Real Estate Case Study

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Chapter 01

Real Estate Investment: Basic Legal Concepts

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Property Rights and Estates

Real property versus personal property.

Estates.

• Based on Rights: Possession versus Not in Possession.

• Based on Possession and Use: Freehold versus Leasehold.

Possessory estates.

• Freehold.

• Fee Simple Estates.

• Life Estates.

Estates

Nonpossessory Estates: Future Estates.

• Reversion.

• Remainder.

Leasehold Estates.

• Estate for Years.

• Estate from Year to Year.

Additional Interests

An interest is a right or claim on real property, its revenues, or production.

• A common example of an interest is when an owner of real estate pledges or encumbers his property as a condition for obtaining a mortgage. The lender is said to have a secured interest.

An easement is a nonpossessory interest in land. The right is for the use of the land for a special purpose.

• Examples include rights of way for road access and utility lines.

Title Assurance 1

Title Assurance.

The Meaning of Title.

• Abstract Term.

• Quantity of Rights Conveyed.

• Abstract of Title.

• Title Chain.

Title Assurance 2

Deeds.

• Grantor & Grantee.

• General Warranty Deed.

• Covenant that the grantor has good title.

• Covenant that the grantor has the right to convey the property.

• Covenant to compensate the grantee for loss of property or eviction as a result of a superior claim.

• No encumbrances on title except those noted.

Title Assurance 3

Deeds.

• Special Warranty Deed.

• Limits the covenants to the ownership duration of the current grantor.

• No guarantees on the ownership of prior grantors.

• Bargain and Sale Deed.

• Conveys property without seller warranties.

• Sometimes called an “as-is” deed.

Title Assurance 4

Deeds.

• Sheriff’s Deed-Trustee Deed.

• Bargain and sale deed received by a buyer from a foreclosure or other forced sale by sheriff or trustee.

• No warranties are added.

• Quitclaim Deed.

• No Covenants.

• The least protection to the grantee.

• Grantor conveys whatever right “may exist.”

Title Assurance 5

Abstract & Opinion.

• Title search.

• Study of relevant records.

• Lawyer’s opinion on title.

• Is it good and marketable?

• Are there any clouds on title?

• Is there a break in the chain of title?

Title Insurance 6

Why Title Insurance and not Abstract and Opinion?

1. Definite contract liability to the premium payer.

2. Reserves sufficient to meet insured losses.

3. Supervision by an agency of the state.

4. Protection to the policyholder against financial loss because of any kind of title defect, disclosed or hidden.

While an abstract and opinion method may still be used because of cost considerations, in general title insurance is used. As a general rule, lenders will require that a buyer use title insurance.

Title Insurance 7

Title Insurance.

• One time premium.

• Unseen Hazards in the Public Record.

• Risk is spread among many property owners.

• Owners’ Policy.

• Insures the interest of a new owner.

• Lender’s Policy.

• Insures the interest of the lender.

Recording Acts

Recording protects the interest of the owner.

Constructive Notice.

• A person is deemed to have whatever information is in the public record.

Mechanics’ Liens.

• May be recorded “after the fact.”

• Seller’s affidavit.

• Lien waiver.

Limitations on Property Rights 1

Government Restrictions.

• Police Power.

• Zoning, building codes, etc.

• Eminent Domain.

• Eminent domain is relatively expansive; depending on the state, government has relatively broad powers on what property they may take possession of through eminent domain and for what purpose.

Limitations on Property Rights 2

Private Restrictions.

• They serve to limit future owners to achieve personal or business objectives.

• Deed restrictions.

• Subdivision restrictions.

Chapter 02

Real Estate Financing: Notes and Mortgages

Notes 1

Evidence of Debt.

Major Provisions. • Amount borrowed.

• Rate of interest.

• Dollar amount, due dates, and number of payments.

• Maturity date.

• Reference to security for the loan.

• Application of payments.

• Default.

Notes 2

Major Provisions (continued).

• Penalties for late payment and forbearance provisions.

• Provisions for unscheduled (early) payments.

• Notification of default and acceleration clause.

• Nonrecourse clause. • Note that even if there is a nonrecourse clause, loans are generally with

“recourse” if the “bad boy” provisions are violated. This could include fraud or misrepresentation. Another example would be if the borrower willfully damages the asset, the borrower will generally be held personally responsible for the damage.

Notes 3

Major Provisions (continued).

• Loan assumability.

• Assignment clause.

• Future advances.

• Release of lien by lender.

As you can see, a promissory note has a lot of component pieces.

The Mortgage Instrument 1

Note & Mortgage. • The note and the mortgage are not the same thing.

• Note: Obligation to pay.

• Mortgage: Pledges property as security.

The mortgagor is the borrower. The mortgagee is the lender. This is often confused by people who are new to the industry.

The Mortgage Instrument 2

Minimum Mortgage Requirements. • Appropriate identification of mortgagor and mortgagee.

• Proper description of the property serving as security for the loan.

• Covenants of seisin and warranty.

• Provision for release of dower rights.

• Any other desired covenants and contractual agreements.

The Mortgage Instrument 3

Important Mortgage Covenants. • Funds for Taxes Private Mortgage Insurance.

• Charges & Liens.

• Hazard Insurance.

• Preservation and Maintenance of the Property.

• Breach of Covenants.

• Transfer of property or a beneficial interest in borrower (“Due on sale clause”).

The Mortgage Instrument 4

Important Mortgage Covenants (Continued). • Borrower’s Rights to Reinstate.

• Right of Entry: Lender in Possession.

• Future Advances.

• Subordination Clause.

Additional Mortgage Concepts 1

Assumption of Mortgage. • Liability.

• Release of grantor from assumed debt.

Acquiring Title “Subject to” a Mortgage. • Liability.

Additional Mortgage Concepts 2

Property Covered. • Land.

• Improvements.

• Easements.

• Fixtures.

• Special case of trade fixtures.

• Mineral Rights.

• After-acquired property.

Additional Mortgage Concepts 3

Senior (“First”) & Junior Mortgages.

Recording Mortgages. • Protect Lien Priority.

• “First in time is first in right.”

Seller Financing. • Purchase Money Mortgage.

• Use of Subordination Clause.

Additional Mortgage Concepts 4

Land Contract. • Seller retains naked title.

• Purchaser has equitable title.

• Seller conveys title when purchaser completes the performance obligations.

Default. • Breach of mortgage contract.

• Technical default.

Alternatives to Foreclosure: Workouts 1

Restructure the loan. • Recasting.

• Extension Agreement.

• Alternatives.

Transfer of mortgage to new owner.

Alternatives to Foreclosure: Workouts 2

Voluntary Conveyance.

• Deed in Lieu of Foreclosure. • Please note that the presence of a 2nd mortgage will make it

problematic for the borrower to simply give a deed in lieu of foreclosure to the 1st mortgage holder. In that case, the 2nd mortgage would remain in effect and would not be extinguished by a deed in lieu of foreclosure.

Friendly Foreclosure.

Prepackaged Bankruptcy.

Short Sale.

• Potential exists for a taxable event.

Foreclosure 1

Judicial Foreclosure. • Judgment Lien.

Redemption. • Equity of Redemption.

• Prior to foreclosure.

• Statutory Right of Redemption.

• After foreclosure.

• Not in every state.

Foreclosure 2

Property Sale. • Fixing a Price by public auction.

• Upset price.

• Trust Deed: Trustor, Trustee, Beneficiary.

• Power of Sale Clause.

• Court authority not necessary.

• Used in a Limited Number of States.

• Purchaser Buys Any Title Defects.

Foreclosure 3

Parties. • Senior & Junior Lien Claimants.

Deficiency Judgment. • Property price does not cover claim.

• Several states limit the applicability of deficiency judgments.

Taxes in Default. • Tax sales.

Bankruptcy

Chapter 7. • Liquidation.

Chapter 11. • Available to business owners.

• Reorganization.

• Cramdown.

Chapter 13. • Reorganization.

Chapter 03

Mortgage Loan Foundations: The Time Value of Money

Future Value 1 Compound Interest.

• Earning Interest on Interest.

Basic Components.

• PV = Initial deposit.

• i = Interest rate (some authors use “r”).

• n = Number of years.

• FV = Value at a specified future period.

Future Value 2 General equation:

= +(1 ) n

nFV PV i

Future Value 3 Example 3-1:

• What is the value at the end of year 5 of $100 deposited today if the interest rate is 10% compounded annually?

5 5 $100(1.10)

$100(1.61051)

$161.05

FV =

Future Value 4 • Example 3-1 Using a Financial Calculator:

Future Value 5 Semi-Annual Compounding.

• In Example 3-1, what if interest were paid semi- annually instead of annually?

• There would be two compounding periods in each year.

• There would be a periodic rate to match the multiple compounding periods.

• The time period would be doubled.

• Most importantly, the future value would be higher. Additional compounding periods will affect the final result.

Future Value 6 Our general equation becomes:

1 n m

i FV PV

  

= +    

where m = number of compounding intervals in a year.

Future Value 7

• i

m is also called the period rate.

• For Example 1:

5 2

.10 100 1 +

100(1.62889)

$162.89

FV 

  =

   

Future Value 8 If the nominal rate is 6%, the effective annual yield changes as follows:

Compounding Interval Effective Annual Yield

Annually 6.00%

Semiannually 6.09%

Quarterly 6.14%

Monthly 6.17%

Daily 6.18%

Future Value 9 Two alternatives for multiple compounding periods and most financial calculators.

• You can change P/Y to the number of compounding periods.

• Example: Change P/Y to 2 for semiannual compounding.

• You can enter a periodic rate.

• Example: Enter i/2 as the interest rate for semiannual compounding.

Future Value 10 • If you change P/Y to 2, then

Future Value 11 Notice the difference in Future Value when multiple compounding periods are used:

• $162.89 (semi-annual) versus $161.05 (annual).

This shows the effect of earning interest on interest. The more compounding periods there are per year, the higher the future value will be.

Financial Functions: Concept Box 3.1 1

• PMT (n, i, PV, FV).

• PV (n, i, PMT, FV).

• FV (n, i, PV, PMT).

• i (n, PV, PMT, FV).

• n (i, PV, PMT, FV).

Financial Functions: Concept Box 3.1 2

These screenshots are from Excel.

For complex analysis, Excel is far superior to a financial calculator.

Note that the arguments in brackets are “optional”.

Present Value 1 • Discounting: Converting Future Cash Flows to the Present.

• General equation.

= 1

(1 + ) n n

PV FV i

Present Value 2 Example 3-2:

• What is the value today of $2,000 you will receive in year 3 if the interest rate is 8% compounded annually?

1 = 2000

(1.08)

= 2,000(0.79383)

= $1,587.66

PV      

Present Value 3 • Example 3-2 Using a Financial Calculator:

Present Value 4 • Example 3-2 with 8% Compounded Monthly.

• Mathematically:

1 =

1 +

n n m PV FV



              

  ,= n i n mPV FV MPVIF

Present Value 5

12 3

1 = 2000

.08 1 +

= 2000(.78725)

= $1574.51

PV 

              

Present Value 6 • If P/Y is changed to 12.

Annuity Level Cash Flow Stream.

Terminates at some date in the future.

Ordinary Annuity.

• Cash flows begin one period from today.

Annuity Due.

• Cash flows begin immediately.

Annuity: Future Value 1 • General Equation:

1 2 = (1 + ) + (1 + ) + ... +

n n FV P i P i P

− −

−

=  + +

1 = (1 )

n t

t FV P i P

Annuity: Future Value 2 Example 3-3:

• What is the future value of a 5-year ordinary annuity with annual payments of $200, evaluated at a 15% interest rate?

5 (1 + .15) 1

FVA = 200 .15

= 200(6.74238)

= $1,348.48

− 

Annuity: Future Value 3 • Using the Financial Calculator:

Annuity: Future Value 4 • For Example 3-3, if payments were to be received monthly.

• Mathematically:

 −  −    

=  + +  + + +        

1 2

1 1 ... 12 12

n m n m i i

FV P P P

 −

= 

  =  + +

   

1 1

t n m

i FV P P

Annuity: Future Value 5

5 12 .15

1 + 1 12

= 200 .15

= 200(88.5745)

= $17,714.90

   −  

        

Annuity: Future Value 6 • Using the Financial Calculator, if P/Y = 12.

Annuity: Future Value 7

• General Equation:

=  +  + +  + + +

1 2

1 1 1

(1 ) (1 ) (1 ) n

PV PMT PMT ... PMT i i i

= = 

(1 )

t t

PV PMT i

Annuity: Future Value 8 Example 3-4:

• If you had the opportunity to purchase a $500 per year, ten-year annuity, what is the most you would pay for it? The interest rate is 8%.

  − 

  

1 1

1.08 PVA = 500

.08

= 500(6.7100)

= $3355.00

Annuity: Present Value 1 • Using the Financial Calculator:

Annuity: Present Value 2 • For Example 3-4, if Payments Were to Be Received Monthly.

• Mathematically:

            

= + + +           + + +      

1 2 12

1 1 1 ...

1 1 1 12 12 12

PV P P P i i i

Annuity: Present Value 3

120

1 1

.08 1 +

12 PVA = $500

.08

= $500(82.4215)

= $41,210.74

  −

      

             

Annuity: Present Value 4 • Using the Financial Calculator, if P/Y = 12.

Time Value of Money—Extensions 1

Given the basic equations that we have discussed, we can solve for any missing single variable.

Some common applications.

• Solve for the interest rate.

• Compute payments to accumulate a future sum.

• Compute payments to amortize a loan.

Time Value of Money—Extensions 2

Rate of Return or Discount Rate.

Example 3-5:

• Reed & Portland Trucking is financing a new truck with a loan of $10,000, to be repaid in 5 annual end-of-year installments of $2,504.56. What annual interest rate is the company paying?

Time Value of Money—Extensions 3

• Set P/Y = 1:

Time Value of Money—Extensions 4

Example 3-6:

• A bank makes a $100,000 loan and will receive payments of $805 each month for 30 years as repayment. What is the rate of return to the bank for making this loan?

• This is also the cost to the borrower.

Time Value of Money—Extensions 5

• Set P/Y = 12.

Time Value of Money—Extensions 6

Example 3-7: Accumulating a Future Sum.

• An individual would like to purchase a home in five (5) years. The individual will accumulate enough money for a $20,000 down payment by making equal monthly payments to an account that is expected to earn 12% annual interest compounded monthly. How much are the equal monthly payments?

Time Value of Money—Extensions 7

• Set P/Y = 12.

Time Value of Money—Extensions 8

• The Power of Compounding.

• In Example 3-7, our saver deposited:

$244.89 × 60 = $14,693.40

• Interest earned was:

$20,000 − $14,693.40 = $5,306.60

Time Value of Money—Extensions 9

Example 3-8: Amortizing a Loan.

• Your company would like to borrow $100,000 to purchase a piece of machinery. Assume that you can make one payment at the end of each year, the term is 15 years, and interest rate is 7%. What is the amount of the annual payment?

Time Value of Money—Extensions 10

• Set P/Y = 1:

Equivalent Nominal Annual Rate

• ENAR = Equivalent Nominal Annual Rate.

• EAY = Effective Annual Yield.

  = + −     

(1 ) 1mENAR EAY m

Solving for Annual Yields with Partial Periods

• The XIRR function in Excel can be used for calculating annual yields with partial periods.

• Note that the XIRR assumes that all years have exactly 365 days. It does not account for leap years.

( )365 0

1 rate j

P  =

Chapter 04

Fixed Interest Rate Mortgage Loans

Mortgage Interest Rates

• Demand for mortgages is essentially derived demand; without a demand for real estate, the demand for mortgages would not exist.

• What will borrowers pay for the use of funds?

• What are lenders willing to accept for the use of funds?

• Mortgage Funds Supply Factors: Alternative Investments.

Components of the Mortgage Interest Rate 1

Real Rate of Interest.

• Time Preference for Consumption.

• All things being equal, we would rather consume now.

• Interest is compensation to delay a purchase.

• Production Opportunities in the Economy.

• Competition for funds when there are other investment opportunities.

Inflation Expectation.

• Directly impacts interest rates.

Nominal interest rates.

• Generally expressed on annual basis.

Components of the Mortgage Interest Rate 2

Default Risk.

Interest Rate Risk.

• Anticipated Inflation and Unanticipated Inflation.

Prepayment Risk.

Liquidity Risk.

Legislative Risk.

• Governments periodically change the “rules of the game.” As a lender, you take on the risk that the government may change the laws that will make it more difficult or impossible for you to collect on a debt.

Components of the Mortgage Interest Rate 3

it = r1 + p1 + f1

r1 = real rate

p1 = premium for risks

f1 = premium for inflation

Understanding Fixed Interest Rates Mortgage Loan Terms

Loan amount.

Loan maturity date.

Interest rate.

• Nominal versus real.

Periodic payments.

• Effective annual rate of interest.

Constant Payment Mortgage (CPM).

Loan Amortization Patterns

Accrued Interest and Loan Payments.

• Accrual rate versus pay rate.

Type of CPM Loan Pay Rate Loan Balance at Maturity

Fully Amortizing > Accrual rate Fully repaid

Partially Amortizing > Accrual rate Not fully repaid

Interest Only = Accrual rate = Amount Borrowed

Negative Amortizing < Accrual rate > Amount Borrowed

Mortgage Payment Patterns 1

Example 4-1.

Calculating the Payment for a CPM.

• $100,000 Mortgage.

• 7.0% Interest.

• 30 Years.

• Monthly Payments.

Mortgage Payment Patterns 2

Note that this could also be easily calculated in Excel using the PMT() function.

