Final Summary Real Estate Finance and Investments
Lecture 1 – Intro
Most important aspects real estate
- Note that the value of a building is not only the structure but also the land
underneath it
- Location
▪ The characteristics of the location affect the value of the building
▪ That value is capitalized in the price
▪ Examples
o Walking score
o Shops/ restaurants near by
o Access to transportation
o Etcetera
▪ 50% of the house price per square meter could be attributed to
neighborhood characteristics
- Durability
▪ Many buildings were constructed a long time ago
o 17th century canal houses are still very expensive
▪ Modern buildings look very different
▪ In the course of their lifetime, the function of buildings may change
o Large residences are converted into apartments
o Warehouses are transformed into apartments
Lecture Wheaton & Torto – Office rents
Why do we construct price indices?
- To get a summary statement of market conditions
▪ Changes in ‘the’ price for owner-occupied housing are published regularly
and get a lot of attention
Repeat-sales analysis
- Compare the prices of houses that have been sold twice
▪ Characteristics are (mostly) identical
- They cancel out
▪ Unobserved characteristics are not a problem!
▪ ∆𝑙𝑛𝑃𝑖 = 𝑙𝑛𝑃𝑖𝑡 − 𝑙𝑛𝑃𝑖𝜏 = 𝛼𝑡 − 𝛼𝜏 + ∑𝑘 𝛽𝑘 𝑋𝑘𝑖 − ∑𝑘 𝛽𝑘 𝑋𝑘𝑖
Hedonic price analysis
- Purpose: measure a constant-quality price index
▪ Prices of real estate (= value of buildings) have a price component and a
quality component
▪ The state of the market is reflected in the price component
▪ So, we want to measure the value or price conditional upon quality
- Methodology:
, ▪ OLS with dummies for geographical market and/or time period and quality
aspects
- The coefficients of the quality components can be interpreted as the marginal
willingness to pay for them by market participants
▪ They can be used to make references more comparable to an object under
consideration
- The specifications we consider impose that buildings with any given set of
characteristics have the same evolution of their price:
▪ With a linear specification: the same absolute change
▪ With a log-linear specification: the same relative change
Estimation
- Hedonic price estimation strategy:
▪ 𝑃𝑖 = 𝛼𝑚(𝑖),𝑡(𝑖) + ∑𝑘 𝛽𝑘 𝑋𝑘𝑖 (𝑙𝑖𝑛𝑒𝑎𝑟)
- Log of LHS is generally taken:
▪ 𝑙𝑛𝑃𝑖 = 𝛼𝑚(𝑖),𝑡(𝑖) + ∑𝑘 𝛽𝑘 𝑋𝑘𝑖 (𝑙𝑜𝑔 − 𝑙𝑖𝑛𝑒𝑎𝑟)
▪ The price index is:
o exp (𝛼𝑚(𝑖),𝑡(𝑖) )
- quality differences are absorbed by the 𝛽𝑘 s
Wheaton-Torto analysis
- Price/sqm is the dependent variable
- Characteristics of the lease contract are the explanatory variables
- If the market is competitive:
▪ Price differences reflect the value of characteristics
▪ Renters compare the various buildings and choose the one that suits them
best on the basis of price and characteristics
▪ The trade-offs they make are reflected in the estimates
- Example
▪ Gross vs net lease
▪ Taxes passed through or not
Average and hedonic rents
- Hedonic rents differ from average or median prices because they control for quality
differences
▪ A hedonic price index is an attempt to describe the development over time of
a building of constant quality
- If in a particular period more high-quality buildings are sold/rented this is reflected in
the average rent
▪ But the higher rent does not reflect a higher price, but a higher quality
Housing versus commercial real estate
- For houses often many characteristics are known
▪ For instance, in NVM data
- For commercial property this is typically not the case
▪ Although the general impression is that heterogeneity is as important in
commercial real estate
, ▪ Concern about omitted variables is therefore real
- For housing many more observations than for commercial real estate
Dutch commercial real estate
- Index based on transaction information collected by real estate agents
- For some years the only index available in the Netherlands
- Separate series for retail, offices, industrial
- Since the euro crisis prices of commercial real estate appear to lag behind those of
residential real estate
Hedonic price functions and references
- Hedonic price analysis is (more or less) an academic activity
▪ Abstract analysis, based on large numbers of observations, often with
considerable differences
- Real estate agents use references to estimate the value of a building
▪ Specific buildings, small number of observations, selected because of
similarity
- Approaches can be combined
▪ For instance, one can use coefficients of hedonic price equation to make
references more comparable to the building under consideration
Discussion
- Prices reveal a lot of useful information about the functioning of real estate markets
- Price, absorption, and vacancies are not independent variables
▪ Are simultaneously determined by the market
▪ Endogeneity is a potential problem
Lecture 2 – Chapter 5 & 6
Real estate valuation
- What determines the willingness to pay (reservation price) of an investor?
