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Applied Econometrics - AEF > Real Estate Finance > Flashcards

Real Estate Finance Flashcards

1
Q

Three purposes of valuation?

A

Transfer purpose –> M&A

Strategic purpose –> financing transactions, insurance, tax compliance

Economic feasibility –> feasibility analysis, purchase or leasing decisions, invest. Decis.

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2
Q

Difference between report date and valuation date?

A

• Report date; date on which the value signs the report

Valuation date; the date on which the opinion of value is based

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3
Q

Three most common definitions of market value

A

§ Appraisal institute
□ Most probable price of a specified date in cash, for which the property rights should sell after reasonable exposure in a competitive market

		§ RICS
			□ Estimated amount for which an asset should exchange on the valuation date between a wiling buyer and seller in an arm's length transaction

		§ TEGoVA Estimated amount which the property should exchange for on the date of valuation between … same as RICS
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4
Q

What is HBU?

A

Highest Best Use: any use of the property that is physically possible, financially sustainable, legally permitted, economically convenient, and which therefore allows the value itself to be maximized

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5
Q

What does HBU imply for market value of a property?

A

That it has a SINGLE market value

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6
Q

What is the key difference between investment value and market value?

A

Market value –> objective value

Investment value –> subjective value

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7
Q

What is physical senescence and functional obsolencence? and what do they depend on?

A

Both stemming from the aging of the building.

Physical senescence is the technical resistance, and the loss of value depends on maintenance –> that is, you CAN CONTROL the degree of physical senescence

Functional obsolescence is the efficiency in use, and the loss of value depends on market factors –> that is, you CANNOT CONTROL the degree
Functional obsolescence is the reduction of an object’s usefulness or desirability because of an outdated design feature that cannot be easily changed

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8
Q

What are the three types of risk/return profiles?

A

Core; income-producing properties

Value-added: existing properties with a potential value increase achievable with building refurbishment

Opportunistic; highest risk –> development projects and trading operations

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9
Q

The three economic classification of properties?

A

1) Residential

2) Commercial
- Non-flexible
- Flexible
- Trade-related

3) Land
- Greenfield
- Brownfield

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10
Q

What are the two main uses of space?

A 
Consumer good (residential properties)
Means of production (commerical properties)
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11
Q

What type of land category is more risky? Greenfield or Brownfield?

A

Brownfield, due to uncertainties around demolition and decontamination cost

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12
Q

Is land a safe or a risky investment?

A

Highly risky; very volatile value.

Can be seen as a call option, where the underlying asset is the value of the property, with the exercise price being the cost of construction. The lower the cost of construction, the more value the land has

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13
Q

How many properties do you need in your portfolio to eliminate 30% of specific risk?

A

Around five.

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14
Q

When is minimal reduction of risk achieved? and what is the minimum?

A

Achieved above 30 properties.

There remain around 60% risk of a non-diversified portfolio

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15
Q

Classifications of property locations?

A

Residential (central, semi-central, peripheral)

Office sector (CBD, sem-centre, peripehry/hinterland)

Retail sector (High-street, premium, mainstream)

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16
Q

What characteristics must be followed to achieve comparability when applying sales comparison approahces?

A

1) reliability (high)
2) uniformity (high)
3) specificity (high)
4) recentness (recent/comparable)

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17
Q

The three traditional market approaches to valuation?

A

1) Direct sales comparison
2) Hedonic pricing model
3) Multipliers and rules of thumb

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18
Q

The two traditional cost based valuation approaches?

A

1) replacement cost approach
2) reproduction cost approach

DO NOT CONFUSE THESE; Reproduction; is the cost of an EXACY copy, replacement is the cost of a building with similar functionality

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19
Q

The two traditional income valuation approaches?

A

1) Direct capitalization approach

2) DCF

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20
Q

What are the two limitations to traditional valuation methods?

A

1) Cost approach is VERY limited in applicability and does not return market value, but rather a MAX price
2) Both the market approach and the income approach are based on market data, so both should be comparative, with the difference only being the subject of comparison

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21
Q

What are the two NEW valuation approaches and sub-approaches?

A

1) Sales comparison approahces
- Direct comparison approach
- Hedonic pricing model

2) Income capitalization comparison methods
- Direct capitalization approach
- DCF

** Multiples not included because they are quick and dirty, and do not have any theoretical right..

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22
Q

What are the intralease, interlease and blended lease discount rates?

A

All three used when determining the discount rate in a DCF analysis:

Intralease; used when a certain lease is in place

Interlease; used when a lease is NOT in place

Blended; weighted average, used when risk differential is not explicit

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23
Q

What is the difference between non-recourse and limited recourse loans?