Mortgage Payment Patterns 3

Interest paid in the first month.

• .07

$100,000 $583.33. 12

   = 

 

Principal paid in the first month.

• $665.30 − $583.33 = $81.96.

Every month, interest portion declines.

Every month, principal portion increases.

Exhibit 4-1 in the book shows this.

Exhibit 4-2: Monthly Payment, Principal, Interest, and Loan Balances for a Fully Amortizing, Constant Payment Mortgage

Access the long description slide.

Exhibit 4-3: Relationship between Monthly Mortgage Payments and Maturity Periods: Fully Amortizing Loans

Access the long description slide.

Exhibit 4-7

Access the long description slide.

Computing a Loan Balance 1

Essentially “removing” the interest that was built into the payment.

Two mathematical methods.

• Compute the present value of the remaining payments.

• Compute the future value of the amortized loan amount.

Computing a Loan Balance 2

There are 3 methods to do this with a financial calculator.

• From Example 4-1, what is the future expected loan balance in 8 years?

Computing a Loan Balance: Present Value Method

Computing a Loan Balance: Future Value Method

Computing a Loan Balance: Amortization Function Method • Step 1: Compute Payment = $665.30

• Step 2: Press

Loan Closing Costs 1

Loan Closing Costs.

Additional Finance Charges.

• Loan Origination Fees.

• Cover origination expenses.

• Loan Discount Fees – “Points.”

• Used to raise the yield on the loan.

• Borrower trade-off: points vs. contract rate.

• 1 Point = 1.0% of the loan amount.

Loan Closing Costs 2

Why Points?

• Mortgage rates can be “sticky.”

• It’s a way to price in the risk of a borrower.

• Early repayment of a loan does not allow recovery of origination costs. It’s a way to cover the lender for the overhead of running its business.

• Earn a profit on loans sold to investors at a yield equal to the loan interest rate.

Loan Fees and Borrowing Costs 1

Calculating the effective interest cost.

Example 4-2:

• $250,000 home.

• 80% LTV Loan.

• 8.0% Interest.

• 4 Points.

• 30 Years.

Loan Fees and Borrowing Costs 2

• Step 1: Compute payment using the face value of the loan.

But, with points paid up front, the borrower actually receives less than the face value.

Loan Fees and Borrowing Costs 3

• Step 2:

Loan Amount = $200,000

Points Paid = (0.04 $200,000)

Amount Received = $192,000

− 

• Compute effective interest cost, using the Amount Received from Step 2 & Payment from Step 1.

Loan Fees and Borrowing Costs 4

• Compute effective interest cost:

Loan Fees and Borrowing Costs 5

What is the effective cost if we think this loan might be repaid after 8 years?

• Step 1: Compute PMT = $1467.53.

• Step 2: Compute Future Loan Balance.

Loan Fees and Borrowing Costs 6 • Step 3: Compute effective interest cost.

Truth-in-Lending Act

• Truth-in-Lending Act.

• Annual Percentage Rate (“APR”).

• This applies only to consumers purchasing residences.

“Pricing” FRMs

• By adjusting the fees that are charged, different effective rates of interest may be achieved.

• Prepayment will also effect the effective rate of interest.

Exhibit 4-8: Relationship between Mortgage Yield and Financing Fees at Various Repayment Dates

Access the long description slide.

Other FRM Loan Patterns

• Constant Amortizaton Mortgages.

• Callable Loans.

Reverse Mortgages

• Essentially, we’re running the math in reverse.

• Instead of the borrower receiving money at the beginning and paying it back over time, the borrower is receiving money over time and paying it back at the end of the life of the mortgage.

• This is for an older consumer; it is generally for those 62 or older.

Exhibit 4-2: Monthly Payment, Principal, Interest, and Loan Balances for a Fully Amortizing, Constant Payment Mortgage Long Description

The first graph is called Panel A. This graph shows that a monthly payment of $617.17 is mostly interest at the beginning of the loan period and over time the amount of the payment that goes to interest declines in a nonlinear (concave down) manner. After 15 years, for example, $514.24 still goes to interest, but after 25 years $277.45 goes to interest. The second graph is called Panel B. This graph shows that the $60,000 loan balance decreases to $51,424 after 15 years and decreases to $27,745 after 25 years.

Return to slide containing original image.

Exhibit 4-3: Relationship between Monthly Mortgage Payments and Maturity Periods: Fully Amortizing Loans Long Description

The horizontal axis displays months and shows the values 120, 180, 240, 300, and 360. The associated monthly payments (in the same order) are on the vertical axis and have the values: $860.83, $720. 10, $660.65, $631.93, and $617.17.

Return to slide containing original image.

Exhibit 4-7 Long Description

The first graph is called Panel A. This graph shows four horizontal lines because the monthly payment is constant. The monthly payment for the fully amortizing (FA) loan is $617.17. The monthly payment for a partially amortizing (PA) loan is $605.72. The monthly payment for the interest only (IO) loan is $600.00. Finally, the monthly payment for the negative amortizing (NA) loan is $594.28. The second graph is called Panel B. This graph shows the outstanding loan balance over the life of the loan. The fully amortizing (FA) loan has an ending balance of $0. The partially amortizing (PA) loan has an ending balance of $40,000. The interest only (IO) loan has an ending balance of $60,000. Finally, the negative amortizing (NA) loan has an ending balance of $80,000.

Return to slide containing original image.

Exhibit 4-8: Relationship between Mortgage Yield and Financing Fees at Various Repayment Dates Long Description

If the year of prepayment is year 1, the yield is 15.26%. If the year of prepayment is year 5, the yield is 12.82%. If the year of prepayment is year 30, the yield is 12.41%. The curve defined by these points is decreasing asymptotically to a limit of a yield of 12.00%.

Return to slide containing original image.

Chapter 05

Adjustable and Floating Rate Mortgage Loans

Variable Payment Patterns

Fixed Rate Mortgages.

Adjustable or Floating Rate Mortgages.

Price Level Adjusted Mortgage (PLAM). • Loan balance adjusted for inflation.

• New payment computed using adjusted balance.

Exhibit 5-1

Payments and Loan Balance Patterns, $60,000 PLAM, 4% Inflation = 6% per Year, versus $60,000 CPM, 10% Interest, 30 Years.

Access the long description slide

Fixed Rate and Price Level Adjusted Mortgage

• Fixed rate mortgages can lose substantial value if an unanticipated rise in inflation occurs after the mortgages have been made.

• The PLAM is designed to avoid the loss that would otherwise occur due to unanticipated inflation.

• As you might expect, the popularity of fixed rate mortgages ebbs and flows with the state of the market and the participants’ perception of the stability of inflation rates.

Price Level Adjusted Mortgage

• i = mortgage interest rates, r = expected real rate of interest, p = risk premium, f = expected inflation i = r + p + f.

PLAM balances adjust with changes in inflation.

Two problems

• CPI is not a perfect index for housing prices.

• If borrower’s incomes do not increase at CPI, this may lead to the borrower’s inability to repay.

Basic Issues with Adjustable Rate Mortgages • ARMs do not eliminate interest rate risk.

• The longer the adjustment interval, the more interest rate risk the lender will take on.

• As the lender assumes less interest rate risk by putting it onto the borrower, the lender should expect to receive a lower rate of interest than it would otherwise receive with a fixed rate mortgage.

Adjustable Rate Mortgages 1

A new loan payment is computed at each reset date. • Composite Rate = index + margin.

• Index. • Interest rate that the lender does not control.

• Treasury securities.

• Cost Of Funds Index (COFI).

• London Interbank Offered Rate (LIBOR).

• Margin (or spread). • Premium added to the index.

Adjustable Rate Mortgages 2

Index. Margin. Composite Rate. Reset Date. • When mortgage payment is readjusted.

Negative Amortization. • Payment does not cover the interest due.

Caps. Floors. Assumability. Discount Points. Prepayment. Lockouts. Conversion Option.

Adjustable Rate Mortgages 3

Hybrid Loans. • Longer initial reset period, 3/1, 5/1, and 7/1.

Interest Only ARM and Floating Rate. • Interest only (“i.o.”) for initial period.

• Then, depending on what has been negotiated.

• Pay interest only.

• Pay interest & some principal.

• Sometimes negative amortization.

• Fully amortizing payments required in future.

Adjustable Rate Mortgages 4

For residential loans, the teaser rate is important.

• Initial rate below market composite rate.

• Market Competition.

• Accrual Rate.

• Negative Amortization.

• Payment Shock.

• It is unlikely that all residential borrowers comprehend or appropriately price the inherent risks in adjustable rate mortgages.

Adjustable Rate Mortgages Yield & Rates 1

Yields are a function of: • Initial interest rate.

• Index & margin.

• Any points charged.

• Frequency of payment adjustments.

• Inclusion of caps or floors on the interest rate, payments, or loan balances.

Adjustable Rate Mortgages Yield & Rates 2

Default Risk. • Can borrower afford new payments?

• Impact of negative amortization.

Pricing Risk. • Allocation of interest rate risk.

• Impact on default risk of specific borrowers.

Exhibit 5-2 The Relationship between Interest Rate Risk, Default Risk, and Risk Premiums.

Access the long description slide

Expected Yield Relationships and Interest Rate Risk

Basic Relationships: • FRM versus ARM expected yield at origination.

• Short-term versus Long-term indices.

• Shorter versus Longer time intervals between adjustments.

• Impact of caps & floors.

• Negative amortization.

Adjustable Rate Mortgages 5

Example 5-1 • Unrestricted ARM.

• Loan Amount = $100,000.

• Starting Rate = 5%.

• Term = 30 Years.

• Adjustment Interval = 1 Year.

Adjustable Rate Mortgages 6

• Initial Payment:

Adjustable Rate Mortgages 7

EOY1 Loan Balance • Change n and compute the present value of the remaining payments.

Adjustable Rate Mortgages 8

• The new payment is based on loan balance of $98,524.63.

• If the composite rate = 7%,

Adjustable Rate Mortgages 9

• Note the payment increase:

$662.21 − $536.82 = $125.39

• This could be a problem for a borrower on a tight budget.

Adjustable Rate Mortgages 10

Example 5-2: Interest Rate Caps. • Loan Amount = $100,000.

• Starting Rate = 7%.

• Term = 30 Years.

• Adjustment Interval = 1 Year.

• 2% Annual Rate Cap.

Adjustable Rate Mortgages 11

• Initial Payment:

Adjustable Rate Mortgages 12

• EOY1 Loan Balance:

• New payment is based on loan balance of $98,984.19.

Adjustable Rate Mortgages 13

• The new interest rate cannot be higher than 9% due to the interest rate cap.

• If the Composite Rate = 10%, the 2% cap applies and the interest rate is 9%.

• If the Composite Rate = 8%, the 2% cap does not apply and the interest rate is 8%.

Adjustable Rate Mortgages 14

Example 5-3: Payment Caps. • Loan Amount = $100,000.

• Starting Rate = 6%.

• Term = 30 Years.

• Adjustment Interval = 1 Year.

• Payment Cap = 5%.

Adjustable Rate Mortgages 15

• Initial Payment:

Adjustable Rate Mortgages 16

• EOY1 Loan Balance:

Adjustable Rate Mortgages 17

• New payment is based on loan balance of $98,771.99.

• The dollar increase in the payment cannot exceed the capped payment.

• Capped Payment = $599.55 × 1.05 = $629.53.

Adjustable Rate Mortgages 18

• If the Composite Rate = 10%, the unrestricted payment would be:

Adjustable Rate Mortgages 19

• Since the capped payment is $629.53, it would be used.

• If there is negative amortization,

would be the EOY2 Loan Balance.

Exhibit 5-1 Long Description

The first graph is called Panel A: Monthly payments. It shows a CPM of $527 as a horizontal line and the PLAM payment increasing from $286 to about $1,500.

The second graph is called Panel B: Outstanding loan balances, in thousands of dollars. The loan balance on the CPM decreases in a nonlinear manner from $60,000 to $0 over 30 years. The loan balance on the PLAM increases to about $93,000 by year 15 then quickly decreases to $0 thereafter.

Return to slide containing original image.

Exhibit 5-2 Long Description The first graph is called Panel A. The horizontal axis is labeled interest rate risk to lender and the vertical axis is labeled interest rate risk premium. A line with a positive slope of approximately 1 passes through the origin and is labeled ARM. The point furthest to the right is labeled (B) and is associated with the risk assumed with an FRM.

The second graph is called Panel B. The horizontal axis is labeled interest rate risk to lender and the vertical axis is labeled default risk premium. When the interest rate risk to the lender is low, the default risk premium is high (Point C). As the interest rate risk to the lender increases, the default risk premium decreases to that of an FRM (Point D).

The third graph is called Panel C. The horizontal axis is labeled interest rate risk to lender and the vertical axis is labeled total risk premium. A line passing through the origin with a slope of about 1 is labeled ARM interest rate risk premium. The vertical distance above this line is the default risk premium added to determine the total risk. The maximum interest rate risk to lender is labeled Point E and corresponds to a total risk premium of an FRM.

The final graph is labeled Panel D. The horizontal axis is labeled interest rate risk to lender and the vertical axis is labeled total risk premium. This graph is similar to the last one only it shows two different default risk premiums, creating two parallel lines: ARM borrower #1 and ARM borrower #2. The maximum point on each of these lines corresponds to a total risk premium of an FRM for borrower #1 and an FRM for borrower #2.

Return to slide containing original image.

Chapter 06

Mortgages: Additional Concepts, Analysis, and Applications

Incremental Borrowing Cost 1

Compare financing alternatives.

• What is the real cost of borrowing more money at a higher interest rate?

• Alternatively, what is the required return to justify a lower down payment?

• Basic principle when comparing choices: What are the cash flow differences?

Incremental Borrowing Cost 2

Example 6-1:

• Home Value = $150,000.

• Two Financing Alternatives.

• #1: 90% Loan to Value, 8.5% Interest Rate, 30 Years.

• #2: 80% Loan to Value, 8% Interest Rate, 30 Years.

• It appears there is only a 0.5% interest rate difference, but…

Incremental Borrowing Cost 3

Blank Alternative #1 Alternative #2

LTV 90% 80%

i 8.5% 8%

Term 30 Years 30 Years

Down payment $15,000 $30,000

Loan $135,000 $120,000

Payment $1,038.03 $880.52

Exhibit 6-2: Effect of Loan-to-Value Ratio on Loan Cost

Access the long description slide.

Effect of Loan-to-Value Ratio on Loan Cost

The more you borrow, the higher the interest rate will be.

It is not economically rational to borrow as much money as possible.

There is a point at which you should not borrow more money. The interest rate will be just too high for it to make sense.

Incremental Borrowing Cost 4

Cash Flow Differences.

• Borrow $15,000 more.

• Pay $157.51 per month more.

Incremental Borrowing Cost 5

• 12.28% represents the real cost of borrowing the extra $15,000.

• Can you earn an equivalent risk adjusted return on the $15,000 that is not invested in the home?

• Alternatively, can you borrow the additional $15,000 elsewhere at a lower cost?

Incremental Borrowing Cost 6

In Example 6-1, what if the borrower expects to relocate after 8 years?

We need the future expected loan balances:

• Alt #1: $123,810.30.

• Alt #2: $109,221.24.

• Difference: $14,589.06.

This becomes a future value in our analysis.

Incremental Borrowing Cost 7

• Cash Flow Differences.

Incremental Borrowing Cost 8

Use of discount points.

• Analysis would change.

• Depending on the points, the cash flow difference at time zero would change.

• In Example 6-1, the $15,000 difference would change.

Different maturities.

• In Example 6-1, let’s change the term of the alternative #2 to 25 years.

Incremental Borrowing Cost 9

Blank Alternative #1 Alternative #2

LTV 90% 80%

i 8.5% 8%

Term 30 Years 25 Years

Down payment $15,000 $30,000

Loan $135,000 $120,000

Payment $1,038.03 $926.18

Incremental Borrowing Cost 10

Cash Flow Differences.

• At time 0: $15,000.

• For the first 300 months: $111.85.

• For the final 60 months: $1038.03.

Incremental Borrowing Cost 11

• Using the Cash Flow Register.

Loan Refinancing 1

Borrower considerations.

• Terms on the present outstanding loan.

• What are the new loan terms?

• What are the fees associated with paying off the old loan and obtaining a new one?

Application of basic capital budgeting investment decision.

• What is our return on an investment in a new loan?

Loan Refinancing 2

Example 6-2:

• A borrower has secured a 30 year, $120,000 loan at 7%. 15 years later, the borrower has the opportunity to refinance with a fifteen year mortgage at 6%. However, the up front fees, which will be paid in cash, are $2,500. What is the return on investment if the borrower expects to remain in the home for the next fifteen years?

Loan Refinancing 3

Initial Loan:

• $120,000.

• 30 Years.

• 7% Interest.

• Payment = $789.36.

15 Years Later.

• Loan Balance = $88,822.64.

• New Payment at 6% = $749.54.

Loan Refinancing 4

• Cost = $2,500.

• Benefit = $48.82 per month for 15 years.

Loan Refinancing 5

In Example 6-2, what is the return on investment if the borrower expects to relocate after seven years and not remain in the home for the full 15 years?

• Now we need the expected future loan balances for the original loan and the possible new loan.

Loan Refinancing 6

• Original Loan Balance = $58,557.76.

• Refinanced Loan Balance = $57,036.41.

• Difference = $1,521.35.

Loan Refinancing 7

In Example 6-2, refinancing appears to be a good investment.

Effective cost of refinancing: Prepayment fees on old loan are treated just like origination fees on a new loan.

Borrowing the refinancing cost.

Biweekly payments.

• Lower the amount of total interest over the life of the loan.

