GY462
Topic 1 Real Estate Investment Analysis and Financial Leverage
1. Investment Analysis
2. Financial Leverage
Topic 2 Mortgage Basics & Analysis
3. Fixed Rate Mortgage Loans
4. Mortgage Payment Issues
5. More Flexible Mortgage Arrangements
Topic 3 Real Estate Capital Markets and Securities
6. Real Estate Investment Trusts (REITs)
7. Real Estate Portfolios
8. Debt Securitization
9. Subprime Mortgages and the Dynamics of the Crisis
Seminar
S1 Real Estate Investment Analysis
S2 Pro-Forma & Financial Leverage
S3 Mortgage Analysis
S4 Real Estate Market Securitization
1
,Topic 1 Real Estate Investment Analysis and Financial Leverage
1. Investment Analysis
Risks for RE Investment
1. Operating Cost – Electricity, Property tax, Refurbishment, Management agency cost
2. Vacancy – Opportunity cost of not letting out, Vacancy is riskier than leasing risk
3. Natural Disaster – Damage to property
4. Leasing – Tenant default risk, fluctuation of lease contracts (e.g. expiry)
5. Liquidity – RE is disposed in large lot size (i.e. Usually involve leverage, greater risk),
Indivisibility & Illiquidity (than other FAs) are the largest downside risks
Opportunities for RE Investment
1. Reduce Operating Cost – Energy efficiency (Water, heating)
2. Capital Gain from Terminal Value – Intrinsically determined by how well can be rented out
3. Gain from Rental Growth – TV is a function of rent -> rental growth is important
Income Producing Properties
1. Office Properties ***
- Location *** (CBD: Agglomeration: knowledge spillovers, Public transport brings clients
& workers in, infrastructure e.g. telecommunication) (Suburban: Highway, Parking ***)
- Tenant Mix *** (Multiple tenants: ↓Risk but may ↑OPEX)
- Age *** (New buildings are more efficient, Open planning spaces, Fake ceiling etc.)
- Iconic *** (e.g. BoE)
2. Industrial Properties
- Location to airport, railway, highway ***
3. Residential Properties ***
- Location to amenities, hospital, good school, transportation, consumption opp. ***
- Energy efficiency, Neighborhood, Age, Health & Safety ***
- Usually owned by big RE developers as it is expensive for single entity to develop
- More profitable for big RE developers due to synergy & less agency problem (↑eff.)
4. Retail Properties
- Location *** (Accessibility to highway/Large no. of parking lots available)
- Extra income received from car park
- Strategic choice of retailers’ location in a mall (spread out well-known brands), both
renters and landlords ↑Revenue ↓Cost
5. Hotel
- Location & Accessibility ***
Demand Drivers
- HH: Age, HH structures, Ethnicity etc.
- Office: Potential access to highly educated workers, Age of workforce
Supply Drivers
- Interest rate
- Cost of construction (Time, Opportunity cost for capital)
- Vacancy (Excess supply in a tight market is not ideal)
2
,Valuation of IPP: 1. Discounted Cash Flow Method
- Forecast expected future CF -> Ascertain required return -> Discount CF to PV at required R
- Values occurred in different periods are associated to different risk (i.e. discount rate)
- Discount Rate = Rf + Rp (Rp varies across people, diff type & length of inve’ment & risk pref)
- Uncertain CF (Signed lease CF vs Expected CF not guaranteed) subjects to higher discount rate
- Traditional DCF: Discount CF with appropriate rates in related periods
- Alternative DCF: Discount all CF at intra-lease DR -> Discount uncertain CF at inter-lease DR
- Intra-lease DR: Reflect risk that tenant might default on contractual lease obligation
- Inter-lease DR: Reflect uncertainty of future lease contract (rental mkt risk) & sales price
- Sometimes use blended IRR as shortcut (previously observed returns of similar buildings)
- Reality: Complicated & variety contracts, Uncertain over correct DR
Valuation of IPP: 2. Direct Capitalisation (Cap Rate)
- Measures how risky particular types of property are
- Used to reflect risks & opportunities: ↑Risk(un?)/↓Opp(growth)-> ↑Cap Rate -> ↓Worth, VV
- Varies overtime: Location, Tenant mix, Anchored tenants
$%&' $%&
- 𝑉" = or 𝐶𝑎𝑝 𝑅𝑎𝑡𝑒 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑂𝑏𝑠𝑒𝑟𝑣𝑒𝑑 & 𝐶𝑜𝑚𝑝𝑟𝑎𝑏𝑙𝑒 ( )
()* ,)-./0123-4 H
- Step: Determine cap rate + Estimate initial NOI, by observation for similar properties
- Still applicable if g is negative
- If g>r, opportunity may not stabilised, property is new to market, difficult to apply cap rate
- If nominator already includes growth, don’t use r-g as denominator, double counting otherwise
- Going-in CR (NOI t=1/V): Use when buying properties
- Going-out CR (NOI t=11/V): Use when selling properties as to find property’s TV
- Stabilised CR (Stabilised NOI/V): Average of all NOI over holding periods
Valuation of IPP: 3. Gross Income Multiplier (GIM)
H)MN.
