REAL ESTATE Flashcards
Give 5 reasons to invest in real estate
Current income Capital appreciation Inflation hedge Diversification Tax
Outline 11 main risks of real-estate investing
Business cycle Lead time (development) Cost (development) Availability of capital Unexpected inflation Demographics Liquidity Environmental Information Management Leverage
What are the three ways of valuing real estate
Cost
Income
Sales comparison
Outline the Cost approach for real estate valuation. When is it used? When is it not suitable?
It determines the upper limit of investment value
Total cost=land value + adjusted replacement cost - depreciation
Newer, Unique or specialised properties where comparable are difficult to find.
Not good for old or obsolescent properties
What is highest and best use for?
Highest and best use maximises implied value of land
Implied value of land = value of building - cost of building
What is the link between effective age and Incurable depreciation?
Incurable items increase the effective age
Explain curable deterioration. When is it deducted from replacement cost?
Where the cost of repair is fully reflected in building value
It is the first deduction
List the 2 steps and 5 adjustments in the third step for the cost approach to equity valuation
Step 1 - Estimate market value of the land
STEP 2 - Estimate building replacement cost
Step 3 - adjustments Curable Physical depreciation Incurable depreciation Functional obsolescence Location obsolescence Economic obsolescence
Outline sales comparison approach for real estate and 5 adjustment factors
Market SLAC
Comparable prices adjusted up or down for:
Market conditions Size Location Age Condition of property
NAME 3 methods for THE INCOME Approach to real estate valuation. Which income measures do they use
- The Gross Income Multipler method - this uses gross income
The two following methods use Net Operating Income (NOI) :
- Direct capitalisation approach
- DCF approach
Outline 7 line items to obtain NOI for real-estate valuation
Gross rental income
+ other income
= potential gross income (PGI)
- vacancy and collection losses
= effective gross income (EGI) - Opex
= Net Operating Income (NOI)
Which two expenses are not included in calculation of NOI for real-estate
Interest Cost
Income Tax
What is the effect on the Cap rate when value and income grow at the same rate? Why?
The Cap rate < Discount rate
Cap rate = Discount rate - Growth rate
As in Equity, if Dividends and earnings grow by the same rate, so does retained earnings (equity).
The growth in property value is the growth in equity.
What is the value of a property using capitalisation rate?
What component is forward looking?
Value=NOI(first year after purchase) / (cap rate)
Note Value is t=0, NOI is t=1
NOI is forward looking
Explain the gross income multiplier method.
What is the main disadvantage
GIM = (Sales value) / (Gross income)
It does not exicitly include vacancy rates and opex
1/(gross income multiplier) = (Gross income)/(Sales value)
This is similar to All Risks Yield = Rent/(Sales value)
What is the going in cap rate
It is the discount rate adjusted for growth used to capitalise the first year NOI
Going in cap rate = year 1 (Re-g)
Explain the terminal cap rate.
What is another name for it?
The terminal cap rate is the Cap rate used for the year after the property is expected to be sold
Residual cap rate
Compare going in cap rate with terminal cap rate
The terminal cap rate is usually higher than the going in cap rate because
- Growth rate declines over time
- Interest rate curves usually upward sloping
- Long term income streams are more risky
If growth and/or interest rate outlook is reversed terminal cap rate can be lower than going in cap rate
Outline the discounted cash flow method for real estate valuation.
The total return is the sum of
(a) capitalised first year income
+ (b) growth in income and value for remaining years
- NOI is projected for each year of the holding period
What is the equation for constant growth with the DCF method of real estate valuation.
What are three effects when NOI is constant.
Value = NOI / (r-g)
- Like GGM
If NOI is constant, g=0 - If g=0, value is perpetuity, V=NOI/r
- If g=0, Cap rate = r-0,
so cap rate = Discount rate
Give two other names for Terminal value in real-estate valuation
Outline the estimate of Terminal Value
- Reversion
- Resale
Terminal value is the capitalisation of future NOI (after sale) at a future cap rate
What does t= for NOI when calculating terminal value for a sale in year 4
What year is it discounted at?