• Therefore, if the monthly payment is the same, the extra money will pay down the loan quicker than it would have been paid off.

Loan Refinancing 8

Access the long description slide.

Early Loan Repayment – Lender Inducements

• After a period of rising interest rates, borrowers may have a loan that has an interest rate that is below market.

• A lender could offer a financial inducement to a borrower to prepay the mortgage so that the lender could relend that money to someone else at a higher rate.

Market Value of a Loan 1

How much would an investor pay for the loan?

• The investor is buying the cash flow stream of the loan.

• Discount loan cash flow at the market rate of interest that the investor can earn on investments of equivalent risk.

Market Value of a Loan 2

Example 6-3:

• $100,000 Loan.

• 30 Years.

• 6% interest.

• Payment = $599.55.

• One year later, book value = $98,771.99.

• Assume interest rates have risen to 7%.

Market Value of a Loan 3

• The investor will not pay book value.

• To compute the market value:

Compare this to book value.

Effective Cost of Two or More Loans 1

Basic Technique.

• Compute the payments for the loans.

• Combine into a cash flow stream.

• Compute the effective cost of the amount borrowed, given the cash flow stream.

• Compare the cost to alternative financing options.

Effective Cost of Two or More Loans 2

Example 6-4:

• You need a $500,000 financing package.

• $100,000 at 7%, 30 Years.

• Payment = $665.30.

• $200,000 at 7.5%, 20 Years.

• Payment = $1611.19.

• $200,000 at 8% 10 Years.

• Payment = $2426.55.

Effective Cost of Two or More Loans 3

• Using the Cash Flow Register.

Second Mortgages and Shorter Maturities

Comparing a new mortgage versus an assumable mortgage and a second mortgage.

Home Equity Loans.

Home Equity Lines of Credit (“HELOC”).

• Not a lump sum.

• Some payment flexibility.

• Interest rates are usually adjustable.

• Loan balance will change from month to month as the payment and the amount borrowed changes.

Effect of Below Market Financing on Property Prices

• A seller with a below market rate assumable loan in place may be able to sell the property for more than the seller would otherwise be able to.

• All else equal, a buyer is paying a higher purchase price now in exchange for lower debt payments over the life of the loan.

• Similar to other problems, we compute i and compare it to other equivalent risk investments.

Below Market Financing 1

• Example 6-6: Identical Homes A & B.

Blank A B

Price $120,000 $115,000

Loan Balance $80,000

(assumable)

$80,000

(new loan)

Down payment $40,000 $35,000

I 7% 8%

Term 20 Years 20 Years

Payment $620.24 $669.15

Below Market Financing 2

• In Example 6-6, the buyer can secure below market financing by paying $5,000 more for an identical home.

• The below market financing results in a monthly payment of $48.91 less than if regular financing was used.

Below Market Financing 3

• The buyer earns 10.20% on the $5,000 investment by reducing the monthly payment by $48.91.

Additional Financing Concepts

• Cash Equivalency.

• Wraparound Loans.

• Buydown Loans.

Exhibit 6-2: Effect of Loan-to-Value Ratio on Loan Cost Long Description

This graph displays the loan-to-value ratio (%) on the horizontal axis and the yield rate (%) on the vertical axis. The rate for the incremental amount borrowed increases exponentially as the loan-to-value ratio increases. For example, a loan-to-value ratio of 50% corresponds to a yield rate of about 12%. A loan-to-ratio value of 60% corresponds to a yield rate of about 13%. A loan-to ratio value of 90% corresponds to a yield rate of about 21%. The average rate for the entire loan also increases exponentially as the loan-to-value ratio increases, but at a slower rate. A loan-to-value ratio of 80% corresponds to an average yield rate for the entire loan of about 12%. A loan-to-value ratio of 90% corresponds to an average yield rate for the entire loan of about 13%.

Return to slide containing original image.

Loan Refinancing 8 Loan Cost Long Description 1 The first image shows, Monthly payments, 360

PV equals minus $80,000

i equals 6%

n equals 360

FV equals zero

Solve for PMT equals $479.60

Biweekly Payments, 26 per year

$479.60 divided by 2

PMT equals $239.80.

Advance to rest of long description.

Loan Refinancing 8 Loan Cost Long Description 2 The second image shows, Biweekly Mortgage Loan Payoff Period: PV equals minus $80,000

PMT equals $239.80

i equals 6% divided by 26, which is the annual rate of 6% compounded

Total interest savings:

Total monthly payments, $172,656

Minus total biweekly payments, $152,752

Equals Total interest savings, $19,904

Return to slide containing original image.

Chapter 07

Single Family Housing: Pricing, Investment, and Tax Considerations

Homeownership

Homeownership is not just for shelter. It can also be an investment vehicle.

House Prices.

Income and Employment.

Interest Rates.

Renting versus Owning.

• Economic.

• Other Issues.

Historical Trends

Roughly 2/3 of residential is owned; the rest is rented.

Renting can be favorable for a number of reasons including:

• Need for flexibility.

• Lack of funds.

• Credit quality.

• No desire for risk of ownership.

• A desire to shift maintenance, security, and management to others.

• Avoid volatility in prices.

Tax Considerations

Interest Deduction.

• Qualified residence.

• Maximum deduction.

Points.

Real Estate Taxes.

Capital Gains Exclusion.

• $250,000 and $500,000.

• Primary residence rules and occurrence rules.

Regional Dynamics 1

• Speculative Housing Bubbles.

• Regional Economic Drivers.

• Growth or Decline?

Regional Comparative Advantage.

• Natural Advantages.

• Employee Characteristics.

• Access to Transportation.

• Quality of Life.

Regional Dynamics 2

Base & Service Industries.

Location Quotient.

• LQ > 1 is a base industry.

• LQ < 1 is a service industry.

Employment Multiplier.

This is done very simply by using the following relationship:

1.0 ?

TOT

USE

     

      

Terms in this relationship are as follows:

RE = Regional employment

USE = U.S. employment

j = Industry classification

TOT = Total

Housing Supply 1

Housing Starts.

Existing Home Sales.

Local Supply Influences.

• Interest Rates.

• Zoning.

• Building Codes.

• Land Terrain.

Housing Supply 2

Neighborhood Influences.

• Public goods.

• School quality.

Capitalization Effect.

• Public services provided relative to taxes paid.

Optimal City Size.

Appraisal: Qualifying the Property

Establish Market Value.

• Most probable price under competitive market conditions.

Price, Cost of Construction, and Market Value.

What are market conditions?

What are submarket conditions?

What is the neighborhood?

The Sales Comparison (Market) Approach

• “Subject” is the property being appraised.

• “Comparables” are recently sold similar properties.

• Estimate value of subject by adjusting the sales price of the comparables for any differences.

• Subject Value Estimate = Comparable Sales Price ± Feature Differences.

The Cost Approach

• Subject Value Estimate = Cost New − Depreciation + Land Value.

• Physical depreciation, functional obsolescence, external obsolescence.

• Depreciation is often estimated straight-line.

The Income Approach

• Gross Rent Multiplier (“GRM”).

• Subject Value Estimate = GRM × Rental Income.

• This method is generally not used for single family houses as there tends to not be a deep rental market for that product.

Appraisal: Qualifying the Property 1

• The sales comparison approach is most effective for active residential markets.

• The cost approach is most effective for special use property or newer homes.

• The income approach is most effective for cash flow generating property.

Appraisal: Qualifying the Property 2

Example 7-1:

• Consider the following property:

• 2,000 Square foot; $100 per square foot new.

• 10% of total effective 100 year life span is depreciation estimate.

• Land value is estimated at $30,000.

Appraisal: Qualifying the Property 3

• Cost New = 2,000 × $100 = $200,000.

• Depreciation Estimate = $200,000 × .10 = $20,000.

• Site Value = $30,000.

• Subject Value Estimate = $200,000 − $20,000 + $30,000 = $210,000.

Appraisal: Additional Techniques

• Example 7-2.

• GRM = 4, derived from the market.

• Subject potential gross income (PGI) is $200,000 per year.

• Subject Value Estimate = 4 × $200,000 = $800,000.

Investing in “Distressed Properties” 1

Below Market Value Property.

Reasons:

• Financial.

• Legal.

• Personal.

Investing in “Distressed Properties” 2

Financial Framework.

• Acquisition Phase.

• Holding Period Phase.

• Disposition Phase.

• Profitability.

Investing in “Distressed Properties” 3

Acquisition Phase.

• Information sources for distressed property.

• Legal Research: Title Quality.

• Lenders at auctions.

• Equitable Rights.

• Buying at Auction Conducted by Public Entities.

• Market Research/Costs.

• Inspection Costs.

Investing in “Distressed Properties” 4

Holding Period Phase.

• Financial Issues.

• Renovation cost.

• Interest or other carrying costs.

• Taxes and insurance.

Disposition Phase.

• Selling.

• Renting.

• Occupying.

Chapter 08

Underwriting and Financing Residential Properties

Underwriting Default Risk

Qualifying the borrower and property. • Borrower loan application.

• Property appraisal.

Default insurance.

Payment-to-income ratio.

Loan-to-value ratio.

Classification of Mortgage Loans 1

1. Conventional mortgages.

2. Insured conventional mortgages.

3. FHA- insured mortgages.

4. VA-guaranteed mortgages.

Classification of Mortgage Loans 2

Conventional Mortgages.

• Usually no more than 80% loan to value ratio.

• No government guarantee or insurance.

• Conforming loans. • Meet government sponsored enterprises (“GSE”) loan limit requirements.

• Nonconforming. • “Jumbo” loans.

• Large dollar amount loans.

• Higher interest rate.

• Subprime.

• ALTA (or “low-doc”).

Classification of Mortgage Loans 3

Insured Conventional Mortgage Loans.

• LTV usually > 80%,

• Private Mortgage Insurance.

• Insurer assumes default risk of the larger loan.

• Covers loan amount > 80% LTV.

• Generally no loan maximum but 95% is as far as most insurers will go.

Classification of Mortgage Loans 4

FHA-Insured Mortgage Loans. • Lender completely insured against default loss.

• Strict qualification procedures for borrower and property.

• Lower borrower down payments.

• Loan maximums.

• Section 203b most common program. Other programs include 251, 234c, and 245.

Classification of Mortgage Loans 5

VA-Guaranteed Mortgage Loans. • Qualified veterans.

• Guarantee may not exceed 25% of loan.

• Veteran pays a funding fee.

• Certificate of reasonable value (“CRV”).

• Loan entitlement.

• Unlike FHA program, the VA is providing a loan guarantee, not default insurance.

The Underwriting Process 1

• Dual income.

• Stability of joint income.

Borrower Income. • Verify employment, wages, and will it continue.

• Verify other income.

• Will it continue?

• Is it verifiable on prior tax returns? Two years is the standard.

The Underwriting Process 2

Borrower Assets.

• Verify closing costs and down payment funds.

• Additional savings and investments.

Credit History.

• Credit reports.

• Credit scoring models. • Punctuality.

• Capacity used.

• Years of credit experience.

• Types of credit used.

• Recent searches.

The Underwriting Process 3

Estimated Housing Expenses. • Principal & Interest.

• Mortgage insurance (if any).

• Property taxes.

• Hazard insurance.

• Condominium or cooperative homeowners association dues (if applicable).

Other Obligations. • Auto loans, credit cards, child support, etc.

Compensating Factors.

Standards vary for conventional, insured conventional, FHA, and VA mortgages.

The Closing Process

• Close the buyer’s loan and transfer title.

• Loan and title transfer happen at the same time.

• Financing costs.

The Closing Process: Prorations, Escrow Costs, and Payments to Third Parties

Property taxes, prorations, and escrow accounts.

Mortgage insurance and escrow accounts.

Hazard insurance and escrow accounts.

Mortgage cancellation insurance.

Title insurance, lawyer’s title opinion.

Release fees.

Attorney’s fees.

Pest inspection.

Real estate commission.

Statutory Costs.

• Recording fees.

• Transfer taxes.

Real Estate Settlement and Procedures Act (RESPA)

1. Consumer Information.

2. Advance Disclosure of Settlement Costs.

3. Title Insurance Placement.

4. Prohibition on Kickbacks & Referral Fees.

5. Uniform Settlement Statement.

6. Advanced Inspection of Uniform Settlement Statement.

7. Escrow Deposits.

Federal Truth-In-Lending Requirements

• Annual Percentage Rate (APR).

• This law does not apply to commercial transactions.

• In general, there are more consumer protections in place for residential real estate ownership, lending, and tenancy than there is for the commercial side of the industry.

• There is more disclosure required for adjustable rate mortgages as it is a more complex product.

Chapter 09

Income-Producing Properties: Leases, Rents, and the Market for Space

Property Types: Exhibit 9-1 1

Residual

A. Single family

Detached

Cluster developments

Zero lot line developments

B. Multifamily

High rise

Low rise

Garden apartments

II. Nonresidential

A. Office

Major multitenant- (central business district)

Single or multitenant- suburban

Single tenant - build to suit

Combination office/showroom

professional: Medical

specialized use

B. Retail

Regional shopping centers/malls

Neighborhood centers

Community centers

Strip centers

Specialty /lifestyle centers

Discount/outlet centers

Property Types: Exhibit 9-1 2

C. Hotel/motel

Business/convention

Full service

Tourist/resort:

Limited service

Extended stay

All suites

D. Industrial/Warehouse

Heavy industrial

Light industrial warehouse

Office/warehouse

Warehouse:

Distribution

Research and development (R & D)

Flex space

E. Recreational

Country clubs

Marinas/resorts

Sports complexes

F. Institutional (special purpose)

Hospital/convalescent

Universities

Other

III. Mixed use Developments

Combinations of the above uses

Supply and Demand Analysis

Equilibrium Market Rental Rate.

• Vacancy Rate.

• Supply and Demand.

• Short run versus long-run.

• There are different influences on supply and demand for different product types.

Exhibit 9-2: Rental Market Equilibrium

Access the long description slide.

Exhibit 9-4: Determinants of Supply and Demand – Major Property Types 1 Demand Influences:

Apartments:

Number of households, age of persons in households, size of household incomes, interest rates, home ownership, affordability, apartment rents, housing prices.

Office Space:

Categories of employment with very high proportions of office use includes service and professional employment, including attorneys, accountants, engineers, insurance real estate brokerages and related activity, banking, financial services, consultants, medical dental, pharmaceutical, and so on.

Warehouse Space:

Categories of employment with high concentrations in warehouse use include wholesaling, trucking, distribution, assembly, manufacturing, sales/service, and so on.

Retail Space:

Demand indicators include household incomes, age, gender, population, size, and tastes/preference.

Supply influences:

Vacancy rates, interest rates and financing availability, age and combination of existing supply stock, construction costs, land costs.

Exhibit 9-4: Determinants of Supply and Demand – Major Property Types 2

Property Type Blank Typical Construction Periods

Apartments Suburban, garden walkup Urban mid-, high-rise

6 to 18 months 18 to 24 months

Office Buildings Suburban low-rise CBD mid-, high-rise

18 to 24 months 24 to 28 months

Retail Strips/standalone Neighborhood/community Enclosed mails

6 to 12 months 12 to 24 months 36 to 48 months

Warehouse Suburban, single level 9 to 12+ months

Location and User-Tenants

1. Competition leads to the highest rents in the most profitable locations and land value.

2. Locations will be dominated by clusters of users with similar revenue or operating expense structures.

3. Locations that are most valued will lead to the greatest density.

4. Some locations are competed for by firms that are most cost-sensitive.

The Business of Real Estate

More cost-effective than owning. • Space requirements.

• Owning is a heavy capital investment.

• Stay out of the “real estate business.”

• Maintain operating flexibility. It’s much easier to lease new space, or sub-lease excess space based on staffing levels than it is to buy or sell buildings.

• Maintenance and repair.

• If not used, must dispose of excess space.

This results in specialized real estate firms.

The exception is for specialized facilities or for headquarters facilities where there are business reasons to own instead of lease.

Real Estate Income

Market Rent: The price to rent space under current market conditions.

• Outlook for national economy.

• Economic base of the area.

• Demand.

• Supply.

Vacancy.

• On account of tenant turnover, space is not always leased even in strong markets.

Leases

Lessor = Owner, Lessee = Tenant.

Underwriting Tenants.

• Financial statements.

• Credit ratings.

• Analyst reports.

• Bank relationships.

• Existing obligations.

General Contents of Leases 1

• Parties, Dates, Length.

• Base rent.

• Deposits.

• Condition.

• Allowable uses.

• Restrictions on assignment or subletting.

• Use of common areas and facilities.

• Responsibility for maintenance and repair.

General Contents of Leases 2

• Restrictions on alterations or improvements.

• Construction of any expansion by owner.

• Eminent domain and any consideration.

• Responsibility for payment of specific expenses by lessee and/or lessor.

• Insurance requirements.

• Lease renewal options.

• Estoppels.

Leases and Rental Income

1. Flat Rent.

No rent change over lease term.

2. Step-Up Rents.

Specified rent increases at specified times.

3. Indexed Rents.

Periodic rent adjustment (example: CPI, porter’s wage).

4. Rents adjusted based on revenue/sales performance.

Percentage rent.

Breakpoints and overages.

Leases and Responsibility for Expenses (Recoveries)

Gross (full-service) leases.

• Tenant pays rent only.

• Property owner pays all operating expenses.

Modified (full-service) lease.

• Direct “pass throughs.”

• Non-operating expense “pass throughs.”

Leases with operating expense recoveries.

Comparing Leases: Effective Rent 1

Used to compare different leases.

• Compute present value of rent stream.

• Convert present value to an equivalent level annuity.

