QFIA 112 - CREA Advanced Micro-Level Valuation

Question 1

How commercial real estate differs from typical securities

Answer 1

1. A well-functioning market exists for the underlying physical asset (i.e. commercial buildings)
2. Not as informationally efficient
3. Two markets exist – private real estate and public REIT shares

Question 2

Additional Defininition of market value (MV) and investment value (IV)

Answer 2

• Market value (MV) is the expected price of an asset in the current property market
  
  • The actual price would only be known if the property was sold
  • What you can sell the asset for today
• The investment value (IV) is the value of the property to a particular owner that plans to hold it for a long time
  
  • The IV for the same property could vary by owner
  • private or subjective valuation of a party

Question 3

How is real estate investing similar to capital budgeting?

Answer 3

• because making long-term commitments
• Investment value is the only method used for capital budgeting because there is no market for the underlying assets

Question 4

State NPV in terms of IV and MV from the perspective of a buyer.

Answer 4

NPV = IV - MV

Question 5

State NPV in terms of IV and MV from the perspective of a seller.

Answer 5

NPV = MV - IV

Question 6

How to Measure Investment Value for an property?

Answer 6

• Can only calculate investment value by projecting net cash flows
• Must reflect how the owner would operate the property and the tax situation of the owner
• Discount rates should reflect the opportunity cost of capital (OCC) and be consistent with the capital market.

Question 7

Compare marginal and intramarginal investors

Answer 7

Question 8

Second-Most-Motivated-Buyer Notion

Answer 8

• A notion often used to help conceive of MV in real estate practice
  
  • In this method, the maximum price the second-most-motivated buyer would be willing to pay (the IV of this buyer) is taken to be the MV of the property
  • The most-motivated buyer is the one with the highest IV for the property
• If there is a big difference between the IV of the most-motivated and second-most-motivated buyers, then the property may sell for more than its MV

Question 9

Two Key Guideline in real esate markets

Answer 9

• Avoid paying more than MV, even when IV > MV
• Avoid selling for less than MV, even when IV < MV

Question 10

Two aspects of informational inefficiency

Answer 10

• Random noise
  
  • Difficult to know the precise value of any given real estate asset because properties are unique and traded infrequently
  • Better Information
  • Better Negotiation
  • Pressure to close deal
  • Due diligence
• Inertia/predictability
  
  • Even though the real estate market is somewhat inefficient, it is not fully predictable
    
    • CRE has lower market ineffeciencies that REITs
  • Transaction cost
  • Investment returns over long periods of time are very dependent on how well the property is managed
  • The randomness of transaction noise at the individual property level can overwhelm any effects of market timing
  • Informational inefficiency implies that asset prices move more slowly in response to the arrival of news

Question 11

Valutaion of REIT NAV and Share Price

Answer 11

• NAV: Based on the existing properties while
• Share prices: consider future growth opportunities
• When REIT share prices exceed the NAV, the market is counting on growth

Question 12

State what REIT stands for and provide a definition

Answer 12

REIT = Real Estate Investment Trust
Simple definition: A company owning income-producing real estate

Question 13

Valuation differences between the REIT and private property asset markets

Answer 13

• could be due to differences in
  
  • future cash flow expectations, or
  • the opportunity cost of capital

Question 14

How could REIT enhance cash flows causing valuation differences with private property asset markets

Answer 14

• The REIT could enhance cash flow through better property management skills or economies of scale;
• Owning a particular property could enhance the cash flows of other properties

Question 15

Key points regarding Opportunity Cost of Capital in individual property valuation

Answer 15

1. Derives essentially from the capital markets
2. The risk premium is based on the risk in the future cash flows, not the investor’s risk
3. Capital markets can respond quickly to perceived differentials in expected risk-adjusted returns

• The above forces limit differentials in OCC between the two markets

Question 16

Micro-Level Risk Is in the Property, not in the REIT

Answer 16

• Two REITs may have a different average cost of capital, but that does not mean they would use a different OCC for the same property
• Should focus on marginal cost of capital for the REIT rather than average cost of capital
• Risk resides in the asset, not the investor

Question 17

State five differences between REIT’s and Property Market

Answer 17

1. Liquidity - usually higher with REIT’s
2. Short-term volatility - usually higher with REIT’s
3. Informational efficiency - REIT’s tend to respond more quickly to new information
4. Valuation
5. Different investor populations, and therefore tax considerations as well