Real Estate Equity Investments

Question 1

1. What is the complement option type to financial options?

Answer 1

• A real option. A real option is an option on a real asset rather than a financial security. The real option may be a call option to purchase a real asset, a put option to sell a real asset, or an exchange option involving exchange of nonfinancial assets.

Question 2

2. What is the name of the point in a decision tree at which new information arrives?

Answer 2

• An information node denotes a point in a decision tree at which new information arrives.

Question 3

3. List the two major approaches to valuing private commercial real estate equity.

Answer 3

• The income approach and valuations based on comparable sale prices

Question 4

4. Define effective gross income.

Answer 4

• The effective gross income is the potential gross income reduced for the vacancy loss rate.

Question 5

5. How does the numerator of a pretax discounting approach differ from the numerator of an after-tax discounting approach?

Answer 5

• In the pretax discounting approach, pre-tax cash flows are used in the numerator. In the after-tax discounting approach the estimated after-tax cash flows are used in the numerator.

Question 6

6. How does the equity residual approach to real estate valuation differ from a discounted cash flow approach applied to the assets of a real estate project?

Answer 6

• The equity residual approach focuses on the perspective of the equity investor by subtracting the interest expense and other financing outflows due to mortgage holders (in the numerators) and by discounting the remaining cash flows using an interest rate reflective of the required rate of return on the equity of a leveraged real estate investment (in the denominator). The discounted cash flow approach discounts all cash flows from assets using a rate commensurate with the risk of the assets, not the equity.

Question 7

7. What are the characteristics that distinguish syndications from other real estate investment vehicles?

Answer 7

• Syndications are formed by a group of investors

* Syndications are usually formed to undertake a particular real estate project.

Question 8

8. A real estate project is estimated to offer a 10% after-tax rate of return when the depreciation allowed for tax purposes is equal to the true economic depreciation. In what direction would the expected rate of return change if the depreciation allowed for tax purposes were accelerated relative to the true economic depreciation, and why?

Answer 8

• When depreciation for tax accounting purposes is accelerated in time relative to true economic depreciation, the after-tax return generally increases and exceeds the pretax return reduced by the stated income tax rate.

Question 9

9. What is the effect of using appraised prices of real estate values to estimate risk when the appraisals are based on lagged information (of varying lengths of time lag)?

Answer 9

• In the case of real estate returns, if appraisals are used in place of true market values, and if the appraisals provide dampened price changes, then the resulting return series consistently underestimates the volatility of the true return series, as well as understates the correlation of the returns of the real estate to the returns of other assets in the investor’s portfolio.

Question 10

10. What data (i.e., information) are required to construct a hedonic price index for real estate?

Answer 10

• Hedonic approaches use prices from real estate transactions along with the characteristics (e.g., size, location, construction) of those properties to attribute price changes to property characteristics.

Question 11

after-tax discounting approach

Answer 11

the estimated after-tax
cash flows (e.g., after-tax bond payments) are discounted using
a rate that has been reduced to reflect the net rate received by
an investor with a specified marginal tax rate.

Question 12

appraisals

Answer 12

are professional opinions with regard to the value

of an asset, such as a real estate property.

Question 13

backward induction

Answer 13

is the process of solving a decision tree
by working from the final nodes toward the first node, based
on valuation analysis at each node.

Question 14

closed-end real estate mutual fund

Answer 14

is an investment pool
that has real estate as its underlying asset and a relatively
fixed number of outstanding shares.

Question 15

commingled real estate funds (CREFs)

Answer 15

are a type of private
equity real estate fund that is a pool of investment capital
raised from private placements that are commingled to
purchase commercial properties.

Question 16

comparable sale prices approach

Answer 16

values real estate based
on transaction values of similar real estate, with adjustments
made for differences in characteristics.

Question 17

data smoothing

Answer 17

occurs in a return series when the prices
used in computing the return series have been dampened
relative to the volatility of the true but unobservable underlying
prices.

Question 18

decision node

Answer 18

is a point in a decision tree at which the

holder of the option must make a decision.

Question 19

decision tree

Answer 19

shows the various pathways that a decision
maker can select as well as the points at which uncertainty is
resolved.

Question 20

depreciation

Answer 20

is a noncash expense that is deducted from
revenues in computing accounting income to indicate the
decline of an asset’s value.

Question 21

depreciation tax shield

Answer 21

is a taxable entity’s ability to reduce
taxes by deducting depreciation in the computation of taxable
income.

Question 22

discounted cash flow (DCF) method

Answer 22

The income approach when cash flows are discounted rather

than accounting estimates of income.