Example 9-1:

Consider the following rent schedule.

• Year 1 = $12/square foot.

• Year 2 = $14/square foot.

• Year 3 = $15/square foot.

Comparing Leases: Effective Rent 2

• Step 1: Compute the present value.

Comparing Leases: Effective Rent 3

• Step 2:

This is the effective rent for this rent schedule.

Comparing Leases: Effective Rent 4

• Use the same procedure to evaluate all potential lease alternatives.

• This measures the return to the lessor and cost to the lessee.

Developing Statements of Operating Cash Flow

Rental Income

+ Other Income.

+ Expense Recoveries.

− Vacancy and Collection Losses.

− Concessions.

Effective Gross Income (EGI).

− Operating Expenses.

− Cap Ex/Improvement Allowances.

Net Operating Income (“NOI”).

Office Leases

• Variable terms.

• Premium & Discounts.

• Rentable area.

• Usable area.

• Load factor.

Industrial Property Leases

• Similar to office leases.

• More individualized for tenant.

• Term tends to be longer than office leases.

• Tend to be pass-through.

• Premiums & Discounts.

Retail Leases

Sales per Rentable Square Foot and Traffic Counts.

Provisions on operations may include limits on other tenants.

Anchor and In-Line Tenants.

• Rent Differences.

Percentage rent lease.

• Breakpoint.

• Overage.

Common Area Maintenance (“CAM”).

Apartment Leases

Shorter Term.

Impact of consumer protection laws.

Gross Potential Rental Income.

• Full occupancy.

Loss to Lease.

• The concept of loss to lease is that since the leases in residential real estate are so short, a landlord is always on the verge of catching up to whatever market is. The loss to lease shows what this differential is.

Exhibit 9-2: Rental Market Equilibrium Long Description This graph displays units of space on the horizontal axis and rent per unit on the vertical axis. Supply and demand curves are drawn. Their intersection point defines the market rent and this is where there is an equilibrium in occupancy. To the right of that the supply exceeds the demand and there is an existing stock of space.

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Chapter 10

Valuation of Income Properties: Appraisal and the Market for Capital

Valuation Fundamentals 1

Market Value is the most probable price given the following conditions. 1. Buyer and seller are typically motivated.

2. Parties are well informed or well advised and acting in their best interest.

3. Reasonable time in the market.

4. Payment in cash or its equivalent.

5. Traditional financing.

Appraisal Process 1

• The appraisal process is performed by appraisers and others seeking to establish value.

Access the long description slide.

Appraisal Process 2

The Three Approaches. • Sales Comparison Approach.

• Income Capitalization Approach.

• Cost Approach.

For most of the rest of this book, we will focus on the income capitalization approach, but the other two have substantial validity also.

Sales Comparison Approach

• Use data from recently sold “comparables” to derive a “subject” market value.

• Adjust comparable sales prices for feature, age, and size differences, etc.

• Lump sum adjustments and square foot adjustments.

• Subjective process.

Income Approach 1

There are three methods for the income approach. • Gross Income Multipliers (“GIM”).

• Direct Capitalization Method.

• Discount Present Value Method.

Income Approach 2

• 1st Income Method: Gross Income Multiplier (“GIM”).

Sales Price GIM

Gross Income =

• Apply GIM to the subject property.

• Example 10-1: Recent sales of similar property.

Blank 1 2 3

Sales Price $600,000 $750,000 $450,000

Gross Income $100,000 $128,000 $74,000

GIM 6x 5.86x 6.08x

Income Approach 3

Selecting the GIM from the comparables is an education opinion. • Which is most similar to the subject?

• How should they be weighted?

• If 6x is determined to be the GIM and the subject has gross income = $120,000; Value Estimate = 6 × $120,000 = $720,000.

Income Approach 4

• 2nd Income Method: Capitalization Rate.

NOI Value

R =

• Example 10-2: Recent similar property sales.

Blank 1 2 3 4

Sales Price $368,000 $425,000 $310,000 $500,000

NOI $50,000 $56,100 $42,700 $68,600

R 13.57% 13.20% 13.77% 13.72%

Income Approach 5

Capitalization Rate Range: • 13.20% < R < 13.77%,

The “cap rate” choice is an educated opinion of the appraiser. • Which property is most similar to the subject?

Note: The higher the cap rate, the lower the value.

Income Approach 6

If the subject NOI = $58,000, the value estimate could be.

• $58, 000 $58,000

< Value < .1377 .1320

• $421,205 < Value < $439,394.

Care must be taken when determining R.

Income Approach 7

Considerations when determining R.

Consider the comparables. • Similarity to subject.

• Physical Attributes.

• Location.

• Lease Terms.

• Operating Efficiency.

Exhibit 10-7: Risk and Return Trade-Off by Type of Investment

Access the long description slide.

Income Approach 8

Consider the comparables.

• How is NOI determined? • Stabilized NOI.

• Nonrecurring capital outlays.

• Lump Sum.

• Averaged.

• Was NOI skewed by a one-time outlay?

• Depending on the analyst, leasing commissions, tenant improvements, and recurring capital outlays may or may not be including in the calculation of net operating income.

Income Approach 9

3rd Income Method: Discounted Present Value. • Compute the present value of future cash flows.

• Forecast NOI.

• Choose holding period.

• Select discount rate based on risk and return of comparable investments (r).

• Determine reversion value of property.

Exhibit 10-6

Ten-Year NOI Forecast, Hypothetical Hills Apartments.

Year NOI % Growth Year NOI % Growth

1 $338,800 – 6 $416,127 3

2 355,740 5 7 428,611 3

3 373,527 5 8 441,469 3

4 388,468 4 9 450,299 2

5 404,007 4 10 459,304 2

This is a projection. Growth rates can and will vary over time as market conditions evolve.

Income Approach 10

Estimating reversion value. • Not an exact science. In general, there should be a relationship between

risk and return.

• Method 1: Discount remaining cash flows using a terminal cap rate (RT).

• RT = (r − g) → average long-run growth in NOI is positive.

• RT = (r) → growth is zero.

• RT = (r + g) → growth is negative.

Income Approach 11

10 9

NOI REV

r g =

−

Note that if you are calculating the reversion at the end of year 9, you use year 10’s NOI to do so.

The logic is that a future cares more about what they’re going to make in their first year of ownership than what you made in the past.

Income Approach 12

Estimating reversion value. • Method 2: Estimate RT from sales data of older “comparable” properties

• 5 year holding period for a new property.

• In general, as properties age, they become less able to produce income relative to their younger peers. As a result, the cap rate should be higher for older properties.

• What are current cap rates for 5 year old property?

• Use this as a starting point in determining the terminal cap rate.

• Method 3: Estimate resale value from expected changes in property value.

Income Approach 13

Example: • A property has a projected year 1 NOI of $200,000. NOI is projected to

grow by 4% per year for the following 2 years, then by 2% per year for the subsequent 2 years at a 1% constant rate afterward. Given a required return of 13%, what is the value of the property?

Income Approach 14

Example 10-3: • NOI1 = $200,000.

• NOI2 = $208,000.

• NOI3 = $216,320.

• NOI4 = $220,646.

• NOI5 = $225,059.

• Constant 1% growth begins.

Income Approach 15

Example 10-3:

6 5

NOI $227,310 Terminal Value

r g .13 .01 = =

− −

= $1,894,250

Income Approach 16

Example 10-3:

Land Values: Highest and Best Use Analysis

• Land prices are volatile relative to income producing real estate.

• The land price is determined by its highest and best use, which is the use that results in the highest residual land value.

Highest and Best Use Analysis

Residual Land Value.

• PV – Building Cost = Land Value.

• Step 1: Compute the present value of the estimated cash flows for all alternatives.

• Step 2: Subtract building cost.

• Step 3: Select highest value among the alternatives.

Note: If you can’t build a building that has a PV greater than the cost, the land is worth nothing. There’s no rule that says land has to be worth anything.

Mortgage-Equity Capitalization

Property Value = Mortgage Value + Equity Value.

Determining the discount rate to use for the equity value is challenging. • It should be greater than the discount rate for the lender.

• It should be higher than the rate of return for the property.

• It should be competitive when compared to other investments.

Valuation Fundamentals 2

Reconciliation of Value Estimates • The sales comparison and income approaches should yield similar value

estimates.

Changing Market Conditions and “Going in” Cap Rates • Supply & demand.

• Capital markets.

• Capital markets & spatial market changes.

Valuation of a Leased Estate

• Fee simple versus leased fee.

• Impact of below market leases on overall valuation.

Cost Approach

• Estimate the construction cost if new. • Account for physical deterioration, functional obsolescence,

and/or external obsolescence. • Add land cost. • Same procedure as was discussed in Chapter 7. • The rationale is that no informed buyer would pay more for a

property than it would cost to build a new one. This assumes, of course, that they took the time to construct a new asset into account, and the relative risks of ground up development.

• The cost approach is often used for real estate assets that do not have an efficient market for tenants to lease space. A common example would be heavy manufacturing facilities; there is not a deep or broad market in automobile manufacturing facilities.

Appraisal Process 1 Long Description

1. Ascertain the physical and legal identification of the property.

2. Identify property rights to be valued.

3. Specify the purpose of the appraisal.

4. Specify effective date of value estimate.

5. Gather and analyze market data.

6. Apply techniques to estimate value.

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Exhibit 10-7: Risk and Return Trade-Off by Type of Investment Long Description

The horizontal axis displays risk (with no scale) and the vertical axis displays the expected return (with no scale). A horizontal line is drawn at the riskless rate of treasury bonds. The type of investment in order of increasing risk is commercial mortgages, corporate bonds, real estate investments, and common stocks. The expected returns increase as risk increases in a nonlinear, concave down manner.

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Chapter 11

Investment Analysis and Taxation of Income Properties

Investment Analysis 1

Equity Investment.

Motivations for Investing in Income Properties.

• Rate of Return.

• Price Appreciation.

• Diversification.

• Tax Benefits.

Market Characteristics

Real Estate Cycle:

• Large Market in number and size of properties.

• Competitive.

• Fragmented Ownership.

• Overdevelopment Potential.

• The cycle differs for different property types.

Exhibit 11-1: The “Real Estate Cycle”

Access the long description slide.

Investment Strategies 1

General Investment Strategies:

• Core.

• Core “Plus.”

• Value Added.

• Opportunistic.

Investment Strategies 2

Specialized Strategies:

• Property Sector Investing.

• Contrarian Investing.

• Market Timing.

• Investing for Future Growth.

• Value Investing.

• Investing in “Trophy” or “Blue Chip” Properties.

• Strategy as to Size of Property.

• Strategy as to Tenants.

• Arbitrage Investing.

• Turnaround/Special Situations/Liquidation/Spin Offs.

Market Analysis

• Evaluation of supply and demand for a type of property.

• Absorption.

• Supply of Space.

• Market Rents.

• Forecasting Supply, Demand, Market Rents, and Occupancy.

Introduction to Investment Analysis

Internal Rate of Return (IRR):

• The discount rate at which the net present value of the cash flows is equal to 0.

• If IRR >= r; accept Project.

• If IRR < r; reject Project.

• Where r is the discount rate, or more colloquially, the “hurdle rate.”

Investment Analysis 2

Net Present Value:

• A way to solve for the initial price that an investor may pay given a specified discount rate.

• Discounted value of the cash flows.

• The discount rate is the rate of return that an investor will require in order to make this investment.

• If we include the initial equity investment in this calculation, we can solve for the difference and see how much more or less the investor may pay and still receive a rate that is equivalent to their discount rate.

Debt Financing 1

Equity Dividend = NOI − DS

• NOI = Net Operating Income.

• DS = Debt Service.

The equity dividend is also referred to as the before-tax cash flow from operations (BTCF0)

Measures of Investment Performance Using Ratios Equity Dividend Rate = Equity Dividend/Initial Equity Investment.

• Sometimes referred to as “unleveraged cash on cash” rate.

Debt Coverage Ratio (DCR) = NOI/DS.

• The DCR is a vital ratio for lenders.

• If the DCR is less than 1, the borrower will not be able to service the debt.

• Generally, lenders want a DCR greater than 1 so the borrower has a cushion and can repay.

Internal rate of return to equity investor.

Debt Financing 2

Example:

• $1,000,000 Property;

• 95% allocated to building and 5% to land.

• 70% LTV; 7% Interest Rate, 30 Years.

• $700,000 debt; $300,000 equity.

• Monthly Payment = $4,657.11.

• DS = 12 × $4,657.11 = $55,885.

• NOI1 = $85,000.

Before-Tax Cash Flow 1

Equity Dividend = NOI − DS.

• $85,000 − $55,885 = $29,115.

• This is also the BTCFo for this year.

Equity Dividend Rate = EQDIV/Equity,

• $29,115

9.71%. $300, 000

Debt Coverage Ratio =

• $85, 000

1.52. $55, 885

These ratios all pertain to the first year of operations.

Before-Tax Cash Flow 2

Before-Tax Cash Flow from the Property Sale (BTCFs):

• BTCFs = Sales Price − Mortgage Balance.

• In Example 11-1, if the property were sold in Year 4 for $1,100,000 then,

• BTCF = $1,100,000 − $668,322 = $421,678.

• The mortgage loan balance is $668,322. See Chapter 4.

Taxation of Income-Producing Real Estate

Four Classes of Real Property:

• Real Estate held as a “personal residence.”

• Real Estate held for sale to others – “dealer” property.”

• Real Estate held for use in a trade or business – “trade or business property.”

• Real Estate held as an investment for the production of income – “investment property.”

Depreciable Basis

• The original cost basis includes all costs associated with acquiring the property and transferring the title

• Land value cannot be depreciated

• The depreciable basis is the total value that can be depreciated over the recovery period

• Depreciable Basis = Cost Basis – Land Amount

Depreciation 1

Depreciation

• Depreciable Basis / Recovery Period

Recovery Period is different based on property type

• Residential income producing property (27.5 Years)

• Non-residential income producing property (39 Years)

• Note that the recovery period is a product of the tax code. It will vary based on the laws of the country that the real estate is located in.

Depreciation 2

Years Depreciable Life Methods Allowed

1969 to 1980 Useful life, approximately 30 to 40 years

Accelerated or straight line

1981 to 1983 15 years ACRS based on 175% of straight-line depreciation

1984 to 1985 18 years ACRS based on 175% of straight-line depreciation

1986 19 years ACRS based on 175% of straight-line depreciation

1987 to 1992 27.5 years for residential Straight line

Blank 31.5 years for nonresidential Straight line

1993 to 2017 27.5 years for residential Straight line

Blank 39 years for nonresidential Straight line

After-Tax Cash Flow 1

Calculating the after-tax cash flow from operations.

Step 1: Compute taxable income.

Net Operating Income

• Depreciation.

• Interest.

Taxable Income

After-Tax Cash Flow 2

• For example, if depreciation is based on a building value of $950,000 over 27.5 years, then the annual depreciation would be $34,545.

• The annual interest in year 1 is $48,775. This is not the total debt service; we do not include principal.

After-Tax Cash Flow 3

• Therefore, the year 1 taxable income would be:

NOI $85,000

Depreciation − $34,545

Interest − $48,775

Taxable Income $ 1,680

After-Tax Cash Flow 4

• Step 2: Compute Taxes.

Taxes (at 28%) = 0.28 × 1,680 = $470

• Step 3: Compute after-tax cash flow from operations for year 1.

ATCF1 = BTCF1 − Taxes

= 29,115 − 470

= $28,645

After-Tax Cash Flow 5

Taxes on the property sale:

• Gain from price appreciation.

• The maximum is 15%.

• Gain from accumulated depreciation.

• Taxed at 25%.

• These rates are a product of the tax code, and like depreciation, will vary based on the laws of the country where the property is situated.

After-Tax Cash Flow 6

• From Exhibit 11-28.

• Step 1: Compute tax on property value increase:

$9,360,805 − 8,500,000 = $860,805

Taxed at 15% capital gains rate = $129,121

After-Tax Cash Flow 7

• Step 2: Compute tax on prior depreciation:

5 Years = $918,563

Taxed at 25% = $229,641

• Step 3: Compute total taxes from sale:

$129,121 + $229,641 = $358,761

After-Tax Cash Flow 8

Step 4: Compute after-tax cash flow from the property sale.

ATCFs = BTCFs − Taxes.

ATCFs = $431,678 − $49,545 = $382,133.

Analysis.

• Compute After-Tax Internal Rate of Return.

• Compute After-Tax Net Present Value.

Types of Taxable Income

Passive Income:

• Rents from real estate, and royalties from oil and gas rights.

Active Income:

• Salaries, wages, bonuses, and commissions.

Portfolio Income:

• Interest, dividends, and capital gains.

Passive Activity Loss Restrictions 1

• Passive losses cannot be used to reduce active or portfolio income.

• Passive losses may be used to reduce other passive income.

• Passive losses not used may be used in future years or at the same time of sale.

Passive Activity Loss Restrictions 2

1st Exception:

• Active participants may deduct up to $25,000 in passive losses against other non-passive income, subject to limitations such as their adjusted gross income. This is from the 1986 Tax Reform Act.

2nd Exception:

• Broad exception for real estate professionals from the Passive Activity Loss rules under the Tax Act of 1993.

• For many of you, if you enter the real estate business, this will apply to you.

Exhibit 11-1 The “Real Estate Cycle” Long Description

The horizontal axis displays the market condition and has four values: Recovery, Expansion, Balance, and Decline. The vertical axis displays the percent occupied. A horizontal line is labeled normal range. A curve begins below normal range at the point (recovery, apartments). The function increases to a peak and the point (expansion, office) is labeled. Then the function decreases to the horizontal line (normal range) and the point (balance, warehouse) is labeled. Finally, the function dips below the normal range and the market condition is in decline. The point, retail, is found there.