NOI t=5
Discounted at year 4
What cap rate uses rent instead of NOI?
How is it calculated?
The ARY, “All Risks Yield”
ARY= Rent / (comparable sales price)
Give two other names for contract rent
- Passing rent
2. Term rent
Outline the “term and reversion” approach.
The contract rent value and reversion value are evaluated separately with different capitalisation rates
The term rent cap rate < reversion cap rate
Compare discount rates for contract and reversion
Discount rate for reversion will be higher than for contract rent because reversion is in the future and more risky
Describe the reversion cap rate
The reversion cap rate is derived from future estimates of comparable, fully let properties, discounted to present value
What is reversionary potential
The adjustment of contract rent upwards to market rent
What does t= for reversionary value
For term t=3
t =4 for ERV
Like Terminal value, ERV is discounted by t=3 to PV
Describe the layer approach
Two values:
- Value of contract rent as perpetuity, growth=0, Contract Cap rate = ARY
- Value of incremental rent after reviews, Incremental Cap rate> Contract cap rate
What is the equivalent yield for Term and Reversion and Layer methods
It is a single cap rate applied to the total cash flow that is equivalent to the individual cap rates applied to the two separate cash flows.
What are the 7 steps in DCF analysis for real-estate
Estimate:
- Future income for existing leases
- Probability of lease renewals, rental rates and costs
- OpEx: Fixed, variable (related to occupancy) or hybrid
- CapEx
- Vacancy absorption
- Resale value(reversion)
- Discount rate to determine PV of all future cashflows
Give three ways the Direct Capitalisation approve with DCF for real estate valuation
- Growth (expected) is implicit in cap rate but is explicit in DCF approach.
- DCF is more complex since it includes the complete pattern of NOI over the whole period e. g. Lease by lease analysis.
- DCF does not rely on comparable sales prices.
Give 5 common errors in the DCF approach to real-estate valuation
- Discount rate does not include all risks
- Income growth > expense growth
- Going-in cap rate is inconsistent with Terminal Cap Rate
- Atypical (unrepresentative) NOI is used for Terminal value calculation.
- Cyclical nature of real estate markets is not included.
Describe 10 due diligence areas in private equity real estate investment.
What risks are lowered?
Private debt and equity investors review:
- Lease and rental history
- OpEx
- Cash flow statements
- Environmental inspection
- Engineering / structural
- Ownership history
- Service & Maintenance agreements
- Property survey, boundaries, easements
- Compliance etc.
- Property taxes, insurance etc.
Unexpected legal and physical risks.
Give one example of an appraisal based index. How is it calculated?
NCREIF Property Index is:
value weighted,
includes quarterly appraisal data (not sales data) as follows:
1. Appraisal value (beg and end of quarter)
2. NOI
3. CapEx
4. Return (HPR, IRR) = (NOI - Capex + change in value) / beginning value of quarter
Give the two return components of an appraisal based index
- Income return = NOI/(beg market value)
2. Capital return = (change in market value - CapEx) /(beg market value)
Give three uses of appraisal based indices
- Compare performance with other asset classes
- Measure risk
- Benchmark portfolios
Give three disadvantages of appraisal based indices
- Appraisal lag - appraisal values lag transaction prices
- Appraisal lag smooths returns and under estimates volatility
- Appraisal lag artificially lowers correlation of returns with other asset classes leading to overweight in portfolio diversification construction
Outline a repeat sales index
- A transaction based index
- When a specific property is sold twice in a given period the change in value is a proxy for the market
- Regression allocates the price changes for each quarter
Outline a hedonic index
- Requires only one sale.
- Independent variables are included in the regression to account for different types of properties.
