Week 6

Question 1

What is institutional property?

Answer 1

Institutional property is typically commercial and differentiated by grade and type. The three main types are office, retail and industrial

Question 2

What must be considered when choosing a property investment?

Answer 2

1) Location (most important)
2) Forecast level of new supply
3) Quality of tenants (public sector vs top-end private)
4) Weighted Average Lease Expiry (how long left in the lease)
5) Is it need of refurbishment
6) Zoning arrangements (e.g. dual residential/commercial)
7) Transport

Question 3

Define the following:

1) Outgoings
2) Gross rent
3) Net rent

Answer 3

1) Outgoings are property rates, insurance, repairs and maintenance (ongoing costs associated with property)
2) Rent where the landlord pays outgoings and tenant pays a higher rent
3) Rent where the tenant pays outgoings and tenant pays a lower rent

Question 4

Define the following:

1) Leasing incentive
2) Effective rent
3) Passing rent

Answer 4

1) Leasing incentive is a benefit, usually confidential, offered to a new tenant (e.g. four months rent free)
2) Effective rent is face rent (net rent) less incentives
3) Passing rent is a term used to distinguish from market rent where current rent is above/below market

Question 5

Define the following:

1) Retail lease
2) Occupancy cost
3) Vacancy rate
4) Occupancy cost ratio

Answer 5

1) Base rent plus a % turnover beyond a breakeven point
2) Total cost incurred by tenant to provide for occupancy (including net rent, outgoings, capital costs and depreciation)
3) Vacancy rate is the proportion of empty but occupiable space. A low rate (1%-3%) indicates a higher rent is likely, while a low rate (10%) indicates a lower rent is likely
4) Occupancy cost ratio is occupancy cost over gross turnover

Question 6

Define the following terms related to REITS:

1) REITS
2) Net Income
3) Funds from Operations (FFO)
4) Adjusted FFO

Answer 6

1) Real Estate Investment Trusts
2) Net Income = Rent - management/operating costs - depreciation of capital improvements - amortisation of lease incentives - interest (Note: No Tax)
3) FFO = Net Income + Depreciation + Amortisation
4) AFFO = FFO - Current capex - current lease incentives

Question 7

With respect to what function are properties valued?

Answer 7

Properties are valued according to their highest and best use which may be different to current function

Question 8

What are the three main methods of property valuation?

Answer 8

1) Comparison to similar (but not identical) building
2) Summation, land value + cost of improvements
3) Capitalisation of net income, net income divided by cap rate. This can be adjusted up as an allowance for artificially high net income

Question 9

What are five key historical observations of property performance?

Answer 9

1) Bond rates have fallen further than capitalisation rates because circumstances affecting discount rates also affect rental growth (and thus cap rates have a closer alignment between numerator and denominator)
2) Property portfolios have staggered valuations (i.e. a third to half valued every quarter), so changes in environment take a longer period to flow through. Serial correlation is thus present across quarters when compared to annual (3.3% annualised quarterly volatility vs. 6.2% annual volatility)
3) Spikes in business credit have preceded property collapses, coinciding with credit contraction
4) Office property has fared worse in downturns due to excess of supply/demand imbalance
5) Retail is becoming increasingly affected by online shopping

Question 10

List some characteristics of the direct ownership approach to institutional property investments.

Answer 10

1) Restricts diversification
2) Full control of prices paid and received but significant overhead
3) Institutional super cannot directly leverage

Question 11

List some characteristics of the unlisted pooled vehicles approach to institutional property investments.

Answer 11

1) Retain advantage of smoothed property volatility
2) Better diversification
3) Manager may be external with potential agency risks
4) Vehicle may/may not be leveraged

Question 12

List some characteristics of the A-REITS approach to institutional property investments.

Answer 12

1) Better liquidity but more volatile returns (constant valuation)
2) Management may be external or internal (preferred)
3) Usually leveraged

Question 13

What are the key considerations around property investments?

Answer 13

1) Diversification by type/location
2) Management arrangements
3) Inclusion of development activity
4) Degree of leverage

Question 14

Define the following:

1) Income yield
2) Growth in REIT return
3) Volatility of REIT

using L = D/A, y=cost of debt, r=net rental yield, g=expected growth of net rental income, v=return volatility

Answer 14

1) Income yield = [r - yL]/[1 - L]
2) Growth in REIT return = gr/[r - L*y]
3) Volatility of REIT = v/[1 - L]

Question 15

What are some of the key features of alternative investment types?