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Chapter 12

Financial Leverage and Financing Alternatives

Introduction to Financial Leverage

What is financial leverage? • Benefit of borrowing at a lower interest rate than the rate of return on the

property.

Why use financial leverage? • There are diversification benefits that come from investing less equity. One

can buy additional properties.

• Mortgage interest tax benefit.

• Magnify returns if the return on the property exceeds the cost of debt.

Financial Leverage: Before Tax 1

Positive Financial Leverage. • Returns are higher with debt.

Unleveraged BTIRR. • Return with no debt.

If unleveraged BTIRR > interest rate on debt. • The BTIRR on equity increases with debt.

• There is positive financial leverage.

Financial Leverage: Before Tax 2

BTIRRE = BTIRRP + (BTIRRP − BTIRRD)(D/E)

Equation 1: • BTIRRE = Before-Tax IRR on equity invested.

• BTIRRP = Before-Tax IRR on total investment in the property (debt and equity).

• BTIRRD = Before-Tax IRR on debt (effective cost including points).

• D/E =Debt/Equity ratio.

Financial Leverage: Before Tax 3

• For example, if the before tax return on an investment is 12%, and one can borrow 80% of the purchase price at a 10% interest rate:

BTIRRE = 12% + (12% − 10%) × (80% / 20%)

BTIRRE = 20%

Financial Leverage: Before Tax 4

Equation 1 shows that as long as:

• BTIRRP > BTIRRD, then BTIRRE > BTIRRP, • This implies increasing D/E will yield positive results.

But the use of debt is limited.

• Debt coverage ratio restrictions.

• Higher loan to value ratios are riskier to lenders. If the LTV is too high, the interest rates will be higher.

• Higher debt levels increase risk to equity investor.

Financial Leverage: Before Tax 5

Negative Financial Leverage. • If BTIRRD > BTIRRP, then BTIRRE < BTIRRP, • The use of debt reduces the return on equity.

Financial Leverage: Before Tax 6

Equation 2:

ATIRRE = ATIRRP + (ATIRRP – ATIRRD)(D/E). • ATIRRE = After-Tax IRR on equity invested.

• ATIRRP = After-Tax IRR on total investment in the property.

• ATIRRD = BTIRRD (1 − t).

• After-Tax IRR on debt (effective cost after taxes including points).

• D/E =Debt/Equity.

Exhibit 12-5 Before and After-Tax Positive Leverage

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Exhibit 12-6 Before and After-Tax Negative Leverage

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Financial Leverage: Break-Even Interest Rate

Break-even interest rate.

• Maximum interest rate before negative financial leverage.

( ) D P

D D

ATIRR ATIRR

ATIRR BTIRR 1

BTIRR t t

= −

= − −

D P ATIRR ATIRR

1 1 =

Break-even interest rate is not affected by LTV.

Leverage and the incremental cost of debt.

Exhibit 12-9 After-Tax IRR versus Interest Rates

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Risk and Leverage

Underwriting Loans on Income Properties 1

Market Study and Appraisal.

Borrower Financials.

• Nonrecourse clause. If nonrecourse, it’s sort of like the loan has a built in put option for the borrower.

The Loan to Value Ratio.

The Debt Coverage Ratio.

Underwriting: Debt Coverage Ratio

NOI = Max debt service

Desired DCR target

Maximum debt service = Max loan amount

Mortgage loan constant

3 We are using an interest-only loan in our example, so the mortgage loan constant is simply the loan interest rate. In cases where the loan is amortizing, the denominator should be the mortgage loan constant that corresponds to the appropriate Interest rate and amortization period, expressed on an annual basis, that is 12 times the monthly loan constant discussed in Chapter 4.

Other Loan Terms and Mortgage Covenants Possible Mortgage Covenants. 1. Approve major leases.

2. Approve modifications to existing leases.

3. Approve construction.

4. Supply periodic updates.

5. Annual property appraisal.

6. Notify lender of legal problems.

7. Notify lender of major capital expenditures.

8. Lender has right to visit.

The lender’s goal is to ensure that after the loan is closed, the value and income-producing ability of the asset is not impaired.

Underwriting Loans on Income Properties 2

Lockout Clause.

• Prohibits prepayment of loan for a specified period of time.

Yield Maintenance Fee.

• Guarantees a yield to the lender after a lockout period expires.

Sometimes the fee is fixed as a percentage of the outstanding balance. This percentage may also vary based on the remaining term of the mortgage.

Alternatives to Fixed Rate Loan Structures Mismatch between property income in the early years and constant payment loans.

Income is expected to increase. • Inflation effects.

• New building not fully leased when loan is made.

• Leases may be below market.

Results in different loan structures.

Participation Loans

Equity Participation Loans. • Lower interest rate from lender.

• Lender shares in property cash flow.

• Percent of PGI, NOI, or BTCF, etc.

• Lender motivations.

• Guaranteed minimum return and some protection of real return.

• Investor motivations.

• Easier to meet debt service requirements.

Sale-Leaseback of the Land

Sale-Leaseback of the Land.

• Own building and lease land from a different investor.

Motivations.

• 100% financing possible.

• Lease payments are tax deductible.

• Building is depreciable; land is not.

• Possible purchase option at end of lease. If option is not present, the investor may not be able to buy back the land.

Interest-Only Loans

Interest-Only Loans: “Bullet Loans.” • No amortization for a specified period.

• Balloon payment or amortization afterward.

Accrual Loans

Accrual Loans. • Negative amortization.

• Pay Rate. • Interest rate used to calculate loan payment.

• Accrual Rate. • Interest rate used to calculate the interest charged.

• Accrual loans can be dangerous for a borrower as the amount owed becomes greater over time.

• Structuring the payment for a targeted debt coverage ratio.

• Not always fully amortizing.

• Balloon payment.

Convertible Mortgage

• Lender has an option to convert debt to equity.

Other Financing Alternatives

• Mezzanine Loan.

• Preferred Equity.

Exhibit 12-5 Before and After-Tax Positive Leverage Long Description

The horizontal axis displays the loan-to-value ratio (%) and is scaled from 25% to 85%. The vertical axis displays the IRR on equity (%) and is scaled from 9% to 21%. Both the before- and after-tax IRR on equity increase exponentially, but the before-tax IRR on equity is greater than the after-tax IRR on equity. Other than that the two graphs are roughly parallel.

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Exhibit 12-6 Before and After-Tax Negative Leverage Long Description

The horizontal axis displays the loan-to-value ratio (%) and is scaled from 25% to 85%. The vertical axis displays the IRR on equity (%) and is scaled from 0 to 12%. The before- and after-tax IRR on equity decrease in a concave down manner, but the after- tax IRR on equity has a lower y intercept than the before-tax IRR on equity.

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Exhibit 12-9 After-Tax IRR versus Interest Rates Long Description

The horizontal axis displays the interest rate (%) and is scaled from 10% to 16%. The vertical axis displays the after-tax internal rate of return (%) and is scaled from 0 to 14%. The graph displays three lines with negative slopes: 80% loan, 70% loan, and 60% loan. These three lines intersect at the break-even interest rate. The break-even interest rate is about 12.5%.

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Chapter 13

Risk Analysis

Comparing Investment Returns

Does the income producing property provide a competitive return? • Nature of alternative real estate investments.

• Alternative investments that are not real estate.

• Returns on alternatives.

• Risk differences.

Exhibit 13-1

Risk and Return (Alternative Investments)

Access the long description slide.

Types of Risk 1

Business Risk. • Economic Conditions.

• Tenant Mix.

• Lease Provisions.

Financial Risk. • Increases with the amount of debt.

• Cost and structure of debt.

Types of Risk 2

Liquidity Risk. • Challenges in selling property.

Inflation Risk. • Unexpected inflation.

• Does income increase enough to offset inflation?

Management Risk. • Competency of management’s ability to respond to market conditions.

Types of Risk 3

Interest Rate Risk.

• The impact on variable rate debt.

• The impact of higher rates on residual property value.

Legislative Risk.

• Regulatory changes.

Environmental Risk.

• In the United States, environmental risk applies to anyone in the chain of title. If you buy a property with an environmental issue, you potentially could take on that liability regardless of whether or not you caused the issue.

Due Diligence in Real Estate Investment Risk Analysis

Three primary tools may be employed by investors to minimize their exposure to risk: • Avoidance and identification of risk through due diligence.

• Financial tools such as insurance, hedging, and option contracts.

• Diversification (either into other product types or different locations).

Sensitivity Analysis

Base Case. • Frame of reference for analysis.

Change a single assumption. • What is effect on NPV or IRR?

Scenario Analysis. • Change multiple assumptions at once.

• Identify most likely, pessimistic, and optimistic scenarios.

Partitioning the IRR 1

How is the total IRR distributed between operating cash flow and property sale cash flow? • Compute the IRR.

• Discount cash flows from operations using the IRR.

• Discount cash flow from property sale using the IRR.

• Compute the percentages.

Exhibit 13-5: Partitioning the IRR

Partitioning the IRR 2

• This is useful for comparing alternative similar investments.

• For example, an alternative property may have the same IRR, but if the percent of return from operations is 20% and property 80%, there might be significant risk differences.

• The riskier portion of the return is generally believed to be that which is based on property price appreciation.

Variation in Returns and Risk

Use economic scenarios: • Compute cash flows from operations and property sale for each scenario.

• Compute the IRR in each scenario.

• Multiply the IRR by the probability of the scenario to compute an expected return.

• Need to consider risk.

Exhibit 13-7

Probability Distribution of IRRs (Office, Apartment, and Hotel Properties)

Access the long description slide.

Exhibit 13-8

Risk versus Return

Access the long description slide.

Variation in Returns and Risk 1

Variance.

Standard Deviation. • The lower the standard deviation, the more likely actual return is closer to

expected return.

Expect the actual return to fall within 1, 2, and 3 standard deviations 68%, 95.5%, and 99.7% respectively.

Variation in Returns and Risk 2

Coefficient of Variation.

E(IRR)

 =CV

• Risk per unit of (expected) return.

• Standardized measure of stand-alone risk.

Portfolio considerations.

• Reduce risk by combining assets into a portfolio.

• Diversification.

Lease Rollover Risk

Uncertainty of renewal by existing tenants. • Tenants may not renew leases.

• Possible lengthy vacancy.

• New tenant may require money for tenant improvements.

• Commissions are an additional cost for new tenants.

Market Leasing Assumptions with Renewal Probabilities

• Market Rent.

• Months Vacant.

• Leasing Commissions.

• Tenant Improvements.

Monte Carlo Simulation

• A Monte Carlo Simulation is a technique for analyzing risk where a probability distribution can be specified for one or more inputs.

Exhibit 13-23: Monte Carlo Simulation

Access the long description slide.

Exhibit 13-24: Distribution of NOI Growth Rates

Access the long description slide.

Exhibit 13-25: Distribution of IRRs

Access the long description slide.

A “Real Options” Approach to Investment Decisions Defined. • Purchase land, but wait to develop.

The Option. • Construct or not construct in the future.

Additional Uses and Strategy. • Excess land purchased for possible future development. • Multiple phases to a development. • Building renovation.

The real option approach to land valuation implies a higher land value than the traditional approach.

Exhibit 13-1 Long Description

The horizontal axis displays risk and the vertical axis displays return. In order of increasing risk and return are the following investments: T-bills, municipal bonds, mortgage-backed securities, corporate bonds, real estate, and common stocks. The lowest return is the riskless rate, but return is constant regardless of risk.

Return to slide containing original image.

Exhibit 13-7 Long Description

All three probability distributions are fairly normal in shape, but the apartment property has the lowest IRR, office property has a slightly greater IRR, and the greatest IRR is for hotel property.

Return to slide containing original image.

Exhibit 13-8 Long Description

Apartment has a fairly low risk (about 3.5%) and a fairly low expected return (15%). Office has a moderate risk (8%) and a moderate expected return (18.5%). Hotel has the greatest risk (12%) and the greatest expected return (20%).

Return to slide containing original image.

Exhibit 13-23: Monte Carlo Simulation Long Description

1. Specify pessimistic, most likely and optimistic value for the NOI growth rate.

2. Select a random number between 0 and 1.

3. Determine an NOI growth rate from the triangular distribution.

4. Calculate the IRR using NOI growth and other inputs.

5. Repeat this process 1,000 times.

6. Observe the distribution of IRRs and summary statistics.

Return to slide containing original image.

Exhibit 13-24: Distribution of NOI Growth Rates Long Description

The NOI growth rates vary from 1.3% to 4%. The most common NOI growth rate is 3.1%. This growth rate occurs about 21% of the time. The distribution is slightly left skewed. Growth rates of 1.3% and 4% occur about 1% and 2% of the time, respectively.

Return to slide containing original image.

Exhibit 13-25: Distribution of IRRs Long Description

The distribution of IRRs has a mean of 9.87% and is skewed to the left. The minimum IRR is 7.27%, which occurs with a probability of about 0.5%. The most common IRR is 9.97%, which occurs about 25% of the time. The maximum IRR is 11.15% and occurs about 7% of the time.

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Chapter 14

Disposition and renovation of income properties

Disposition Decisions 1

Disposition Consideration. • Changes in expectations over an anticipated holding period.

• Market rent problems.

• Tax law changes.

• Equity build-up.

• There is an opportunity cost of not selling the property. Over time, the equity that is built up represents substantial buying power that could be redeployed to buy additional properties.

• Reduced interest payments and lower tax deduction.

Disposition Decisions 2

Decision Rule: Property Disposition. • What can the investor net if the property is sold today?

• What is the future expected performance of the property for the current investor if not sold?

• Should the property be sold and the funds invested in another property?

Disposition Decisions 3

Expected cash flows are adjusted for current expectations. • New rental income growth rate assumptions.

• Original cost and depreciation stay in place.

• Tax rates change to reflect current laws.

• Mortgage and interest stay the same.

• What is the expected future sale price of the property?

Disposition Decisions 4

• If the investor will net $100,000 after all taxes and expenses if the property is sold today, can it be invested and earn a greater return than if the property is not sold?

• Basically, it’s a matter of comparing future streams of cash flow.

Disposition Decisions 5

The future expected net cash flows for a three-year holding period are: • ATCF0 = ($100,000).

• ATCF1 = $10,000.

• ATCF2 = $11,000.

• ATCF3 = $12,000.

• ATCF3(sale) = $103,000.

• Compute IRR = 11.82%.

Disposition Decisions 6

The ATIRR = 11.82% is what the investor gives up by selling the property and taking $100,000 today.

Is there an investment of comparable risk that can earn a greater ATIRR? • If yes, the sale is justified.

• If not, property should be held onto.

Disposition Decisions 7

Return to a New Investor. • New investor has a new adjusted basis in the property.

• New investor depreciates the property based on tax law as of new purchase date.

• As tax laws change, this could influence sale decisions as it may favor new investors more or less favorably.

What can a new investor earn given the changes? • Compute an ATIRR for the new investor.

Disposition Decisions 8

Marginal Rate of Return.

• Property Disposition: • Evaluate disposition for a one-year holding period.

• Repeat the evaluation for subsequent one-year holding periods.

• This generates a series of marginal returns based on one-year holding periods.

( 1) ( 1) ( )

( )

S O S

ATCF t ATCF t ATCF t MRR

ATCF t

+ + + − =

Disposition Decisions 9

Marginal Rate of Return. • Disposition Rule:

• Sell when MRR falls below assumed reinvestment rate for funds from property sale.

• Optimal holding period.

• Reinvestment Rate:

• Could be constant or could change with overall market conditions.

• Should reflect market rates and return on alternative investments.

Exhibit 14-8: Marginal Rate of Return for the Next 10 Years

Year Marginal Rate of Return/Year

6 15.43%

7 15.56

8 15.65

9 15.69

10 15.71

11 15.69

12 15.65

13 15.58

14 15.49

15 15.38

Exhibit 14-9

Holding Period Analysis

Access the long description slide.

Exhibit 14-10

Holding Period Analysis

Access the long description slide.

Disposition Decisions 10

Refinancing as an Alternative. • Increase the current LTV ratio by refinancing.

• Provides additional funds to invest.

• Incremental cost of refinancing.

• What are the additional funds obtained by refinancing?

• What are the additional cash outflows?

• Solve for i: can this be earned or borrowed funds?

• Diversification benefits from reinvesting loan proceeds.

Example of Incremental Cost of Financing

Blank Current Balance

Monthly Payment

Balance after Five years

New loan $187,500 $1,975 $179,350

Existing loan 142,432 1,470 129,348

Difference $ 45,068 $ 505 $ 50,002

• If you solve this, borrowing $45,068 and having a future balance of $50,002 and an incremental payment of $505 is equivalent to an interest rate of 14.93%.

Tax-Deferral Strategies upon Disposition 1

Installment Sale. • In essence, a form of “seller financing.”

• Profit ratio = gross profit/contract price.

Tax-Deferral Strategies upon Disposition 2

Like kind, tax deferred, or tax free exchange.

• Also known as a “1031 exchange.” It is so named because it is defined in Section 1031 of the United States tax code.

• Specific time frames must be followed.

• Safe harbor rules. • Qualified escrow accounts, trusts, and intermediaries.

• Balancing equities. • Unrecognized gain = realized gain – boot.

• Reverse exchanges are also possible.

Disposition Decisions 11

Renovation as an alternative. • What are economic trends?

• Is property improvement justified?

• Grow the size of the asset or upgrade the quality • Should it be converted to a new use (such as office to apartments or rental

apartments to condos)?