- Unexplained variation shows the change in market conditions
Compare transaction based indices v appraisal based indices
- Transaction based indices better than appraisal based.
2. However use of statistical processes (regression) can lead to noisy observations with random elements.
Outline 4 forms of real estate investment
Private equity (direct ownership)
Private debt (direct lending)
Publicly traded equity (indirect ownership)
Publicly traded debt (mortgage backed securities)
Give 8 characteristics of real estate investment
Heterogenous High unit value Active management High transaction costs Depreciation and desirability Cost and availability of debt capital Lack of liquidity Difficulty in determining price
Give 3 classifications of real estate
Residential
Non residential
Income producing
Name 4 types of commercial property
Office
Industrial
Retail
Multi-family
What drives the demand for office space
Employment, jobs
What drives the demand for industrial space
Overall economy
What drives demand for retail space
Consumer spending
What drives demand for multi-family
Population growth
What is the debt service coverage ratio
DSCR= (First Year NOI) / (debt service)
Debt service = interest plus principal
What is LTV
LTV=(Loan amount) /(appraisal value)
What is another name for the equity dividend rate? How is it calculated? What is the period?
Cash on cash return = (First year cash flow) / equity
Only the First One year period
What is leveraged IRR? How is it calculated?
IRR with Leverage includes cashflows over all years in the holding period.
The end of period sales proceeds are reduced by the mortgage balance.
Compare the cost, income and sales approach
Cost = value of land + adjusted replacement cost
Sales comparison = comparable properties are adjusted for differences with the subject property
Income approach = the present value of the future cash flows over the holding period
Compare the direct capitalisation and DCF methods
Direct capitalisation: a cap rate applied to first-year NOI, increase in growth is implicit in the Cap rate.
DCF: future cashflows, Capex and terminal value are projected and discounted back over the holding period. Growth rate of NOI is explicit.
Explain Leverage in real estate investment
Leveraged IRR. As long as investment return is greater than cost of debt capital.
Give two examples of publicly traded equity securities for real estate
Equity REIT’s
REOC’s
Give three examples of publicly traded debt securities in real estate
Mortgage REIT’s
Residential MBS
Commercial MBS
Give 7 advantages of investing in real estate through publicly traded securities
Liquidity - much higher than private investment
Lower minimum investment - fractional ownership, shares with smaller dollar values
Limited liability - unlike general partnership liability
Premium properties - access to prestigious high value properties
Active management - professional management, no investor management required
Investor protections - as for the rules for other publicly traded securities
Easier to achieve Diversification - through holdings in different property types and geographies
Give 3 advantages of investing in REITs
Exemption from tax
Predictable earning
High dividend yield
Give 7 disadvantages of investing in publicly traded real estate securities
Lower tax efficiency compared to direct ownership
Lack of control
Costs of operating a public corporate structure
Volatility due to market pricing
Limited growth potential of income
Forced equity issuance (REIT’s have low amount of retained earnings so have to issue equity to purchase new opportunities)
Structural conflicts of interest
Give 9 due diligence factors for REIT’s
Remaining lease
Inflation protection
Contract rents vs market rents
Costs of re-leasing
Tenant concentration
Tenant financials
Competition
Balance sheet
Management quality
Give 4 characteristics for Shopping/Retail REITs
Retail sales growth / job creation
Stable revenue stream
Dependant on consumer spending
Due diligence - sales & rental rates
Give 4 characteristics of office REITs
Job creation. Supply of new space vs demand
Long (5-25 year) lease terms
Changes in vacancy and rental rates
New space and its quality
Give the 10 characteristics of Residential REIT’s across the 4 classes
- Population growth and job creation
- Competition, inducements, regional economy, inflating operating costs
- Demographics, income trends. Age and appeal of properties.