- 𝐺𝐼𝑀 = Value of property represented in multiple of gross revenue
012OO ,.P.QN.
- Require less info than CR, difficult to apply in real estate practice, only for small apartments
when expense record not available
- GIM and GR observed from local rental market
Valuation of IPP: 4. Equivalent Yield
R)OOSQT &QU2V. (N11.Q- ,.Q-)M H)MN./R)OOSQT &QU2V.
- 𝑉= + [
W W (YZW)
- 2 Parts: Current income up to next rent review + Current estimate of rental value at review
Valuation of IPP: 5. Sales Comparison Approach
- Analyse data of recently sold highly comparable properties -> Adjust for difference
- Rationale: No one would pay more for a property than other recent investors
Valuation of IPP: 6. Construction Cost Approach
- Analyse construction costs and cost of buying land
- Rationale: No one would pay more for a property than it would cost to build it
3
, Choice of Discount Rate
- Specific to type of property and its contribution to portfolio (i.e. portfolio required return)
- Depend on risk characteristics of project (Diff mission diff risk, e.g. pension vs speculator, LR vs SR)
- Reflect opportunity cost of capital (probably a safe bond offering same return as invest in RE)
- From: Surveys, Historical data, Observed transaction of similar properties
- Element of subjectivity towards discount rate is involved depend on portfolio composition
Pro Forma Basics (Multi-year CF forecast)
- Shown to lenders (Ability to repay) and to outside investors (Value to be generated)
Operating CF Potential Gross Income (Rent * SF) Rent Roll by SF * Rent PSF
- Occur regularly - Vacancy Allowance (Vac Rate * PGI) Forecast pr of expected vacant period for each
throughout space, differ from available space (under lease
holding period but tenant can’t pay rent -> sublease)
due to normal + Other Income Overage rent, Charge to common space, Parking,
operation of Advertising, Concierge service, catering
property - Operating Expenses Fixed: Taxes, Insurance, Mng (even if self mng)
Variable: Maintenance, Gross-over-space Utility
Exclude: Income tax, Depn
= Net Operating Income /
- Capital Improvement Expenditure Leasing costs (once-off):
>> Improve bargaining power -> better 1. Tenant IE: Customised physical improvement
position in property mng, e.g. Bank in LSE 2. Leasing commissions to brokers, unless in-hse
= Property Before-Tax CF /
Reversion CF Property Value at Time of Sale By Going-out Cap Rate (Risk & Opportunity),
- Occur only at use NOI when new new buyers actually own it
time of sale due - Selling Expenses /
to sale of assets = Property Before-Tax CF /
Measures of Investment Performance using Ratio
- Price PSF, Cap rate, Equity dividend rate (NOI/Equity), Debt coverage ratio (***Mortgage nego.)