• What is the renovation cost?

• Does it require additional equity?

• What are available financing sources?

Disposition Decisions 12

Renovation as an alternative. • Calculate the incremental change in the expected future operating cash

flows.

• Calculate the incremental change in the future expected selling price of the property.

• Determine the IRR on the additional equity investment.

• Compare the IRR to alternative equivalent risk investments.

Disposition Decisions 13

Additional Considerations. • Combined renovation and refinancing.

• Portfolio balancing.

• Rehabilitation Investment Tax Credits.

• Dollar for dollar reduction in taxes.

• 10% credit if placed into service before 1936, 20% if certified historic structure.

• Low-Income Housing Tax Credit.

• Creation of Tax Reform Act of 1986.

• 9 percent and 4 percent credits.

Exhibit 14-9 Long Description

The horizontal axis is labeled year and is scaled from 6 to 15. The vertical axis displays the return (%) and is scaled from 0.153 to 0.158. A horizontal line at 0.155 is labeled the reinvestment rate. A parabola that opens down and peaks at year 10 is labeled MRR. MRR intersects the reinvestment rate just before year 14. This is the optimal holding period.

Return to slide containing original image.

Exhibit 14-10 Long Description

The horizontal axis is labeled year and is scaled from 6 to 15. The vertical axis displays the return (%) and is scaled from 0.153 to 0.158. A parabola that opens down and peaks at year 10 is labeled MRR. A function labeled reinvestment rate is shown. It has a y intercept of 0.155 and increases in a nonlinear, concave up manner. It intersects MRR around year 6.5 and after year 11. Just after year 11 is the optimal holding period.

Return to slide containing original image.

Chapter 15

Financing Corporate Real Estate

Corporate Real Estate: User Firms 1

Why do corporations own real estate?

• Needed for operations and choose to own rather than lease.

• Ownership provides diversification from core business.

• Retain property from previous business operations.

• Acquire real estate for future expansion or relocation.

Benefits.

• Save on lease payments.

• Tax benefits of depreciation.

• Property value appreciation and sale.

• Can lease back the property if the space is needed.

Potential Negatives.

• Opportunity cost of capital invested in real estate.

• Impact of ownership on financial statements.

• Inefficient use of space.

Corporate Real Estate: User Firms 2

Lease-versus-Own Analysis 1

Owning.

• Investing in real estate.

• Requires an equity investment in the property.

Leasing.

• No equity investment.

Compute cash flow difference at time 0.

• Equity investment in the property.

Compute Annual Operating Cash Flow Differences.

• Leasing requires expensed lease payments.

• Owning requires an interest payment on debt and property depreciation (non-cash charge).

• Assumes business operations are not affected.

Lease-versus-Own Analysis 2

Compute Residual Cash Flow Difference.

• There is no residual value when leasing.

• Owning gives a residual value when the property is sold.

Compute the IRR on the equity investment in the property.

• Does the IRR justify the ownership risk?

• Required rate of return should probably be higher than the after-tax cost of corporate debt, although probably not as high as would be normally required for a corporate investment.

Lease-versus-Own Analysis 3

Importance of Residual Value.

• The decision to own is an investment in the residual value and adds an asset to the balance sheet.

• What are expected changes in residual value?

• What facilities will the corporation use or need?

• Purchasing gives a corporation the option to maximize use. If a corporation owns it, it can make changes to bring the asset to its highest and best use.

Lease-versus-Own Analysis 4

A Note on Project Financing

Mortgage debt versus unsecured corporate debt.

• The interest rates will be different. Depending on the credit rating of the corporation, unsecured corporate debt may be less expensive than mortgage debt.

• Non-recourse mortgage debt has an option to default.

Factors Affecting Lease-versus-Own Decisions 1

Space requirements.

• Space needed versus optimal building size.

Amount of time space is needed.

• Asset life versus expected use life.

• Illiquidity of real estate.

Risk bearing.

• Do other investors have a comparative advantage?

• Operating risk versus property value risk.

• Dispersed operations versus geographically concentrated operations.

Management expertise.

• Real estate management is often not a core competency.

Maintenance.

Special purpose buildings.

Tax Considerations (and impact of The Tax Reform Act of 1986).

• Reduced depreciation tax shield by extending tax depreciation lives.

• Reduced highest individual tax rates to below corporate rates.

• Limitations on passive losses.

• Reduced taxes as a deciding factor in lease vs. own.

Access to capital markets.

• Effect of the cost of capital.

Control.

• Goodwill may exist at the present location.

• Landlord may try to take advantage of the goodwill and charge higher rates.

Factors Affecting Lease-versus-Own Decisions 2

Effect on financial statements.

• Accounting income vs. cash flow.

• Residual value potential not reflected in statements.

• Real estate carried at book value, not market value.

• Corporate inefficiency in not recognizing the highest & best use of real estate.

• Debt ratio impacts.

Factors Affecting Lease-versus-Own Decisions 3

Off-Balance Sheet financing.

• Operating lease.

• No impact on balance sheet.

• Capital lease.

• Long-term asset and long-term liability equal to present value of lease payments.

• Increases debt-to-assets ratio.

• Capital lease requirements (any one).

• Lease life is greater than 75% of asset’s life.

• Ownership transferred to lessee at the end.

• “Bargain purchase” option.

• Present value of lease payments ≥ 90% of market value of the asset.

• In the past, companies would use unconsolidated subsidiaries to own real estate but report only the equity ownership. Changes by FASB now severely restrict the use of unconsolidated subsidiaries.

Factors Affecting Lease-versus-Own Decisions 4

The Problem of “Hidden Value”.

• Real estate may not be fully valued in the stock price of public companies.

• Corporation is vulnerable to takeover and sale of undervalued assets.

• Managers must consider alternative uses to real estate.

• Sale.

• Sale – Leaseback.

• Why are there share price discounts?

• Real estate valuation is difficult, and it is more so when the real estate is part of an operating company.

• Lack of property development plans.

• Alternative uses of real estate may be preferred.

• Market valuation of accounting income versus cash flow.

Factors Affecting Lease-versus-Own Decisions 5

The Role of Real Estate in Corporate Restructuring

Sale-Leaseback.

• Company wants to sell the real estate, but needs the space.

• Company receives cash from property sale.

• Company loses remaining depreciation allowance.

• Company removes residual value risk.

Sale-Leaseback 1

Analysis.

• Compute the ATCF if the property is sold today.

• Compute the incremental ATCF from operations that occur with leasing.

• Compute the residual value lost with the sale today.

• Compute the IRR.

• This is the return from owning or cost of leasing.

Financial statement implications.

• Additional income from gain on sale.

• Increase in earnings per share.

Removes a financing option from those that would try to takeover the company.

Gives the corporation freedom to relocate if it is a short-term lease.

Sale-Leaseback 2

• Sale-leaseback provides real estate value estimate to market.

• Capital from the sale could be returned to investors.

• Capital provided from sale could be used to fund future growth opportunities.

Sale-Leaseback 3

Chapter 16

Financing Project Development

Overview: The Planning and Permitting Process

Permitting.

• Size and cost of the proposed development.

• Price an investor will pay to obtain the land.

• Price a project may bring when sold.

The Development of Income Producing Property There are five steps to the development of income producing property.

1. Acquire a site.

2. Develop it.

3. Finish it and get it ready for occupancy.

4. Manage.

5. Sell.

Exhibit 16-1 Phases of Real Estate Project Development and Risk

Access the long description slide

Developer Business Strategies 1

Develop, own, manage, and lease projects for many years.

• Leasing and management are major components of the business model.

Develop, own, lease-up to normal occupancy, then sell.

• Buyers could be insurance companies, syndicates, etc.

• Sometimes continue to manage the property after sale.

Developer Business Strategies 2

Develop land and buildings in a master-planned development.

• Business parks and industrial parks.

• Some “build to suit” for a single tenant.

Some developers specialize in specific development phases.

Most developers will consider a serious offer to purchase at any time.

The Development of Income Producing Property 1

Market Risks and Project Feasibility:

• Risk begins with acquisition.

• Seasoned Property.

• Leasing Prior to Completion.

• Demand Factors.

• Vacancy rates, rent levels, predevelopment leasing commitments.

• Post-development competition.

• What do end users want?

The Development of Income Producing Property 2 Project Risks:

• Site Location.

• Value increases with tenant perception.

• More valuable sites result in higher-quality developments.

• Density increases with value perception.

• Specific Component Risk.

• How design features and amenities are valued by potential tenants.

• Uncertainty about how quantity and quality of services should be packaged.

Financing Project Development 1

Developer Challenges:

• National and local economies.

• Competition among developers.

• Changes in tenant preferences.

Project Development:

• Finance land acquisition with intent of developing it and selling it.

• Development is impacted by the regulatory environment.

Financing Project Development 2

Permitting:

• Application.

• Site.

• Location.

• Preliminary Design.

• Zoning.

• If in compliance, then permitted.

• If not in compliance, then appeals process.

• City planning department input.

Project Development Financing 1

Equity investment:

• Developer.

• Partnership.

Construction (Interim) loan:

• Often referred to as an acquisition and development loan (“ADL”) or a construction and development loan (“C&D”).

• Appraised value of completed development.

• Hard costs.

• Materials and labor.

• Soft costs.

• Planning, leasing and management costs.

Project Costs

Cost per square foot of gross building area:

• Compare with comparable property.

Loans to cover improvement costs only.

Generally, there is some level of equity investment made by the developer.

Holdbacks:

• Lender holdbacks prevent developers from drawing down funds at a faster rate than they pay to contractors.

Project Development Financing 2

Loan Structures:

• Short-term financing if the intent is to sell the property after completion and lease-up.

• Permanent loan and construction loan if the developer retains ownership as part of their business model.

• Construction financing followed by extended financing (a “mini-perm”) if the developer might own the property for a short while.

Project Development Financing 3

Complications:

• In multi-loan financing, a permanent loan must be in place first.

• If a sale is planned, market conditions may require a committed buyer in place.

• Excess speculative and open-ended construction lending may lead to overbuilding.

Typical ADL Funding Pattern

Lender Requirements in Financing Project Development Loan submission information.

• Detailed description of development and market analysis.

Requirements become complicated when multiple lenders are needed.

• Permanent commitment.

• Binding agreement between developer and permanent lender.

• Permanent lender or “take out” commitment “takes out” the construction lender.

Lender Requirements 1

Standby commitments.

• Binding agreement, but low expectation of being used.

• Used when:

• Developer does not want to pay fees for a permanent loan.

• Expectation of securing a better permanent loan later.

• Plans to sell the project and permanent loan is not needed.

Lender Requirements 2

Permanent lender common contingencies:

• Expected date of project completion.

• Occupancy upon completion.

• Approval of all leases.

• Provision for acquisition and development loan modification and/or extension.

• Permanent lender approval of all design changes.

• Permanent lender approval of any changes in materials.

• Permanent lender approval of changes in contractors.

• Review and approval of acquisition and development loan agreement.

Lender Requirements 3

Construction or Interim Loan:

• Usually local lenders who.

• Know the local market.

• Monitor construction progress.

• Disburse funds as phases are completed.

Mini-perm loan.

Monthly draw method.

• Work is verified by architect or engineer.

Floating interest rate.

Lender Requirements 4

Closing the Interim Loan:

• Assignment of commitment letter.

• Create obligation between interim and permanent lenders.

• Triparty buy-sell agreement.

• Used in lieu of assigning the commitment letter.

• Create obligation between all three parties.

• Permanent lender will buy the construction loan directly from the construction lender.

• Two lenders agree about their duties and responsibilities.

Lender Requirements 5

Permanent Loan Closing:

• Lender confirms that contingencies are met.

• Nonrecourse Clause.

• Restrict lender’s claim in default.

• Increase emphasis on property quality.

• Credit enhancements.

Feasibility, Profitability, and Risk – Additional Issues

Profitability before and after Taxes:

• Before-Tax Cash Flows and After-Tax Cash Flows.

• Net Present Value.

• Internal Rate of Return.

Sensitivity Analysis, Risk, and Feasibility Analysis.

Exhibit 16-1 Phases of Real Estate Project Development and Risk Long Description

• The phases of development over time are:

• 1. Phase I: Land acquisition.

• 2. Phase II: Construction.

• 3. Phase III: Completion and occupancy.

• 4. Phase IV: Management.

• 5. Phase V: Sale.

• The trend is the same regardless of whether the completion is ahead of, on, or behind schedule. Risk increases to Phase III then decreases, but the risk is greatest in each phase if the completion is behind schedule and the risk is lowest in each phase if the completion is ahead of schedule.

Return to slide containing original image.

Chapter 17

Financing Land Development Projects

The Land Development Process—An Overview 1

Land development.

• Acquire land.

• Construct utilities and surface improvements.

• Resell developed sites to project developers or home builders.

What is the demand for the final product?

• Individual lots and pads.

Is there sufficient land for the development plan?

The Land Development Process—An Overview 2

• Land developer may be, but is not always, the builder.

• All development plans include subdivision of sites within the tract of land.

• Highly fragmented, competitive, and local business.

• The developer is a facilitator of the development process.

Exhibit 17-1

Land Development Process

StageⅠ Initial Contact by Land Broker

Stage Ⅱ Option Period

Stage Ⅲ Development Period

Stage Ⅳ Sales Period

• Site inspection • Soil studies, engineering

• Purchase Land • Implement marketing program

• Preliminary market study

• Feasibility, appraisal, and design strategy

• Close on land development loan

• Begin construction of improvements

• Additional coordination with builder

• Preliminary cost estimates

• Bidding and/or negotiating with contractors subject to closing

• Submit Plan for public approvals, submit package for financing

• Implement financial controls

• Coordinate with contractors, Consultants, Public sector

• Implement design controls with builders

• Implement facility management and /or begin homeowner association

The Land Development Process—An Overview 3

Land acquisition.

• Developer decision: Should the land be purchased?

• Using an option contract.

• The right to purchase for a specific price. The price may be tied to certain thresholds being achieved, such as obtaining government approvals for a certain level of density.

• Not an obligation. The buyer can always choose to walk away.

• Set time period and expiration date.

• Option price paid to land owner to hold the land until the expiration date.

The Land Development Process—An Overview 4

Option ties up the land while research is done.

Cost of excavating and grading.

• Topography, drainage, soil condition, subsurface.

Demand for potential mix of lots.

Supply of similar sites.

The Land Development Process—An Overview 5

Estimate of value upon completion.

Cost of any improvements to site.

• Bids necessary.

Obtain regulatory approval of plan.

• Planning commission.

Arrange financing.

The Land Development Process—An Overview 6

Financing & Development.

• Three Common Alternatives.

• Purchase land for cash and secure a loan for improvements.

• Down payment on land, seller financing of the balance, loan for improvements.

• Down payment and one loan for land plus improvements.

The Land Development Process—An Overview 7

Land Improvement Loans.

• Draw down.

• Open end loan.

• Floating rate.

• First lien on land and improvements.

• Loan is paid down as sites are sold.

• Release Schedule.

Lender Requirements in Financing Land Development 1

Loan Submission Package.

• Detailed project description.

• Financial data.

• Market information.

• Regulatory and legal information.

Loan Closing.

Final Commitment.

Lender Requirements in Financing Land Development 2

General Contracts and Subcontracts.

• Labor and Material Payment Bonds and Completion Bonds.

• Labor and material bonds.

• Completion bonds.

• Title Insurance.

• Holdbacks.

• Ensure completion of work by subcontractors.

• Extension Agreements.

• Gap financing.

Land Acquisition and Development Costs

Site Acquisition.

Hard Costs.

• Site preparation and utility installation.

Soft Costs.

• Site engineering.

• Public approval fees.

• Loan fees.

Operating Costs.

Sales and Repayment Rates

Sales estimates drawn from market studies.

Matching sales & repayment.

Lien release.

Release price.

Release schedule.

• Lenders desire a faster repayment rate so that they are paid off before all of the parcels are sold. This is a product of negotiation between developer and lender.

Exhibit 17-11 Calculation of the Release Price per Parcel

Lot Type Release Price before

Acceleration Acceleration

Factor Acceleration Release Price

Cluster $11,534 1.2 $13,840

Standard 27,681 1.2 33,217

Creek 28,835 1.2 34,602

Project Feasibility and Profitability

Project Feasibility.

• Does market value after development exceed all costs?

• Net cash flow schedule.

• Project IRR and Net Present Value.

• Entrepreneurial Profits: Should the developer’s profit be included also? If it is, you may be “double counting” the profit.

• Sensitivity Analysis.

Chapter 18

Structuring Real Estate Investments: Organizational Forms and Joint Ventures

Organizational Forms

Sole Proprietorship.

Partnerships.

• General partnership.

• Limited partnership (“LP”).

• Limited liability partnership (“LLP”).

Limited liability company (“LLC”).

Corporations.

• C Corporation.

• S Corporation. • No more than 100 shareholders.

• No corporations as shareholders (shareholders must be individual persons).

• No nonresident alien investors.

• No more than one class of stock.

Joint Ventures 1

1. Risk sharing.

2. Combine expertise with capital.

• Developer/operator/sponsor.

• Investor.

3. Speculative objectives.

Joint Ventures 2

Organizational Forms.

Profit Sharing.

• Initial and additional capital.

• Share in cash flow.

• Share in sale.

• Preferred return?

• Taxable allocation of income and loss.

• Control operations and decisions.

Initial Capital Contributions

• The money partner may put up 90 to 95 percent of the money. The developer/manager may put up 5 to 10 percent.

• The key concept here is that the developer/manager needs to put up something so there is an alignment of interests.

Sharing Cash Flow from Operations

In Proportion.

• Pari Passu distribution.