- Costs of home ownership, rent controls
Give 14 factors of Health Care REITs
Population growth New supply vs demand Leases to health care providers are usually net leases Demographics Government funding Construction cycles Financial condition of operators Tenant litigation Operating trends Government funding Litigation settlements Insurance costs Competitors new facilities vs demand
Give 11 factors for Industrial REITs
Retail sales growth Population growth Less cyclical than other REITs 5-25 year net leases Slow change in income and value Shifts in composition of local and national industrial base and trade Trends in tenant requirements Obsolescence of existing space Need for new types of space Proximity to transportation Trends in local supply and demand
What are the main factors in Hotel REITs
Job creation Supply of new space vs demand Variable income Not protected by long-term leases Cyclical sector Exposed to business cycle Changes in business and leisure travel Exposure to travel disruptions Occupancy, room rates Operating Profit margins vs industry averages RevPAR Trends in forward bookings Maintenance expenditures New construction in local markets Financial leverage
Give 9 factors in Storage REITs
Population growth Job creation Space rented in gross leases Ease of market entry leads to oversupply Competition Trends in housing sales Demographic trends New business startup Seasonal demand trends
What is an UPREIT
Controlling interest (GP) in a partnership that
Owns and operates properties
Upreits are most common
What is a downreit
An ownership interest in more than one reit partnership
Give the 5 most important factors affecting the types of REITs
National GDP growth Job creation Retail sales growth Population growth New space supply vs demand
What is the difference between a gross lease and a net lease
Fill later
Describe NAVPS
Estimated cash NOI
÷ Assumed cash rate
= estimated value of operating real estate
+ other Tangible assets (cash, receivables, development land)
- debts and liabilities
= NAV
Describe FFO
A measure of continuing operating income
Adjusts reported earnings as follow:
FFO =
Accounting Net earning
+ Depreciation expense
- Gains (+losses) from property sales
= Funds From Operations (FFO)
Describe relative value approaches
Market based multiples:
- Price to FFO
- Price to AFFO
Describe 4 advantages if ROECs over REIT
- Free to invest in:
(a) any kind of real estate
(b) related activity - More resources can be used for development.
- Can retain more earnings for future opportunities.
- Increased leverage.
Describe characteristics of shopping center REITs
- Regional shopping malls -
(a) enclosed space,
(b) high priced goods,
(c) lease terms 3-10 years
(d) plus percentage of sales (participatory leases)
(e) anchor retailers - long term fixed rents or own - Community shopping centers -
(a) stores linked by open air walkways
(b) basic goods & services
(c) similar lease terms for all
(d) non participatory
(e) periodic increases
Describe Office REITs
- Usually multi-tenanted properties
- Tenants pay proportionate share of OpEx, communal costs and property tax
- Rental income is stable
- Can be supply demand mismatch over lifecycle
- Location, transportation, quality
Describe Industrial REITs
- Single or multi-tenant
- Warehouse, distribution, light manufacturing
- Less cyclical:
(a) longer lease terms
(b) shorter construction times
(c) build and pre-lease - Location and availability of transport
Describe multi-family residential REITs
- Rental apartments leased to individual tenancies
- Competition of supply
- Economic sensitivity, inflation, OpEx, maintenance
- Local demographics
- Government controls
- Energy costs
Describe Storage REITs
- Own and operate self-storage places
- Gross leases
- Typically monthly rents
- Low barriers to entry
- Risks excess supply
- Local demographics and seasonal trends
Describe Health Care REITs
- Nursing homes, assisted living, hospitals, medical and rehab
- Tax exemptions for leasing to health care providers
- Net leases
- Relatively less sensitive to economy
- Sensitive to Demographic changes
- Operating trends
- Government funding
- New constructions
Describe Hotel REITs
- Similar to healthcare REIT’s, cannot self operate and have tax advantages
- Rent is major part of a hotels operating cash flow, this part enjoys the tax related discount
- Exposed to business cycle and global macro trends
- Occupancy rates, location, trends, margins
- RevPAR - revenue per available room
Describe diversified REITs
- Own and operate more than one type of property
- Lower risk due to Diversification
- Management experience
- Property type
- Local market PRESENCE
Which type of REIT is most sensitive to Retail Sales Growth
- Shopping/Retail
2. Industrial
Which type of REIT is most sensitive to Job Creation
- Office
2. Hotel
Which type of REIT is most sensitive to Population Growth
- Residential
- Health care
- Storage
Which type of REIT is also sensitive to Job Creation
- Shopping / Retail
- Residential
- Storage
Which type of REIT is also sensitive to New Space Supply vs Demand(H2O)
- Health care
- Hotel
- Office
Which type of REIT is also sensitive to Population Growth
- Industrial
Which type of REIT has 5-25 year lease terms
- Office
2. Industrial
Describe NAVPS of a REIT
Market based values
- The per share excess value of the assets over liabilities.