Question 23

effective gross income

Answer 23

is the potential gross income

reduced for the vacancy loss rate.

Question 24

effective tax rate

Answer 24

is the actual reduction in value that
occurs in practice when other aspects of taxation are included
in the analysis, such as exemptions, penalties, and timing of
cash flows.

Question 25

equity residual approach

Answer 25

focuses on the perspective of the equity investor
by subtracting the interest expense and other cash outflows
due to mortgage holders (in the numerator) and by
discounting the remaining cash flows using an interest rate
reflective of the required rate of return on the equity of a
leveraged real estate investment (in the denominator).

Question 26

exchange-traded funds (ETFs)

Answer 26

represent a tradable
investment vehicle that tracks a particular index or portfolio
by holding its constituent assets or a subsample of them.

Question 27

fixed expenses

Answer 27

examples of which are property taxes and
property insurance, do not change directly with the level of
occupancy of the property.

Question 28

FTSE NAREIT US Real Estate Index Series

Answer 28

is a family
of REIT-based performance indices that covers the different
sectors of the U.S. commercial real estate space.

Question 29

gearing

Answer 29

is the use of leverage

Question 30

hedonic price index

Answer 30

estimates value changes based on an
analysis of observed transaction prices that have been
adjusted to reflect the differing characteristics of the assets
underlying each transaction.

Question 31

income approach

Answer 31

values real estate by projecting
expected income or cash flows, discounting for time and risk,
and summing them to form the total value.

Question 32

NCREIF Property Index (NPI)

Answer 32

is the primary example
of an appraisal-based real estate index in the United States and
is published by the National Council of Real Estate
Investment Fiduciaries (NCREIF), a not-for-profit industry
association that collects data regarding property values from
its members.

Question 33

net lease

Answer 33

the tenant is responsible for almost all of the

operating expenses.

Question 34

Net Operating Income (NOI)

Answer 34

is a measure of periodic earnings
that is calculated as the property’s rental income minus all
expenses associated with maintaining and operating the
property.

Question 35

Net Sale Proceeds (NSP)

Answer 35

is the expected selling price
minus any expected selling expenses arising from the sale
of the property at time T.

Question 36

Open-end real estate mutual funds

Answer 36

are public investments
that offer a non-exchange traded means of obtaining access to
the private real estate market.

Question 37

Operating expenses

Answer 37

are non-capital outlays that support

rental of the property and can be classified as fixed or variable.

Question 38

potential gross income

Answer 38

is the gross income that could
potentially be received if all offices in the building were
occupied.

Question 39

pre-tax discounting approach

Answer 39

is commonly used in
finance, where pre-tax cash flows are used in the numerator of
the present value analysis (as the cash flows to be received),
and the pre-tax discount rate is used in the denominator.

Question 40

private equity real estate funds

Answer 40

are privately organized funds
that are similar to other alternative investment funds, such as
private equity funds and hedge funds, yet have real estate as
their underlying asset.

Question 41

profit approach

Answer 41

to real estate valuation is typically used
for properties with a value driven by the actual business use of
the premises; it is effectively a valuation of the business rather
than a valuation of the property itself.

Question 42

real estate development projects

Answer 42

can include one or more
stages of creating or improving a real estate project,
including the acquisition of raw land, the construction of
improvements, and the renovation of existing facilities.

Question 43

real estate joint ventures

Answer 43

are private equity real estate funds
that consist of the combination of two or more parties,
typically represented by a small number of individual or
institutional investors, embarking on a business enterprise
such as the development of real estate properties.

Question 44

real estate valuation

Answer 44

is the process of estimating the market
value of a property and should be reflective of the price at
which informed investors would be willing to both buy and
sell that property.

Question 45

real option

Answer 45

is an option on a real asset rather than a

financial security.

Question 46

risk premium approach

Answer 46

to estimation of a discount rate
for an investment uses the sum of a riskless interest rate and
one or more expected rewards—expressed as rates—for
bearing the risks of the investment.

Question 47

stale pricing

Answer 47

The use of prices that lag changes in true market prices

Question 48

syndication

Answer 48

are private equity real estate funds formed by a
group of investors who retain a real estate expert with the
intention of undertaking a particular real estate project.

Question 49

vacancy loss rate

Answer 49

is the observed or anticipated rate at
which potential gross income is reduced for space that is not
generating rental income.

Question 50

variable expenses

Answer 50

examples of which are maintenance,
repairs, utilities, garbage removal, and supplies, change as
the level of occupancy of the property varies.