Measures of Investment Performance using CF Projections
NPV
- Maximise NPV across all mutually exclusive alternatives
- Accept projects when NPV ≥ 0
- Too Good?: Hidden problems to be discovered in future, Over-confident assumptions,
Ethical issues, Omitted expenses (CAPEX, Borrowing cost, Vacancy, Leasing concession)
IRR (Rate that sets expected future CF to be worth the given price, Used to rank projects)
- Maximise difference between project’s expected IRR and required return
- Reject when expected IRR ≤ Required return (Hurdle rate)
4
Topic 1 Real Estate Investment Analysis and Financial Leverage
1. Investment Analysis
2. Financial Leverage
Topic 2 Mortgage Basics & Analysis
3. Fixed Rate Mortgage Loans
4. Mortgage Payment Issues
5. More Flexible Mortgage Arrangements
Topic 3 Real Estate Capital Markets and Securities
6. Real Estate Investment Trusts (REITs)
7. Real Estate Portfolios
8. Debt Securitization
9. Subprime Mortgages and the Dynamics of the Crisis
Seminar
S1 Real Estate Investment Analysis
S2 Pro-Forma & Financial Leverage
S3 Mortgage Analysis
S4 Real Estate Market Securitization
1
,Topic 1 Real Estate Investment Analysis and Financial Leverage
1. Investment Analysis
Risks for RE Investment
1. Operating Cost – Electricity, Property tax, Refurbishment, Management agency cost
2. Vacancy – Opportunity cost of not letting out, Vacancy is riskier than leasing risk
3. Natural Disaster – Damage to property
4. Leasing – Tenant default risk, fluctuation of lease contracts (e.g. expiry)
5. Liquidity – RE is disposed in large lot size (i.e. Usually involve leverage, greater risk),
Indivisibility & Illiquidity (than other FAs) are the largest downside risks
Opportunities for RE Investment
1. Reduce Operating Cost – Energy efficiency (Water, heating)
2. Capital Gain from Terminal Value – Intrinsically determined by how well can be rented out
3. Gain from Rental Growth – TV is a function of rent -> rental growth is important
Income Producing Properties
1. Office Properties ***
- Location *** (CBD: Agglomeration: knowledge spillovers, Public transport brings clients
& workers in, infrastructure e.g. telecommunication) (Suburban: Highway, Parking ***)
- Tenant Mix *** (Multiple tenants: ↓Risk but may ↑OPEX)
- Age *** (New buildings are more efficient, Open planning spaces, Fake ceiling etc.)
- Iconic *** (e.g. BoE)
2. Industrial Properties
- Location to airport, railway, highway ***
3. Residential Properties ***
- Location to amenities, hospital, good school, transportation, consumption opp. ***
- Energy efficiency, Neighborhood, Age, Health & Safety ***
- Usually owned by big RE developers as it is expensive for single entity to develop
- More profitable for big RE developers due to synergy & less agency problem (↑eff.)
4. Retail Properties
- Location *** (Accessibility to highway/Large no. of parking lots available)
- Extra income received from car park
- Strategic choice of retailers’ location in a mall (spread out well-known brands), both
renters and landlords ↑Revenue ↓Cost
5. Hotel
- Location & Accessibility ***
Demand Drivers
- HH: Age, HH structures, Ethnicity etc.
- Office: Potential access to highly educated workers, Age of workforce
Supply Drivers
- Interest rate
- Cost of construction (Time, Opportunity cost for capital)
- Vacancy (Excess supply in a tight market is not ideal)
2
,Valuation of IPP: 1. Discounted Cash Flow Method
- Forecast expected future CF -> Ascertain required return -> Discount CF to PV at required R
- Values occurred in different periods are associated to different risk (i.e. discount rate)
- Discount Rate = Rf + Rp (Rp varies across people, diff type & length of inve’ment & risk pref)
- Uncertain CF (Signed lease CF vs Expected CF not guaranteed) subjects to higher discount rate
- Traditional DCF: Discount CF with appropriate rates in related periods
- Alternative DCF: Discount all CF at intra-lease DR -> Discount uncertain CF at inter-lease DR
- Intra-lease DR: Reflect risk that tenant might default on contractual lease obligation
- Inter-lease DR: Reflect uncertainty of future lease contract (rental mkt risk) & sales price
- Sometimes use blended IRR as shortcut (previously observed returns of similar buildings)
- Reality: Complicated & variety contracts, Uncertain over correct DR
Valuation of IPP: 2. Direct Capitalisation (Cap Rate)
- Measures how risky particular types of property are
- Used to reflect risks & opportunities: ↑Risk(un?)/↓Opp(growth)-> ↑Cap Rate -> ↓Worth, VV
- Varies overtime: Location, Tenant mix, Anchored tenants
$%&' $%&
- 𝑉" = or 𝐶𝑎𝑝 𝑅𝑎𝑡𝑒 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑂𝑏𝑠𝑒𝑟𝑣𝑒𝑑 & 𝐶𝑜𝑚𝑝𝑟𝑎𝑏𝑙𝑒 ( )
()* ,)-./0123-4 H
- Step: Determine cap rate + Estimate initial NOI, by observation for similar properties
- Still applicable if g is negative
- If g>r, opportunity may not stabilised, property is new to market, difficult to apply cap rate
- If nominator already includes growth, don’t use r-g as denominator, double counting otherwise
- Going-in CR (NOI t=1/V): Use when buying properties
- Going-out CR (NOI t=11/V): Use when selling properties as to find property’s TV
- Stabilised CR (Stabilised NOI/V): Average of all NOI over holding periods
Valuation of IPP: 3. Gross Income Multiplier (GIM)
H)MN.