Answer 15

1) Liquidity is often restricted/limited
2) Fees are high and not always disclosed
3) Leverage can be used to transform asset (and stability)
4) Performance measurement is hard to determine due to high idiosyncratic risk

Question 16

Outline how private equity works and the expected return for investors.

Answer 16

Super gives funds to managers, who then go and take majority positions. Money is committed to these managers and then drawn as required. They are typically highly leveraged investments, allowing investors to earn the liquidity premium, and have very high fees. Performance varies by vintage year, though private equity is expected to outperform public equity

Question 17

Define the following hedge fund strategies:

1) Convertible arbitrage
2) Long/Short Equity
3) Event driven distressed
4) Event driven risk arbitrage
5) Fixed income arbitrage
6) Global macro

Answer 17

1) Convertible arbitrage involves buying bonds and shorting underlying equity
2) Long/Short Equity is dealing purely in equities
3) Event driven distressed involves investing in capital structures close to bankruptcy then exploiting a forced sale
4) Event driven risk arbitrage captures the spread in mergers (buy target then wait for the price to approach bid)
5) Fixed income arbitrage involves trading anomalies in securities
6) Global macro involves tactical allocation globally

Question 18

How does the long/short equity strategy work?

Answer 18

Managers enter into securities agreements with brokers, they borrow the stock, sell it alongside pledged collateral, then stock returned after manager has bought it back at a (hopefully) lower price. Standard variant is 130/30 - where you long for $130 and short $30 for every $100.

Question 19

What are some of the key features of hedge funds as investment options?

Answer 19

1) Hedge funds didn’t go down with equity during the tech bust, but as they became more popular and quality diminished, they also suffered during the GFC and did not recover afterwards.
2) Typical fee structure is base (1.5%-2%) plus performance fee (15%-20%) sometimes on top of the cash rate not market rate
3) Hedge fund structures have been replicated in practice, passively mimicked at lower fees, but this is not a good idea
4) Traditionally hedge funds have been opaque about allocations, but there is no reason for this

Question 20

What are some of the key features of infrastructure as an asset class?

Answer 20

1) Stable, predictable LT cash flows
2) Often linked to inflation or other escalation rates
3) Monopoly (like) market characteristics
4) Very high levels of gearing/leverage
5) High valuations
6) Limited recourse (no guarantee of full money back)

Question 21

What are the three types of infrastructure assets?

Answer 21

1) Public-private-partnership (PPP) - gov agrees contract with private company to build project in return for set payments. Leverage up to 90% due to stable flows
2) Regulated Assets - monopoly-like characteristics with income typically linked to economic activity. Leverage of 50-70% (as the cyclicality amplifies risk)
3) Private sector sponsored infrastructure - Standalone/part of supply chain underpinned by counterparty. Gearing is dependent on level of risk/nature/industry etc.

Question 22

Distinguish between brownfield and greenfield investments.

Answer 22

Brownfield investments are in assets that are currently operational and have strong secured cash flows. Greenfield investments, on the other hand, are not yet operational and have a higher risk and return than Brownfield investments.

Question 23

What are the four types of infrastructure investors?

Answer 23

1) Infrastructure sponsor - highly skilled and dedicated, take a lead sponsor role on projects and are a long term holder of equity/asset manager
2) Financial investor - like a super fund, they seek large mature brownfield investments and are willing to pay a price premium. They are unskilled at asset management.
3) Greenfield investor - Equity willing to take on delivery risk and seek to exit on completion, achieving capital gain from resale
4) Industrial investor - Investment arms of major construction firms, facilitating enhanced return

Question 24

How can we perform valuations on infrastructure?

Answer 24

1) Enterprise valuation (whole of the asset) from the top down - NPV of free cash flows at hurdle rate - or bottom up - maximise debt then equity and value
2) Equity (measured on post-tax distributions) - presence of gearing alters the risk/return for equity and discount rates can be very low
3) Debt, either existing debt principal outstanding (assets with existing debt) or remeasure at ‘supportable debt’ (new capital structure of an asset).

IRRs are typically very low

Question 25

What are some of the key valuation inputs?

Answer 25

Key valuation inputs include:

1) Revenue stream, look at the risk inherent in volume * price, contracted risk, escalation and levels of uncertainty
2) Where in the asset life cycle do we currently reside
3) Cost profile (labour vs. non-labour, capex requirements)
4) Length of remaining concession period or asset life (how many years of cashflows are left)
5) Optimisation/value enhancements - will the company need to do extra work to enhance/add value?