Preferred Distribution.

• Preferred Return.

• Disproportionate sharing.

• Cumulative versus non-cumulative.

• Promote.

Specified Fees.

Sharing of Cash Flow from Sale

Repay any debt.

Return of initial investment (if not repaid previously).

Remainder Distributed.

• Predetermined portions.

• IRR Preference.

• IRR Lookback.

Syndications

Formed to acquire, develop, manage, operate, or market real estate.

Not an organizational form.

Limited partnership.

• Private offering.

Identified Assets versus Blind Pool.

Public syndicate.

Partnership Agreement 1

Financial Considerations.

• Initial equity contributions.

• Future assessments provision.

• Distribution allocation.

• Special allocation.

• Capital accounts.

Partnership Agreement 2

Evaluating the Investment.

• Risk & return of comparable investments.

• Compensation to syndicator.

• General partner “carve out” of fees.

• Is there an equity investment by the syndicator?

Partnership Allocations and Substantial Economic Effect

Substantial Economic Effect.

• Was an allocation reflected by an adjustment to the capital account?

Equalizing Capital Accounts.

• Adjust cash distribution to partners.

• Change the allocation of the gain from sale.

• Gain charge-back method.

Use of the Limited Partnership in Private and Public Syndicates 1

Association.

1. Business association.

2. Objective to carry on business.

3. Continuity of life.

4. Centralized management.

5. Limited liability.

6. Free transferability of interest.

Use of the Limited Partnership in Private and Public Syndicates 2 Most Partnerships.

• No continuity of life.

• General partner has unlimited liability.

• Limited transferability of interests.

Use of Corporate General Partners.

• Safe harbor requirements.

Use of the Limited Partnership in Private and Public Syndicates 3

Private versus Public Syndicates.

• Regulation D.

• Accredited Investor.

• Security issuers officers, directors, etc.

• $150,000 and 20% rule.

• $1 million net worth rule.

• $200,000 income rule.

• Private offerings are usually limited to 35 or fewer investors.

Concept Box 18.2 Investment options under New Regulations

Investor Qualification Blank

Maximum Investment

Maximum Capital Raise Proof of status Secondary Market

Accredited Investor

TitleⅡ, REG D (506c)

No limit None, but only 2000 investors

Verification of investor status by issuer or platform

No, but a market is being developed

Blank Title Ⅳ, Reg A+ No limit Same as for unaccredited below

N/A Yes

Blank Title Ⅲ, Crowdfunding Draft Regulations

10% of income above $100,000

$1,000,000 Platform operator verifies

Only to accredited investor

Unaccredited Investor

Title Ⅳ, Reg A+ Tier 1

No limit $20 million in 12 months; No limit on number of investors

No verification required

Yes

Blank Title Ⅳ, Reg A+ Tier 2

No more than 10% of wealth

$50 million in 12 months, no limit on number of investors

No verification reguired

Yes

Blank Title Ⅲ Crowdfunding Draft Regulations

$2,000 to $100,000 with cap of 5% of income or net worth if income less than $100,000; cap of 10% if income greater than $100,000

$1 million in 12 months

Platform operator verifies

12 month prohibition on resale except to accredited investor

Regulation of Syndicates 1

Investment Objectives & Policies.

• Fully identified properties.

• Blind pool investment.

• Use of leverage.

• Period of ownership before assets are sold.

• Land development investments to be allowed.

• Joint ventures with developers and other investors.

• Acquisition of foreclosed properties for resale.

Regulation of Syndicates 2

Promoters and Managers’ Compensation.

• Asset, Income, or Cash Flow Base.

Investor Suitability Standards.

• Lack of Liquidity.

• High Tax Bracket Investors.

Federal and State Securities Authorities

• Federal and state securities laws apply to real estate syndication.

• The degree of applicability will vary depending on the specific transaction.

Chapter 19

The Secondary Mortgage Market: Pass-Through Securities

Evolution of the Secondary Mortgage Market

1. Allows originators to replenish funds.

2. Facilitates geographic flow of funds.

3. Provides an investment option for savers.

Early Buyers of Mortgage Loans

Provides an investment option for savers.

• Mortgage companies and thrifts.

FHA insurance and VA guarantees.

• Minimum underwriting standards.

The Secondary Market after 1954

1954 Charter Act: FNMA or “Fannie Mae.”

• Enhance secondary market operations.

• FHA and VA mortgages.

• Manage prior direct loans.

• Manage special assistance programs.

• FNMA transforms into a private organization.

• FNMA issues securities.

• The “Treasury backstop.”

• As of 2008, Fannie Mae went under government control.

The Government National Mortgage Association

HUD Act 1968: GNMA or “Ginnie Mae.” • GNMA manages and liquidates FNMA loan portfolio.

• Special assistance functions.

• Guarantee timely payment of principal and interest for FHA-VA mortgage pools.

• Eliminated any default delay in payments to investors. This led to virtual explosion in secondary market and rise of pass-through securities.

The Federal Home Loan Mortgage Corporation Emergency Home Finance Act 1970: FHLMC or “Freddie Mac.”

• Provide a secondary market for conventional loans.

• Allowed FNMA to purchase conventional mortgages.

• FHLMC allowed to purchase FHA and VA mortgages.

• Fannie Mae and Freddie Mac compete for all mortgage loans but they do tend to still focus on their original lines of business.

• As of 2008, Freddie Mac is under government control.

Operation of the Secondary Mortgage Market

Operation:

• Direct Sale Programs.

• Mandatory Commitment.

• Optional Delivery.

Mortgage-Related Security Pools:

• Securitization

Exhibit 19-1: Funds Flow Analysis (Direct Purchase Programs)

Access the long description slide.

The Development of Mortgage-Related Security Pools

In this chapter and the next, we’ll cover the major types of mortgage-backed securities including:

1. Mortgage-backed bonds (MBBs).

2. Mortgage pass-through securities (MPTs).

3. Mortgage pay-through bonds (MPTBs).

4. Collateralized mortgage obligations (CMOs).

Mortgage-Backed Bonds 1

• Issuer retains ownership of mortgages.

• Mortgages held in trust.

• Fixed coupon rate.

• Specific maturity.

• Overcollateralization.

• Mark to market.

Mortgage-Backed Bonds 2

Investment Rating:

• Mortgage Quality.

• Geographic Diversification.

• Interest Rates on Mortgages.

• Prepayment Probability.

• Overcollateralization.

• Appraised value and debt coverage ratio if commercial mortgages.

Mortgage-Backed Bonds 3

Example 19-1: Mortgage Bond Valuation.

• 20-year to maturity.

• Par value of $10,000.

• 10.5% annual coupon.

• At issue, bond market investors require an 11% interest rate.

• What is the initial price of the bond?

Mortgage-Backed Bonds 4

• Example 19-1:

Mortgage-Backed Bonds 5

• In Example 19-1, what would be the price of the bond 5 years later if investors required a 12% return?

• n is 15 years.

• i is 12%.

Mortgage-Backed Bonds 6

• Example 19-1:

Mortgage-Backed Bonds 7

Zero Coupon Bond:

• The only cash flow to an investor is a lump sum at maturity.

• No interim coupon payments.

• Also called “deep discount” bonds.

• Analysis is just computing the present value of a lump sum.

Mortgage Pass-Through Securities

• Ownership interest in a pool of mortgages.

• Trustee is owner of the mortgages in the pool.

• Principal and interest are passed through.

• Servicing and guarantee fees.

Exhibit 19-3 Mortgage Pass-Through Securities: Issuance and Funds Flow

Access the long description slide.

Important Characteristics of Mortgage Pools 1

• Security Issuers and Guarantors.

• Default insurance.

• Prepayment patterns and security for mortgages in pools.

• Coupon rates, interest rates, and number of seasoned mortgages in pools.

Important Characteristics of Mortgage Pools 2

• Number of mortgages and geographic distribution.

• Borrower characteristics and loan prepayment.

• Nuisance calls.

Exhibit 19-4: Selected Characteristics of Mortgage Pass-Through Securities

Issuer Mortgage companies, thrifts, others: GNMA pass-throughs

FHLMC: participation certificates

FNMA: mortgage- backed securities

Guarantor against default on mortgages

FHA, VA, FmHA Private mortgage insurance, FHA/VA

FHA/VA, private mortgage Insurance

Types of mortgages in pool* FRM, GPM, MH, ARM FRM, GPM, ARM, MF, seconds

FRM, GPM, ARM, MF, seconds

Interest rate on mortgages in underlying pools allowed to vary?

Yes Yes Yes

Seasoned mortgages allowed in pools?

Yes Yes Yes

Nature of payment guarantee Timely payment of P & I and prepayments

Timely payment of P & I and eventual prepayments

Timely payment of P & I and prepayments

Guarantor GNMA and credit of U.S. government

FHLMC only FNMA only

*Key

FRM = 1 to 4 single-family, 30-year fixed rate mortgages.

GPM = Graduated payment mortgages.

ARM = Adjustable rate mortgages.

MH = Manufactured housing mortgages.

MF = Multifamily housing mortgages.

Seconds = Mortgage pools secured by second mortgages.

Mortgage Pass-Through Securities: A General Approach to Pricing 1

Interest Rate Risk.

Default Risk.

Risk of Delayed Payment of Principal and Interest.

1. As of 2008, Ginnie, Fannie, and Freddie are all under government control.

Prepayment Risk.

1. Number of mortgages in the pool.

2. Distribution of interest rates on such mortgages.

3. Number of seasoned mortgages included in the pool.

4. Geographic location of borrowers.

5. Household (borrower) characteristics.

6. Unanticipated events (example: flood, earthquake).

Mortgage Pass-Through Securities: A General Approach to Pricing 2

• Pass-Through Rates, Yields, and Servicing Fee.

• Weighted Average Coupon (“WAC”).

• Stated Maturity Date of Pool.

• Weighted Average Maturity.

• Payment Delays by Servicer.

• Pool Factors.

Secondary Mortgage Market 1

Example 19-2:

• A mortgage pool consists of the following:

• $500,000 of 30-year 7% Fixed Rate Mortgages.

• $200,000 of 29-year 6.5% Fixed Rate Mortgages.

• $300,000 of 28-year 6% Fixed Rate Mortgages.

• What is the weighted average coupon and average maturity of the mortgage pool? If there is a servicing fee of 0.5%, what is the quoted maturity and quoted coupon rate?

Secondary Mortgage Market 2

• Example 19-2:

Amount Maturity Interest Rate Weight W × M W × I

$500,000 30 7% .5 15 3.5

$200,000 29 6.5% .2 5.8 1.3

$300,000 28 6% .3 8.4 1.8

$1,000,000 Blank Blank Blank WAM = 29.2 WAC = 6.6

• Quoted Maturity = 30 Years.

• Quoted Coupon Rate = 6% − 0.5% = 5.5%.

Secondary Mortgage Market 3

Pricing Issues: • Mortgage-Backed Bonds.

• Specified maturity.

• Specified coupon payment and face value.

• Pricing methodology is relatively straightforward.

• Mortgage Pass-Through Securities: • Cannot define a specific maturity.

• Cannot define specific cash flows.

• Pricing is based on prepayment assumptions.

Secondary Mortgage Market 4

Prepayment Assumptions:

1. Average Maturity.

2. Constant Rates of Prepayment.

3. FHA Prepayment Experience.

4. PSA Prepayment Model.

Convexity:

• Price Compression.

Exhibit 19-8: MPT Security Cash Flow Payments to Individual Investors at Various Prepayment Rates

Access the long description slide.

Exhibit 19-9: MPT Security Prices at Various Required Rates of Return and Prepayment Rates

Access the long description slide.

Exhibit 19-1: Funds Flow Analysis (Direct Purchase Programs) Long Description

The mortgage originator sells the mortgages to a buyer. In the mid-1950s, the buyers were life insurance companies who used policyholder reserves as their source of funds and eastern thrifts who used savings deposits as their source of funds. From the mid-1960s to the present, the buyer was Fannie Mae and the source of funds were notes and debentures. From the mid-1970s to the present, the buyer is the FHLMC and the source of funds is notes and debentures and those funds flow back to the mortgage companies, thrifts, commercial banks, and others.

Return to slide containing original image.

Exhibit 19-3 Mortgage Pass-Through Securities: Issuance and Funds Flow Long Description

The mortgage companies, thrifts, commercial banks, and others create pools that are backed by Fannie Mae and the FHLMC. They issue securities purchased by security dealers (underwriting and security sales). The source of funds are mutual funds, IRAs, KEOGHs, life insurance companies, pension funds, and other. The funds flow back to the security dealers and then flow back to the mortgage loan originator.

Return to slide containing original image.

Exhibit 19-8: MPT Security Cash Flow Payments to Individual Investors at Various Prepayment Rates Long Description

The horizontal axis displays the period in years scaled from 1 to 10. The vertical axis displays cash flows (in thousands of dollars) scaled from $0 to $20. If the prepayment rate is 0% the cash flows are constant at $4,000. If the prepayment rate is 10% the cash flows decreases linearly from about $6,000 to about $1,000 over the 10 years. If the prepayment rate is 50% the cash flows decreases exponentially from about $16,000 to less than $1,000 by year 5.

Return to slide containing original image.

Exhibit 19-9: MPT Security Prices at Various Required Rates of Return and Prepayment Rates Long Description

The horizontal axis displays the required rate of return (%) and is scaled form 7.5% to 12.5%. The vertical axis displays the price (in thousands of dollars) and is scaled from $22 to $28. For each of the prepayment rates the price decreases linearly as the required rate of return increases. As the prepayment rate increases, the slope of the line decreases, meaning as the prepayment rate increases the amount that the price decreases as the required rate of return increases is not as great.

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Chapter 20

The Secondary Mortgage Market: CMOS and Derivative Securities

Mortgage Pay-Through Bonds (MPTBs)

Bond, not an equity ownership interest.

Debt obligation of issuer.

Pass-through of interest and principal.

Credit rating derives from three things.

• Riskiness of mortgages.

• Extent of over collateralization.

• Whether or not there are US gov’t bonds or agency obligations as excess collateral.

Collateralized Mortgage Obligations 1

Collateralized Mortgage Obligations (CMOs).

Debt instrument.

Mortgage pool owned by issuer.

Pass-through of interest and principal.

Multiple classes of securities issued.

• Different maturity classes.

• Different priority for payment of principal and interest.

• Tranches.

Exhibit 20-1 Contents of a CMO Security Offering with Sequential Pay Tranches

Collateralized Mortgage Obligations 2

Overcollateralization.

• Represents equity interest of issuer.

• Residual cash flow is return to issuer.

• Cash flow = interest earned – interest paid.

• Prepayment problem.

• Reinvestment problem.

• Calamity call.

Collateralized Mortgage Obligations 3

Sequential Payout Tranche Structure.

• Tranche Z: Paid Last.

• Tranche A: Principal, Prepayments, & Interest Received First.

• Tranche B: Interest Only Until Tranche A is Paid.

• And so on for any additional tranches.

Exhibit 20-3: Cash Flows to Class A, B, and Z Investors (prepayment rate = 0%) 1 Tranche A (coupon rate = 9.25%; amount invested = $ 27,000,000)

Period Amount Owed to Security

Holder at End of Period All Principal from Pool and

Interest from Z Class Coupon Interest

Total Payments

0 $ 27,000,000 Blank Blank Blank

1 19,214,893 $7,785,107 $2,497,500 $10,282,607

2 10,573,424 8,641,469 1,777,378 10,418,846

3 981,394 9,592,030 978,042 10,570,072

4 0 981,394 90,779 1,072,173

5 0 0 0 0

6 0 0 0 0

7 0 0 0 0

8 0 0 0 0

9 0 0 0 0

10 0 0 0 0

Exhibit 20-3: Cash Flows to Class A, B, and Z Investors (prepayment rate = 0%) 2 Tranche B (coupon rate = 10.00%; amount invested = $ 15,000,000)

Period Amount Owed to Security

Holder at End of Period All Principal from Pool and

Interest from Z Class Coupon Interest

Total Payments

0 $ 15,000,000 Blank Blank Blank

1 15,000,000 0 $1,500,000 $1,500,000

2 15,000,000 0 1,500,000 1,500,000

3 15,000,000 0 1,500,000 1,500,000

4 5,334,240 $9,665,760 1,500,000 11,165,760

5 0 5,334,240 533,424 5,867,664

6 0 0 0 0

7 0 0 0 0

8 0 0 0 0

9 0 0 0 0

10 0 0 0 0

Exhibit 20-3: Cash Flows to Class A, B, and Z Investors (prepayment rate = 0%) 3 Tranche Z (coupon rate = 11.00%; amount invested = $ 30,000,000)

Period Amount Owed to Security

Holder at End of Period Interest Accrued Interest

Principal Allocation Total Payments

0 $ 30,000,000 Blank Blank Blank Blank

1 33,300,000 $3,300,000 $3,300,000 Blank Blank

2 36,963,000 3,663,000 3,663,000 Blank Blank

3 41,028,930 4,065,930 4,065,930 Blank Blank

4 45,542,112 4,513,182 4,513,182 Blank Blank

5 44,067,644 5,009,632 Blank $1,474,468 $ 6,484,101

6 36,509,978 4,847,441 Blank 7,557,666 12,405,107

7 28,120,968 4,016,098 Blank 8,389,009 12,405,107

8 18,809,168 3,093,307 Blank 9,311,801 12,405,107

9 8,473,069 2,069,008 Blank 10,336,099 12,405,107

10 0 932,038 Blank 8,473,069 9,405,107

Exhibit 20-4: Residual Cash Flows (prepayment rate = 0%) Residual Equity Class ($3,000,000 Invested)

Period Total Cash Flow

into Pool Total Payments to A, B

and Z Classes Residual Cash Flows to

Equity Class

0 Blank Blank $(3,000,000)

1 $12,735,107 $11,782,607 952,500

2 12,735,107 11,918,846 816,261

3 12,735,107 12,070,072 665,035

4 12,735,107 12,237,933 497,174

5 12,735,107 12,351,765 383,342

6 12,735,107 12,405,107 330,000

7 12,735,107 12,405,107 330,000

8 12,735,107 12,405,107 330,000

9 12,735,107 12,405,107 330,000

10 12,735,107 9,405,107 3,330,000

Residual IRR = 20.19%

Collateralized Mortgage Obligations 4

Expected Maturities.