- 𝐺𝐼𝑀 = Value of property represented in multiple of gross revenue
012OO ,.P.QN.
- Require less info than CR, difficult to apply in real estate practice, only for small apartments
when expense record not available
- GIM and GR observed from local rental market
Valuation of IPP: 4. Equivalent Yield
R)OOSQT &QU2V. (N11.Q- ,.Q-)M H)MN./R)OOSQT &QU2V.
- 𝑉= + [
W W (YZW)
- 2 Parts: Current income up to next rent review + Current estimate of rental value at review
Valuation of IPP: 5. Sales Comparison Approach
- Analyse data of recently sold highly comparable properties -> Adjust for difference
- Rationale: No one would pay more for a property than other recent investors
Valuation of IPP: 6. Construction Cost Approach
- Analyse construction costs and cost of buying land
- Rationale: No one would pay more for a property than it would cost to build it
3
, Choice of Discount Rate
- Specific to type of property and its contribution to portfolio (i.e. portfolio required return)
- Depend on risk characteristics of project (Diff mission diff risk, e.g. pension vs speculator, LR vs SR)
- Reflect opportunity cost of capital (probably a safe bond offering same return as invest in RE)
- From: Surveys, Historical data, Observed transaction of similar properties
- Element of subjectivity towards discount rate is involved depend on portfolio composition
Pro Forma Basics (Multi-year CF forecast)
- Shown to lenders (Ability to repay) and to outside investors (Value to be generated)
Operating CF Potential Gross Income (Rent * SF) Rent Roll by SF * Rent PSF
- Occur regularly - Vacancy Allowance (Vac Rate * PGI) Forecast pr of expected vacant period for each
throughout space, differ from available space (under lease
holding period but tenant can’t pay rent -> sublease)
due to normal + Other Income Overage rent, Charge to common space, Parking,
operation of Advertising, Concierge service, catering
property - Operating Expenses Fixed: Taxes, Insurance, Mng (even if self mng)
Variable: Maintenance, Gross-over-space Utility
Exclude: Income tax, Depn
= Net Operating Income /
- Capital Improvement Expenditure Leasing costs (once-off):
>> Improve bargaining power -> better 1. Tenant IE: Customised physical improvement
position in property mng, e.g. Bank in LSE 2. Leasing commissions to brokers, unless in-hse
= Property Before-Tax CF /
Reversion CF Property Value at Time of Sale By Going-out Cap Rate (Risk & Opportunity),
- Occur only at use NOI when new new buyers actually own it
time of sale due - Selling Expenses /
to sale of assets = Property Before-Tax CF /
Measures of Investment Performance using Ratio
- Price PSF, Cap rate, Equity dividend rate (NOI/Equity), Debt coverage ratio (***Mortgage nego.)
Measures of Investment Performance using CF Projections
NPV
- Maximise NPV across all mutually exclusive alternatives
- Accept projects when NPV ≥ 0
- Too Good?: Hidden problems to be discovered in future, Over-confident assumptions,
Ethical issues, Omitted expenses (CAPEX, Borrowing cost, Vacancy, Leasing concession)
IRR (Rate that sets expected future CF to be worth the given price, Used to rank projects)
- Maximise difference between project’s expected IRR and required return
- Reject when expected IRR ≤ Required return (Hurdle rate)
4
