (net)
What is the difference between NOI and EBITDA?
NOI: measures the operating profitability of properties in the real estate industry
EBITDA = Net Income + Taxes + Interest Expense, net + Depreciation + Amortization.
EBITDA reflects the operating profitability of an entire corporation. NOI measures a property’s profit potential.
What are the three methods of appraising a property?
Income approach: divide a property’s pro forma, NOI, by the market cap rate
Cost approach: based on the total cost of replacing the property (reconstructing the property from scratch)
Sales comparison approach: recent historical sales data of comparable properties to estimate the valuation of a property
Walk me through the income approach to real estate valuation?
Capacity to generate income, most often projected on a twelve-month time horizon.
1) Project forward NOI
2) Determine market cap rate (research on recent comp sales)
3) Estimate property value
Property Value = Forward NOI ÷ Market Cap Rate
What does the cash-on-cash return measure?
The percentage of an investment expected to be distributed in cash before income taxes.
Cash on Cash Return (%) = Annual Pre-Tax Cash Flow ÷ Initial Equity Invested
What is the intuition behind the cost approach?
Pricing of a property should be determined by the cost of the land and cost of construction, minus depreciation.
Estimated Property Value = Land Value + (Cost New – Accumulated Depreciation)
Replacement Cost < Asking Price =reasonable
Replacement Cost > Asking Price
=not reasonable
What is the difference between the yield on cost (YoC) and cap rate?
YOC: measures the risk-return of a property at its core
Yield on Cost (%) = NOI ÷ Total Project Cost
Explain how to calculate NOI from EGI?
1) EGI = Potential Gross Income (PGI) – Vacancy and Credit Losses
2) NOI = EGI – Direct Operating Expenses
What is the loan-to-value ratio (LTV)?
the risk of a real estate lending proposal by comparing the requested loan amount to the appraised fair value of the property securing the financing.
LTV = Loan Amount ÷ Appraised Property Value
Higher LTV = Greater Credit Risk + Higher Interest Rate
Lower LTV = Less Credit Risk + Lower Interest Rate
What does the loan to cost ratio (LTC) measure?
Analyze credit risk by comparing the total size of a loan to the total development cost of a real estate project.
Loan-to-Cost Ratio (LTC) = Total Loan ÷ Total Development Cost
The lower the LTC ratio, the less risk for borrowing (vice versa for a higher LTC ratio).
From the perspective of a lender, is a higher or lower debt yield preferred?
Debt yield measures the riskiness of a RE loan based on the estimated return on investment for a CRE loan.
Higher debt yield = higher potential return on investment on the loan (and vice versa).
Debt Yield (%) = Net Operating Income (NOI) ÷ Total Loan Amount
What is the operating expense ratio (OER)?
The percentage of a property investment’s gross income allocated to pay off its operating expenses.
LOW = GOOD
OER = Total Operating Expenses ÷ EGI
What is the difference between a capital lease and operating lease?
Capital lease: functions like purchasing a long-term fixed asset, in which the accounting treatment “spreads” the recognition of the acquisition cost across its useful life.
Operating Lease: a rental agreement in which the right to use the leased asset is transferred to the lessee for a set period, and the lessee must return the property at the end of the lease term.
What is the difference between operating and non-operating expenses in real estate?
Operating expenses: the recurring costs that are part of the day-to-day core operations of the property itself (ex. property management fees, utilities, taxes, insurance, repairs and maintenance)
Non-operating expenses: capital expenditures (Capex), tenant improvements, leasing commissions (broker fee), mortgage payments
What is the equity multiple?
The ratio between the total cash distributions collected from a property and the initial equity contribution (ex. cash investment)
Equity multiple = 1.0 - break-even
Equity multiple < 1.0 - unfavorable
Equity multiple > 1.0 - favorable
What is the difference between levered IRR and unlevered IRR in real estate investing?
IRR: measures the % yield received on a property investment across a pre-defined period. Neglects effects of financing
Levered IRR: expected rate of return after factoring in the leverage used to fund the investment.
What is the difference between the going-in and terminal cap rate?
Going-in cap rate is pre-calculated on day of purchase, terminal is at exit year & final sale price.
The cap rate on the exit date can deviate substantially from the estimated terminal cap rate.
Going-in cap rate > Terminal cap rate is the most ideal
How does the interest rate environment impact property values?
Low interest rates: low cost of financing, increase in demand
High interest rates: high cost of financing, reduction in demand
If interest rates rise, the cost of borrowing increases, reducing the purchasing power of consumers and the affordability of properties.
What are the three common commercial lease structures?
Triple-Net (NNN) Lease: tenant is responsible for all property operating expenses on top of the base rent (taxes, maintenence, etc.) most common CRE
Full-Service Lease (FS): landlord pays all operating expenses of the property (usually higher base rent)
Modified Gross Lease (MG): mix of both, split responsibilities
What does the term “stabilization” refer to in property development?
Occupancy rate & Rent pricing are each on/around market occupancy & rate
What is a good debt service coverage ratio (DSCR) in commercial real estate?
DSCR measures the riskiness of a loan.
DSCR = NOI ÷ Annual Debt Service
= 1.0 - breakeven
< 1.0 - insufficient income
> 1.0 - sufficient income
Lenders prefer a higher DSCR because a greater margin of safety and affirms that the property generates enough income to handle the current debt burden without the risk of defaulting on the loan.
What is the net absorption rate?
Net absorption reflects the change in tenant demand relative to the supply available in the market.
Net Absorption = Total Space Leased – Vacated Space – Net Space
Higher net absorption rate: implies strong demand for CRE properties
Lower net absorption rate: indicates a surplus of available properties in the market.
What is the development spread used to determine?
The profitability that could potentially be earned on a real estate development project.
The greater the development spread, the more economically better a proposed development project likely is.
What is breakeven occupancy in commercial real estate?
The percentage of occupied units needed to cover its total costs, including fixed and variable costs.
Breakeven Occupancy Ratio (%) = (Total Operating Expenses + Debt Service) ÷ Potential Gross Income (PGI)
What are the step to calculate the unlevered free cash flow of a property?
The cash flow before deducting debt payments, such as interest or mortgage payments.
Unlevered Cash Flow = NOI – Capital Reserves – Capex – Tenant Improvements – Leasing Commissions
What are the step to calculate the levered cash flow of a property?
Reflects net cash flow (NCF) post-financing, contrary to the unlevered cash flow metric.
Levered Cash Flow = Unlevered Cash Flow – Debt Service
Debt service = annual mortgage pmt, interest expenses