A

Non-recourse: When collateral is sold, bank cannot take more from client

Limited recourse: Bank can take more from borrower, to cover the loan, after the collateral is sold

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24
Q

What kind of guarantees can the bank take on a loan?

A

Real; pledge on SPV shares AND mortgage on property

Contractual; assignment of recievables as collateral, contractual covenants

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25
Q

Types of bank loan contractual forms?

A

Bank account overdraft facilities –> flexible form, which makes it possible to switch between withdrawals and repayments

Fixed maturity loans –> fixed or variable interest

Most common type: REVOLVING SECURED CREDIT LINE
- The most flexible form of financing for real estate

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26
Q

What does OMV and MLV stand for? what are the main differences?

A

OMV = Open Market Value
- Value between independent buyer and seller after proper marketing

MLV = Mortgage Lending Value
- Value based on prudent assessment of future marketability taking into account LONG-TERM sustainability aspects –> no speculation

Usually MLV < OMV, because depreciation is taken into account in MLV

OMV is internationally recognized as the go-to approach

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27
Q

In terms of loan agreements, what legal system will typically have the most specified contracts, and which will have the least?

A

Common law; EVERYTHING is regulated

Civil law: contracts are more concise, and statutory laws govern the contract

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28
Q

What three variables determine the amount of loan granted?

A
  • The project and the costs associated with construction of that project
  • The collateral provided
  • The creditworthiness of the borrower
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29
Q

What kind of rates are included in the loan agreement?

A

Standard rate: (base rate + margin)

Default rate: (overdue rate)

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30
Q

Three ways of hedging a floating interest rate?

A

1) interest rate cap
2) collar
3) IRS –> interest rate swap

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31
Q

What is a swaption?

A

Opportunity to ababdon an IRS agreement

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32
Q

What is the difference bewteen a bullet and a semi-bullet repayment schedule?

A

Semi-bullet have an interest-only period (just like bullet), but then it will have a period with BOTH interest and repayment. Where bullet is full repayment at termination.

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33
Q

What are the two main types of covenants, and their sub-divisions?

A

Balance sheet covenants and Financial covenants

They can be negative –> DO NOT take on more debt e.g.

They can be positive –> MAINTAIN D/E below 50%

34
Q

How does a negative amortizing constant payment schedule work?

A

You pay interest below the level that you should. The difference of interest then accrues to the principal, implying that residual debt EOP will be larger than the principal.

Save some interest, which accrues to a larger principal

35
Q

What is a declining payment loan with fixed amortization?

A

Amortization is first found to be fixed, then the interest component is calculated, and it will decrease, as you bring down the amount of residual debt

36
Q

What is the formula for the levered equity return?

A

(Unlevered return - cost of debt * loan to value) / (1 - LTV)

37
Q

Due to the MM theorem, we assume no failure costs in investments, there is no correlation between the LOAN and the Total Return. Then what is the volatility of levered equity?

A

Volatility of lev equity = Vol. of unlev. equity / (1 - LTV)

38
Q

What is positive and negative leverage?

A

Positive leverage: Impact of leverage is beneficial when the return on non-debt-funded investment (unlevered) exceeds the cost of debt financing

Negative leverage: when cost of debt exceeds the unlevered return, there is negative leverage

Therefore, ONLY the spread will determine if we have positive or negative effects

39
Q

What is the return on equity a function of?

A

X-axis: leverage ratio (LTV)

Y-axis: Levered equity return

Curve is convex

40
Q

What is characterizes the effect from leverage on risk?

A

More than proportional –> convex relationship between leverage and risk

41
Q

Is the relationship between return and risk constant?

A

YES, it is expected to be constant, the risk-premium remains constant (the slope of the curve) when combining different levels of risk and return

42
Q

How do we find the risk premium?

A

(expected return - risk-free rate) / volatility

43
Q

What are the main merits of mezzanine financing?

A
  • Very flexible between debt and equity like features

- You can increase leverage, without changing the level of financial risk for senior lenders

44
Q

Is mezzanine more expensive than debt financing?

A

Yes, because it ranks lower than senior debt. Also, it has to be lower than equity. So in between the two returns

45
Q

What are the two cost components of mezzanine financing?

A

Equity kicker; makes it possible to benefit from any increase in the OMV of the VC

Subordinate debt; comes in the form of a bank loan, with interest 400-600 bps above market rate

46
Q

What are the most common debt forms within mezzaning financing?