- Based on current market values not book value.
- Difference between NAVPS and REIT.
How to use forecasted cash net operating income to estimate NAVPS
- Obtain NOI by adding G&A to REIT EBITDA
- Determine a cap rate
- Calculate property value
- Add other Tangible assets
- Subtract liabilities
= NAV REIT
NAVPS = NAV / (shares outstanding)
Describe Funds From Operations
- FFO Adjusts reported earnings.
- Measures continuing operating income.
Accounting Net Earnings
+ Depreciation & Amortization
- Gains from sales
+ Losses from sales
= Funds from Operations
(similar to CFO)
Describe Adjusted Funds from Operations
Extends FFO to represent current economic income
- Also known as cash available for distribution.
- Also known as funds available for distribution.
FFO (funds from Operations)
- Non cash (straight line) rent adjustment
- Recurring maintenance type Capex and leasing commissions
= AFFO (adjusted funds from Operations)
AFFO is considered a better measure of economic income than FFO because it consider CapEx
AFFO relies on estimates, considered more subjective than FFO
Name 3 ways to value REITs
- Net Asset Value
- Relative, Price to FFO, Price to AFFO
- DCF
Explain the private and public view of REIT NAV
Public price for NAV tends to be higher than value to private investors
REIT’s tend to trade at Premium to NAVPS
Value investors buy REIT at lowest price premium to NAV
Give 3 factors that impact Price to FFO and Price to AFFO
- Growth expectations
- Risks inherent in the underlying
- Risks related to firm Leverage and access to capital
Explain why DCF and DDM is appropriate for REITs
- REIT’s and REOCs pay dividends
- DCF and DDM used in the same way as for stock valuation
- Two or three stage DDM models
- For DCF use intermediate cash flows and forecast Terminal value
Give the value of a REIT share using DCF and DDM type model
Value of REIT share = PV (dividends for years 1 to n) + PV (Term Value n)
Describe AFFO
Adjusted Funds From Operations = FFO - Non-cash (straight line) rent adjustment - Recurring maintenance and commissions = AFFO (adjusted funds from Operations)
Describe Price to FFO to value NAV per share
- FFO per share = FUNDS FROM OPERATION ÷ Shares outstanding
- Obtain NAV per share from FFO per share using sector Price to FFO ratio
NAV per share = FFO per share x (sector multiple) Price to FFO
Describe how to obtain NAV per share from Price to AFFO
- AFFO per share =
[FUNDS FROM OPERATION
- Non cash rents
- Recurring MAINTENANCE]
÷ Shares outstanding
= AFFO per share
- Obtain NAV per share from AFFO per share using sector Price to AFFO ratio
NAV per share = AFFO per share x (sector multiple) Price to AFFO
Give 5 adjustments in the sales comparison approach to real estate valuation
Compare CLAMS
Condition Location Age Market regime Size
Give 4 items to include / exclude from Operating Expense in NOI calcs
Exclude Income TAX & finance:
- Finance costs
- Income tax
- Personal expenses
Include Property TAX
