Real Estate Investment

Question 1

Risk considerations

Answer 1

stability of expected cash flows from properties
- is interest rate going to be increased?
- is there any probability that major tenants move out?
- are regional industries doing well?

Question 2

Liquidity considerations

Answer 2

Whether target property lies in thin or thick market
- does this property have enough potential buyers? (Thick e.g. office)
- is this property specialised? (Thin e.g. hospital)
- no worries if target is REITs

Question 3

Investment time horizon

Answer 3

• how long do we plan to hold? (Private equity tend to have an exit period whereas REITs do not)
• is it time to sell or buy?

Question 4

Investor expertise and management burden

Answer 4

• are we familiar with this property sector enough?
• how many tenants do we have to manage?

Question 5

Capital constraint

Answer 5

• can we afford to buy this property?
• can we arrange institutional investors to buy this property? (Private equity funds)
• can we attract public sufficiently to buy this property? (Public equity or REITs)
• how much can we borrow using this property as collateral?

Question 6

Direct capitalisation (ratio valuation)

Answer 6

Value = current net operating income (upcoming year NOI) / current market cap rate (yield)

Question 7

Discounted cash flow (DCF)

Answer 7

• Valuation purely depends on future expected net cash flow
• DCF allows investors to focus on fundamentals (income potential) rather than market momentum driven by bubble or burst regimes

Question 8

Required rate of return

Answer 8

• The minimum return for investment, as compensation for a given level of risk

Required rate of return = risk free rate + risk premium

Question 9

CAPM formula

Answer 9

required rate of return = risk free rate + beta*(market risk - risk free rate)

Question 10

Risk free rate

Answer 10

the theoretical rate of return of an investment with zero risk e.g. US T-Bill

Question 11

Risk premium

Answer 11

Return an asset is expected to provide as a form of compensation for investors

Question 12

DCF Cautions

Answer 12

• don’t completely trust the number in DCF
• rental income growth could be set too high
• capital improvement expenditure or terminal cap rate could be set too low

Question 13

NPV Discount rate and rules

Answer 13

Discount rate = investors required rate of return

Rule:
- don’t choose an investment with NPV < 0
- maximise the NPV across all mutually exclusive alternative investments

Question 14

Buyer NPV

Answer 14

NPV = [discounted future cash flow + current property value] - [buying price]

Question 15

Seller NPV

Answer 15

NPV = [selling price] - [discounted future cash flow + current property value]

Question 16

Internal rate of return (IRR) and rule

Answer 16

Discount rate at which NPV is 0

Never invest in an asset with IRR < required rate of return

Question 17

Fixed cost

Answer 17

Does not vary with occupancy level
- property tax
- hazard insurance
- property security
- property management

Question 18

Variable cost

Answer 18

Vary with occupancy level
- utility fees (electricity, water etc.)
- maintenance & routine repairs (light bulb, broken doors etc.)