▪ The investor is a profit maximizer
▪ (Net) revenues from the property are important
▪ These revenues originate from the users
- Net present value is the difference between the willingness to pay and the asking
price
- Separation of ownership and use is common in real estate
▪ Associated with durability
▪ Note the difference in time horizon of users and owners
Discounted cash flow (DCF) approach
- Buying an asset means exchange of present good for future good:
▪ Present good
o The price you pay today
▪ Future good
o Cash flow you expect to earn
o It calls for forward-looking behavior
, • Expectations are important
• Uncertainty is key aspect, but not always made explicit!
- Note, this is directly related to the durability of real estate
The basic valuation formula
- Formula to determine the price of asset:
𝐶𝐹𝑡
▪ 𝑃0 = ∑𝑇𝑡=1 𝑡
(1+𝑟)
▪ 𝑃0 = the price of the asset
o i.e., the present good
o what you are willing to pay now
▪ 𝐶𝐹𝑡 = the (net) cash flow expected in period t
o i.e., the future good
▪ 𝑇 = the time horizon
▪ 𝑟 = the discount rate
o Required return, reflect the uncertainty associated with the project
Simple application
- You are expected to get familiar with the basic valuation formula
- E.g., how would you calculate the price if we suppose a five-year term?
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5
▪ 𝑃0 = (1+𝑟) 1 + (1+𝑟)2 + (1+𝑟) 3 + (1+𝑟) 4 + (1+𝑟) 5
An important special case
- If cash flows are constant over time and continue indefinitely:
𝐶𝐹𝑡 𝐶𝐹
▪ 𝑃0 = ∑∞ 𝑡=1 (1+𝑟)𝑡 = 𝑟
▪ Note that there is no suffix for CF
- This gives a (very) simple relationship between price (=value) and annual return:
▪ The value of the building equals (1/r) times the yield
- The yield CF/𝑃0 is equal to the capitalization rate r
▪ Often used with the initial cash flow
▪ Net or gross initial yield
Capitalization rate (or cap rate)
- The expected rate of return on a real estate investment property
- It is used in the world of commercial real estate to indicate the rate of return that is
expected to be generated on a real estate investment property
- It is calculated by:
𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
▪ 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 𝑜𝑟 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
- This ratio, expressed as a percentage, is an estimation of an investor’s potential
return on a real estate investment
- It is most useful as a quick comparison of the relative value of similar real estate
investments
A finite sum
𝐶𝐹𝑡
- 𝑃0 = ∑𝑇𝑡=1 (1+𝑟) 𝑡 = a finite sum
- Can be interpreted as the difference between two infinite sums
Lecture 1 – Intro
Most important aspects real estate
- Note that the value of a building is not only the structure but also the land
underneath it
- Location
▪ The characteristics of the location affect the value of the building
▪ That value is capitalized in the price
▪ Examples
o Walking score
o Shops/ restaurants near by
o Access to transportation
o Etcetera
▪ 50% of the house price per square meter could be attributed to
neighborhood characteristics
- Durability
▪ Many buildings were constructed a long time ago
o 17th century canal houses are still very expensive
▪ Modern buildings look very different
▪ In the course of their lifetime, the function of buildings may change
o Large residences are converted into apartments
o Warehouses are transformed into apartments
Lecture Wheaton & Torto – Office rents
Why do we construct price indices?
- To get a summary statement of market conditions
▪ Changes in ‘the’ price for owner-occupied housing are published regularly
and get a lot of attention
Repeat-sales analysis
- Compare the prices of houses that have been sold twice
▪ Characteristics are (mostly) identical
- They cancel out
▪ Unobserved characteristics are not a problem!