A

Zero-coupon; No interest pmts, but issues at lower than face value

Stepped interest; interest payments increase over time

Roll-up; Large interest payments at first, then lower

Payment in kind (PIK): Compounding the interest into the principal, and repays only at maturity

47
Q

Most common equity kickers?

A

Warrants
Call options (on the shares)
Preferred shares (convertible to normal shares)
Back-end fees (paid when debt is repaid in full)

48
Q

What is a waterfall payout agreement?

A

Predefined plan of payments, to shift downside risk away from equity investors, and provide greater upside potential return for the developer

Mechanics;

  1. If IRR is lower than expected –> more to the equity investors
  2. If IRR is higher than expected –> more to the developer
49
Q

What is an intercreditor agreement?

A

Regulation of creditors’ claims and reduction of risk by defining the security ranking under ordniary conditions and in the case of default

50
Q

What are the three pillars of Basel II?

A
  1. Minimum capital requirements (8%)
  2. Supervisory review of capital adequacy
  3. Public disclosure
51
Q

What was changed in the first pillar from Basel I to Basel II?

A

Minimum capital requirement was the same = 8%, based on a capital ratio = Capital availble / risk weighted assets.

The change was in the risk component; now consisting of CREDIT risk and MARKET risk

52
Q

What are the three methods for calculating credit risk?

A
  1. standardized approach
  2. IRB foundation
  3. IRB advanced
53
Q

What did Basel III introduce in terms of pillar 1?

A

Banks have to hold 4.5% of common equity

Banks have to hold 6% of TIER I capital of risk weighted assets (up from 4% in Basel II)

54
Q

What capital buffers did Basel III introduce?

A

Mandatory conservation buffer of 2.5%

Discretionary countercyclical buffer of up to 2.5%

55
Q

What did Basel III introduce in regards to leverage ratio?

A

Minimum of 3% leverage ratio

Two required liquidity ratios:

  1. Liquidity converage ratio; need to hold high-liquid assets to cover 30-days of cash flows
  2. Net stable funding ratio; Amount of available stable funding has to exceed the required amount of stable funding over a one-year period of extended stress
56
Q

What was a main implication of the Basel accords for real estate financing?

A

Banks need more equity to finance loans, therefore, shareholders had to invest additional equity into the loans made to clients –> a clear cost for bank shareholders

57
Q

How does the standardized method of assessing credit risk work?

A
  1. split their credit exposures into supervisory categories based on observable characteristics
  2. Establish fixed-risk weights for each category
  3. Make use of EXTERNAL credit assessments to enhance risk sensitivity compared to the previous acoord (Basel II)
58
Q

What does a bank do, if there are no external risk ratings, when they use the standardized method of assessing credit risk?

A

Most cases; 100% risk weighting implying 8% capital requirement (also on commercial property lending)

On FULLY secured mortgages on RESIDENTIAL property, the weight will be 35%

59
Q

Benefits and costs of using the standardized approach of credit risk assessment?

A

Benefits;

  • It is cheap
  • Based on external sources, decrease the amount of internal work needed to install this

Costs;

  • Not detailed enough –> not bank/client relationships assessed
  • Requires the bank to hold A LOT of money, since it is not the optimal way to assess risk
60
Q

What is the main difference between Standard. and IRB approaches for credit risk assessment?

A

IRB uses internal assessments for estimating the risk-weightings

61
Q

When can an IRB scheme be authorized?

A

Only, when it constitutes a CRUCIAL role on daily risk-management

62
Q

What are the four formulas that Basel requires for this risk assessment in IRB?

A
  1. Probability of default (PD)
  2. Loss given default (LGD) –> most flexible parameter
  3. Exposure at default (EAD)
  4. Maturity (M)
63
Q

What credit risk assessment method is better for real estate financing?

A

IRB! since it allows banks to hold less capital by making an in depth analysis of each client (which is more viable because you will have fewer, larger clients)

64
Q

Which valuation method is recommended for Residential properties?

A

Sales comparison approach, since it is easy to obtain data from the sales market, compared to the rental market

65
Q

Overall, which valuation approach is recommended for commercial properties?

A

In general, income capitalization comparison. However sales comparison can also be used, when properties are very homogeneous, and owner and user is NOT separated

66
Q

What valuation method is best for non-flexible commercial properties?

A

No method is good, because it is hard to find information about the sale price om similar assets, as there are very few comparables –> there is basically no space nor investment market to look into

–> could use depreciated cost method as an exception

67
Q

What valuation method is best for flexible commercial properties?

A

Very hard to compare across physical features, and therefore, sales prices obtained through the space market IS NOT a good method. But obtaining yields and rents through the investment market is easier. Thus:

–> INCOME and YIELD approaches are typically recommended

68
Q

What valuation method is best for trade-related properties?

A

Direct comparison could potentially be used, because you can standardize price into $/m2 or $/room (as for residential properties) BUT BEWARE, maybe $/m2 in hotels differ a LOT, and could therefore not be viable. Think about also where the hotel is located/opening hours etc.

69
Q

What valuation methods are viable for land and brownfield valuation?

A

Sales comparable approach (ONLY when comparables exist, but not likely)

Income capitalization approach or multiple period residual value approach (DCF for demolition and reproduction/replacement)

70
Q

When is the direct comparison approach useful?

A

When the value of the property is NOT driven by its income potential

Useful for valuing standard and uniform properties –> residential e.g.

Useful when there is not separated ownership and user (ie. when there does not exist BOTH an investment and a space market)

71
Q

What is the honeycomb cycle?

A

The fact that buyers and seller react sharply to changes in market conditions. In expansions this leads to trading volumes of properties to increase much more than prices, and vice versa, when the market contracts (prices will decrease less than volume).

72
Q

What are the three different loan approaches adopted, when providing financial resources to a project? And how does each of these risk profiles differ?

A

Corporate Finance approach (focusing on the loans disbursed to a party)
- Risk profile; Assessment of the corporate situation to determine which guarantee is needed for the lender

Asset-based approach (leding directly associated with a specific asset)
- Risk profile; Based on the collateral value of the guarantee

Cash-flow based approach (loans are disbursed to a specific project)
- Risk profile; Quality and volatility of cash-flows will be paramount

NOTE; CF approach is mostly used for VERY large real estate funds

73
Q

How does a lender go around assessing the creditworthiness of the borrower in a CF-approach and a project finance approach?

A

CF-approach: Lenders will assess the economic and financial equilibrium of the company, which intends to carry out the investment, based on company accounts/performance

Proj.-Fin approach: assessment concerns the economic and financial equilibrium of the PROJECT to be financed. This is separated in a SPV legally and thereby ring-fencing it to protect the sponsorss core business

74
Q

What does it mean to securitize a loan?

A

Banks fund-raising loans by pooling loans together as a security, which can then be traded on the market

75
Q

What are the two traditional fund-raising systems? and how are they characterized? Can banks choose between them?

A

German system: close relationship between the fund raising activity and the lending activity, reserved to SPECIALIST banks in certain countries

French system: separation between the fund raising activity and the lending activity

Banks are free to choose either one, or a mix, or a different approach –> HOWEVER, banks MUST address the risks associated with fund-raising, which are the mismatch between asset and liability maturities e.g.

76
Q

Under the two different fund-raising systems, how do banks usually raise the funds?

A

German system; Funds are secured on an AD HOC BASIS using COVERED BONDS

French system; Use the interbank market

  • The “price”/”interest” they can raise fund to will therefore depend on their credit rating.
  • Thus, banks with better credit ratings, will provide better terms for borrowers
77
Q

What is the difference between raising capital through covered bonds versus securitization?

A

Covered bonds guarantee a return on capital and interest since part of the bank’s assets are burdened, and are earmarked exclusively for the repayment of these bonds

For the bank issuing the covered bond is that the bank CANNOT remove the bond from their balance sheet (as can be done with securitization). –> therefore, the bank will continue to bear the interest

78
Q

What are the differences between normal and covered bonds?

A
  • Covered bonds offer greater security and therefore liquidity
  • Thus, lower returns and higher ratings
79
Q

What is a bridge loan?

A

Short-term loan facility put in place until the long-term financing is secured, which is often necessary in syndication processes

80
Q

What are the three categories of property investment operations?

A
  1. Development projects (high risk)
  2. Income-producing properties (low risk)
  3. Trading operations (variable risk)
81
Q

Within development projects, what are the three risk components?

A
  1. Zoning risk; The more the initial intended use of the property differs from the target use, the greater the risk
  2. Industrial risk; Risks inherent to the construction activity (raw materials price, cost of labor etc.)
  3. Market risk; Risk stemming from mismatches between budgets and actual results
82
Q

On which two levels do you determine the flexibility of a commercial property?

A
  1. Building –> Is the building built for a specific user (production e.g.)
  2. Use –> Can many people use the space?, even a flexible building can be use-inflexible, if no users occupy the property

Applied Econometrics - AEF (5 decks)

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