▪ ∆𝑙𝑛𝑃𝑖 = 𝑙𝑛𝑃𝑖𝑡 − 𝑙𝑛𝑃𝑖𝜏 = 𝛼𝑡 − 𝛼𝜏 + ∑𝑘 𝛽𝑘 𝑋𝑘𝑖 − ∑𝑘 𝛽𝑘 𝑋𝑘𝑖
Hedonic price analysis
- Purpose: measure a constant-quality price index
▪ Prices of real estate (= value of buildings) have a price component and a
quality component
▪ The state of the market is reflected in the price component
▪ So, we want to measure the value or price conditional upon quality
- Methodology:
, ▪ OLS with dummies for geographical market and/or time period and quality
aspects
- The coefficients of the quality components can be interpreted as the marginal
willingness to pay for them by market participants
▪ They can be used to make references more comparable to an object under
consideration
- The specifications we consider impose that buildings with any given set of
characteristics have the same evolution of their price:
▪ With a linear specification: the same absolute change
▪ With a log-linear specification: the same relative change
Estimation
- Hedonic price estimation strategy:
▪ 𝑃𝑖 = 𝛼𝑚(𝑖),𝑡(𝑖) + ∑𝑘 𝛽𝑘 𝑋𝑘𝑖 (𝑙𝑖𝑛𝑒𝑎𝑟)
- Log of LHS is generally taken:
▪ 𝑙𝑛𝑃𝑖 = 𝛼𝑚(𝑖),𝑡(𝑖) + ∑𝑘 𝛽𝑘 𝑋𝑘𝑖 (𝑙𝑜𝑔 − 𝑙𝑖𝑛𝑒𝑎𝑟)
▪ The price index is:
o exp (𝛼𝑚(𝑖),𝑡(𝑖) )
- quality differences are absorbed by the 𝛽𝑘 s
Wheaton-Torto analysis
- Price/sqm is the dependent variable
- Characteristics of the lease contract are the explanatory variables
- If the market is competitive:
▪ Price differences reflect the value of characteristics
▪ Renters compare the various buildings and choose the one that suits them
best on the basis of price and characteristics
▪ The trade-offs they make are reflected in the estimates
- Example
▪ Gross vs net lease
▪ Taxes passed through or not
Average and hedonic rents
- Hedonic rents differ from average or median prices because they control for quality
differences
▪ A hedonic price index is an attempt to describe the development over time of
a building of constant quality
- If in a particular period more high-quality buildings are sold/rented this is reflected in
the average rent
▪ But the higher rent does not reflect a higher price, but a higher quality
Housing versus commercial real estate
- For houses often many characteristics are known
▪ For instance, in NVM data
- For commercial property this is typically not the case
▪ Although the general impression is that heterogeneity is as important in
commercial real estate
, ▪ Concern about omitted variables is therefore real
- For housing many more observations than for commercial real estate
Dutch commercial real estate
- Index based on transaction information collected by real estate agents
- For some years the only index available in the Netherlands
- Separate series for retail, offices, industrial
- Since the euro crisis prices of commercial real estate appear to lag behind those of
residential real estate
Hedonic price functions and references
- Hedonic price analysis is (more or less) an academic activity
▪ Abstract analysis, based on large numbers of observations, often with
considerable differences
- Real estate agents use references to estimate the value of a building
▪ Specific buildings, small number of observations, selected because of
similarity
- Approaches can be combined
▪ For instance, one can use coefficients of hedonic price equation to make
references more comparable to the building under consideration
Discussion
- Prices reveal a lot of useful information about the functioning of real estate markets
- Price, absorption, and vacancies are not independent variables
▪ Are simultaneously determined by the market
▪ Endogeneity is a potential problem
Lecture 2 – Chapter 5 & 6
Real estate valuation
- What determines the willingness to pay (reservation price) of an investor?
▪ The investor is a profit maximizer
▪ (Net) revenues from the property are important
▪ These revenues originate from the users
- Net present value is the difference between the willingness to pay and the asking
price
- Separation of ownership and use is common in real estate
▪ Associated with durability
▪ Note the difference in time horizon of users and owners
Discounted cash flow (DCF) approach
- Buying an asset means exchange of present good for future good:
▪ Present good
o The price you pay today
▪ Future good
o Cash flow you expect to earn
o It calls for forward-looking behavior
, • Expectations are important
• Uncertainty is key aspect, but not always made explicit!
- Note, this is directly related to the durability of real estate
The basic valuation formula
- Formula to determine the price of asset:
𝐶𝐹𝑡
▪ 𝑃0 = ∑𝑇𝑡=1 𝑡
(1+𝑟)
▪ 𝑃0 = the price of the asset
o i.e., the present good
o what you are willing to pay now
▪ 𝐶𝐹𝑡 = the (net) cash flow expected in period t
o i.e., the future good
▪ 𝑇 = the time horizon
▪ 𝑟 = the discount rate
o Required return, reflect the uncertainty associated with the project
Simple application
- You are expected to get familiar with the basic valuation formula
- E.g., how would you calculate the price if we suppose a five-year term?
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5
▪ 𝑃0 = (1+𝑟) 1 + (1+𝑟)2 + (1+𝑟) 3 + (1+𝑟) 4 + (1+𝑟) 5
An important special case
- If cash flows are constant over time and continue indefinitely:
𝐶𝐹𝑡 𝐶𝐹
▪ 𝑃0 = ∑∞ 𝑡=1 (1+𝑟)𝑡 = 𝑟
▪ Note that there is no suffix for CF
- This gives a (very) simple relationship between price (=value) and annual return:
▪ The value of the building equals (1/r) times the yield
- The yield CF/𝑃0 is equal to the capitalization rate r
▪ Often used with the initial cash flow
▪ Net or gross initial yield
Capitalization rate (or cap rate)
- The expected rate of return on a real estate investment property
- It is used in the world of commercial real estate to indicate the rate of return that is
expected to be generated on a real estate investment property
- It is calculated by:
𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
▪ 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 𝑜𝑟 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
- This ratio, expressed as a percentage, is an estimation of an investor’s potential
return on a real estate investment
- It is most useful as a quick comparison of the relative value of similar real estate
investments
A finite sum
𝐶𝐹𝑡
- 𝑃0 = ∑𝑇𝑡=1 (1+𝑟) 𝑡 = a finite sum
- Can be interpreted as the difference between two infinite sums