Pricing & Prepayment.

Tranche Variations.

• Sinking Fund Structure.

• Planned amortization class tranche.

• Targeted amortization class.

• Pricing speed.

• Companion tranche.

Collateralized Mortgage Obligations 5

Floating Rate Tranches.

• Floater Tranche.

• Coupon rates adjust periodically.

• Inverted Floating Rate Tranche.

• Coupon rate adjusts opposite to its index.

• Scaling.

• Used as a Hedge.

Simple Example of Floating Rate Tranches (a derivative) Case 1:

Interest due to the (F) and (IF) tranches on date of issue, LIBOR = 6%

If, after the issue date, LIBOR increased by 1 percent, the interest payable to both classes of investors would be as shown in case 2.

Case 2:

Interest due if LIBOR increases by 1 percent to percent:

Collateralized Mortgage Obligations 6

Yield Enhancement.

Principal-Only Tranches.

• Similar to a Zero Coupon Bond.

Interest-Only Tranches.

Convexity.

Exhibit 20-15: Summary of Important Investment Characteristics of Mortgage- Related Securities

Blank MBB MPT* MPTB CMO

(a) Type of security interest acquired Debt Equity Debt Debt

(b) Number of security classes One One One Multiple

(d) Party bearing prepayment risk Issuer Investor Investor Investor

(e) Overcollateralization? Yes No Yes Yes

(f) Overcollateral marked to market? Yes NA No No

(g) Credit enhancements used? Yes No Yes No

(h) Maturity period known? Yes No No No

(i) Call provisions? Possibly Cleanup Possibly Calamity and nuisance

(j) Off-balance-sheet financing possible? No Yes No Yes

Commercial Mortgage-Backed Securities (CMBSs) 1

Similar in form to residential MBSs.

• Default risk differs significantly.

Assets in mortgage pool.

• Often interest-only.

• Lump sum principal payment.

Commercial Mortgage-Backed Securities (CMBSs) 2

Senior Tranche (A piece).

Subordinate Tranche (B piece).

Prepayment is less likely than residential mortgages.

• Lockouts.

• Yield Maintenance.

Extension Risk.

Exhibit 20-16: Simplified Example of a Commercial Mortgage-Backed Security Offering

Rating Commercial Mortgage-Backed Securities

First Loss Position.

Credit Ratings.

Credit Enhancements.

1. Issuer or 3rd party guarantee.

2. Surety bonds and letters of credit.

3. Advance payment agreements.

4. Loan substitutions and repurchase agreements.

5. Lease assignments.

6. Over collateralization.

7. Cross-collateralization and cross-default.

Exhibit 20-18: CMBS General Bond Risk Considerations

Source: Diagram created by Mr. Josh Marston. Mass Financial Services, and provided by Charter Research.

*Note that the subordination is equal to I — (LTV/75%), where 75 percent is the LTV for the underlying loan; for example for the AA class, we have I — (57%/75%) = 24% subordination. This is how much loan loss can exist before the next highest rated class loses money. Therefore, AA investors wilt not lose money unless the loan has lost 24 percent of its value.

† Debt service coverage ratio.

‡ Loan-to-value ratio.

Access the long description slide.

Commercial Mortgage-Backed Securities (CMBSs) 3

Collateralized Debt Obligations (CDOs).

• Broader range of collateral.

• B notes (subordinated position of mortgage).

• Lower rated Commercial Mortgage-Backed Securities.

• Mezzanine Loans.

• Preferred Equity.

• While they are often well diversified, the underlying risk is still substantial. The assets are risky.

Managed Collateralized Debt Obligations.

Exhibit 20-19: Illustration of CDO Structure

Access the long description slide.

Exhibit 20-20: Typical CDO Capital Structure

Investor Class Amount ($) Rating Annual Return (%)

Annual Return (%)

Class A $75,000,000 AAA 5.60% 4.20%

Class B 3,000,000 AA 5.84 0.18

Class C 4,000,000 BBB 6.84 0.27

Class D 7,000,000 BB 7.70 0.54

Class E 2,000,000 B 8.72 0.17

Total debt 91,000,000 5.36

Equity 9,000,000 Not rated 15.00 1.35

Service and transactional charges

0.85

Total capital raised $100,000,000 7.56%

Commercial Mortgage-Backed Securities (CMBSs) 4

Real Estate Mortgage Investment Conduits (“REMICs”).

• Creation of Tax Reform Act of 1986.

• All assets must be one of the four following:

• Qualified mortgages.

• Foreclosure property.

• Cash flow investments are limited to short term, passive, interest bearing assets.

• Qualified reserve fund.

Exhibit 20-18: CMBS General Bond Risk Considerations Long Description

The table contains the following columns: Rating, Subordination, DSCR, LTV, and Price. The ratings are: AAA, AA, A, BBB, BB, B, and NR. The subordination percentages, in the same order are: 30%, 24%, 18%, 11%, 6%, 3%, and 0%. The DSCR values, in the same order are: 2.00, 1.84, 1.71, 1.57, 1.49, 1.44, and 1.40. The LTV ratios, in the same order are: 52.50%, 57.00%, 61.50%, 66.75%, 70.50%, 72.75%, and 75.00%. The prices, in the same order are: 102, 101, 100, 98, 75, 65, and 35.

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Exhibit 20-19 Illustration of CDO Structure Long Description

The diagram begins with a large vertical rectangle labeled $500 million property. An arrow points to a congruent rectangle that is split into a $400 million loan and a $100 million equity. An arrow points to another congruent rectangle split in the same manner labeled Commercial real estate investment bank ($400 million) and Entity owning and operating property ($100 million). The commercial real estate investment bank consists of a $300 million A note and a $100 million B note. The Entity owning and operating property consists of a $25 million mezzanine debt, a $25 million preferred equity, and a $50 million common equity. The $300 million A note breaks down into CMBS A class and CMBS B class. The CMBS B class, as well as the $100 million B note, the $25 million mezzanine debt, and the $25 million preferred equity make up the CDO: CDO A class, CDO B class, and CDO C class.

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Chapter 21

Real Estate Investment Trusts (REITS)

Legal Requirements 1

Creation of the Internal Revenue Code. It dates back to 1960 but there have been updates since then.

There are asset and income requirements: • Asset.

• 75% of assets must consist of real estate, cash, and government securities.

• Not more than 5% of the value of the assets may consist of the securities of any issuer if the securities are not includable under the 75% test.

• A REIT may not hold more than 10% of the outstanding voting securities of any one issuer if those securities are not includable under the 75% test.

• Not more than 25% of its assets can consist of stocks in taxable REIT subsidiaries.

Legal Requirements 2

There are asset and income requirements: • Income.

• At least 95% of the gross income must be derived from dividends, interest, rent, or gains from the sale of certain assets.

• 75% of gross income must be derived from rents, interest on obligations secured by mortgages, gains from the sale of certain assets, or income attributable to investments in other REITs.

Legal Requirements 3

Prohibited Transactions.

Distribution Requirements. • 90% of REIT taxable income.

Stock and Ownership Requirements. • 100 person minimum.

Legal Requirements: Management Activities Pre-1986: Management Activity Restriction.

1986 Tax Reform Act relaxed the restriction and led to vertically integrated operating companies.

1991 Kimco Realty Offering.

Taubman Realty Offering. • Umbrella Partnership REIT (“UPREIT”).

Most are self-advised vertical integrated companies.

Real Estate Investment Trusts

Tax treatment. • Accelerated depreciation.

• 40-Year asset life.

• REIT dividends.

• Taxed as ordinary income.

1999 Real Estate Modernization Act. • “Usual and customary” provision of services. This was especially beneficial

to REITs that owned hotels.

• Taxable REIT subsidiaries.

Exhibit 21-1

Market Capitalization of Publicly Traded REITs

Source: See: Data and Research at the NAREIT website: www.nariet.org.

Access the long description slide.

Other Points

• Tax Treatment.

• Violation Penalties and Status Termination.

• Taxable REIT Subsidiaries.

Types of REITs

Equity REITs. • Industrial/Office.

• Retail.

• Residential.

• Diversified.

• Lodging/Resorts.

• Health Care.

• Self-Storage.

• Timber.

• Infrastructure.

The Investment Appeal of Equity REITs

Diversified portfolio.

Liquidity.

Caveats. • Purchase of original property not arm’s length.

• Conflicts of interest.

• Appraisals.

• Sarbanes-Oxley.

Public Nonlisted REITs

Private REITs. 1. REITs for institutional investors.

2. REITs syndicated to investors.

3. “Incubator” REITs.

Importance of FFO (Funds from Operations)

Funds from Operations (FFO). • REIT equivalent to earnings per share.

• Depreciation impact.

Adjusted Funds from Operations (AFFO).

Funds Available for Distribution/Cash Available for Distribution (FAD/CAD). • FAD/CAD is the amount of actual cash that is left over.

REIT Expansion and Growth 1

• Little Free Cash Flow. • Income distribution rules.

• Secondary Stock Offering. • Dilution versus accretion.

• Debt Financing.

REIT Expansion and Growth 2

1. Growing income from existing properties.

2. Growing income through acquisitions.

3. Growing income through development.

4. Growing income through provision of services.

5. Financial engineering.

REIT Expansion and Growth 3

Growing income. • Existing properties.

• Rental income.

• Redevelopment.

• Acquisitions.

• Purchase properties with cash at positive spreads.

• Swap shares for property interests.

REIT Expansion and Growth 4

Growing income. • Development.

• Provision of services.

• Property management, brokerage, development, etc.

• Financial engineering.

• Improve financing terms and lower capital costs.

Important Issues in Accounting and Financial Disclosure: Equity REITs

• Tenant Improvements and Free Rent: Effects on FFO.

• Leasing Commissions and Related costs.

• Use of Straight-Line Rents.

• FFO and Income from Managing Other Properties.

• Types of mortgage debt and other obligations.

• Existence of Ground leases.

• Lease Renewal Options and REIT Rent Growth.

• Occupancy Numbers: Leased Space or Occupied Space.

• Retail REITs and Sales per Square Foot.

• Additional Costs of Being a Public Company.

The Investment Appeal of Mortgage REITs

Mortgage REITs. • Does not own real property. Does own mortgage paper.

Valuing REITs as Investments

• Gordon Dividend Discount Model.

• Income (FFO) Multiple.

• Net Asset Value.

Exhibit 21-1 Long description

Both equity REITs and mortgage REITs were virtually nonexistent until about 1993. Since then the equity REITs increased to about $4 billion in 2005, dropped to about $2 billion by 2008, then increased to about $1 trillion by 2016. Mortgage REITs increased steadily, but slightly from 2001 until 2016 from about $0 to about $0.5 million dollars.

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Chapter 22

Investment Performance and Portfolio Considerations

Sources of Data Used for Real Estate Performance Measurement 1

• Limited data. • Private, negotiated transactions.

• Asset is non-homogeneous.

• Thinly traded market.

Sources of Data Used for Real Estate Performance Measurement 2

• REIT Data: Security Prices.

• Hybrid and Mortgage REITs.

• NCREIF Property Index: Property Values.

• Data Sources for Other Investments.

Exhibit 22-1 Common Sources of Data Used for Measuring Investment Performance 1

Real Estate- Equity Returns Description of Data

NAREIT- Equity REIT Share Price Index and Dividend Yield Series

Monthly index computed based on share prices used in the index are obtained from the New York Stock Exchange (NYSE), NYSE MKT LLC, and National Association of Security Dealers Automated Quotation (Nasdaq) system. Divided data are collected by NAREIT. Properties owned may be levered or unlevered. Index values are available from 1972 to the present.

NAREIT- Mortgage REIT Share Price Index and Dividend Yield Series

Monthly index computed on share price data of REITs that make primarily commercial real estate loans (construction, development, and permanent), although some make or purchase residential loans (both multifamily and single family). Prices obtained from NYSE, NYSE MKT LLC, and Nasdaq market system. Dividend data are collected by NAREIT. Monthly index data available from 1972 to the present.

NAREIT- Hybrid REIT Index Monthly index compiled by NAREIT from share prices and dividends for REITs that (1) own properties and (2) make mortgage loans. Sources of data are the same as for equity and mortgage REITs. Index values are available from 1972 to the present.

Exhibit 22-1 Common Sources of Data Used for Measuring Investment Performance 2

Real Estate- Equity Returns Description of Data

NCREIF Property Index – National Council of Real Estate Investment Fiduciaries

NCREIF members contribute data based on about 5,000 properties, with an aggregate market value of about $200 billion, that are owned by pension fund plan sponsors through investment managers. An index is calculated quarterly and data consist of (1) net operating income and (2) beginning- and end-of-quarter appraised values for all properties. Actual sale prices are used, as available. Quarterly index values are available from 1978 to the present.

Common Stocks- Standard & Poor’s (S & P) 500

Daily index based on common stock prices for the 500 corporations with the highest market value of common stock outstanding. Data available from the financial press. Dividend data compiled by Wilshire and Associates and included in a monthly and annual total return index by Ibbotson Associates, Chicago. Daily index data available from 1926 to the present.

Corporate Bonds- Barclays Capital U.S Aggregate Bond Index

The U.S. Aggregate Bond Index covers the USD-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The index includes bonds from the Treasury, government-related, corporate, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS sectors. The U.S Aggregate Bond is a component of the U.S. Universal Index in its entirely. The index was created in 1986, with index history backfilled to January 1, 1976.

Government Securities U.S. Treasury bills and bonds. Price data obtained from The Wall Street Journal. A monthly total return series compiled by Ibbotson Associates, Chicago. Daily index data available from 1926 to the present

Exhibit 22-2

Cumulative Total Returns for REITs, S&P 500, NCREIF, Bonds, and T-Bill Indexes, 1985 to 2014

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Computing Holding Period Returns 1

• Holding Period Returns.

11TT

DPP HPR

−

− +−

PT = End of period price

PT−1 = Beginning of period price

D1 = Dividends

Computing Holding Period Returns 2

Example 22-1: • Purchase price $100.

• Sales price $110.

• Dividend received $5.

• $15

HPR = 15%. $100

Computing Holding Period Returns 3

• Geometric Mean Return.

1= + + + −n 1 2 n

GMR (1 HPR )(1 HPR ) (1 HPR )

• Arithmetic Mean – a simple (non-compounded) average

Computing Holding Period Returns 4

Example 22-2: • Consider the following annual returns:

• 15%, 20%, −30%, 22%.

• Arithmetic mean 25 20 30 22

9.25%. 4

+ − +  = =   

• Geometric mean ( )( )( )( ) .25

1.5 1.2 .7 1.22 1.= −  

• Geometric mean = 6.39%.

Comparing Investment Returns

• HPRs and Inflation.

• Comparing Risk Premiums.

Risk, Return, and Performance Measurement 1 Historical comparisons.

Risk. • Business risk.

• Default risk (from leverage).

• Liquidity risk.

Variability in asset returns & risk premiums.

Risk, Return, and Performance Measurement 2 Coefficient of Variation.

• = Standard Deviation of Returns/Mean Return.

• Risk per unit of return.

• Also known as “risk-to-reward” ratio.

Portfolios.

• Asset efficiency: Does adding an asset to a portfolio add to returns while maintaining or lowering portfolio risk?

Calculating Portfolio Returns.

... )HPR(W)HPR(WHPR jjiiP ++=

where W’s are weights.

Exhibit 22-7: Correlation Matrix for Investment Alternatives

1978 to 2014

Blank CPI Bonds S&P 500 T-Bills NCREIF REITs

CPI 1 Blank Blank Blank Blank Blank

Bonds −0.2078 1 Blank Blank Blank Blank

S&P 500 0.0014 0.1047 1 Blank Blank Blank

T-Bills 0.4764 0.1815 0.0375 1 Blank Blank

NCREIF 0.2980 −0.1212 0.1344 0.2895 1 Blank

REITs 0.0818 0.2091 0.6169 0.0684 0.1525 1

Exhibit 22-8

Portfolio Returns of NCREIF and S&P 500 Stocks, 1978 to 2009

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Exhibit 22-9

Efficient Frontiers

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Elements of Portfolio Theory 1

Example 22-3:

Portfolio: • Asset A: weight 30%, return 10%. • Asset B: weight 40%, return 15%. • Asset C: weight 30%, return 18%.

Portfolio return: • (.3 × 10) + (.4 × 15) + (.3 × 18) = 14.4%.

Elements of Portfolio Theory 2

Portfolio risk: • Standard deviation.

• Not a weighted average

• There is interaction between returns of assets

Covariance: • Absolute measure of how two data series (such as asset returns) move

together over time

Elements of Portfolio Theory 3

Correlation:

• Relative measure of movement.

• Range of +1 to −1.

ij σσ

COV =

• For example, as the correlation approaches +1, two series are said to move very closely together. The converse is also true.

Elements of Portfolio Theory 4

Portfolio weighting: • Efficient frontier.

• Maximum return for a given risk level.

Diversification & real estate: • Historical evidence.

• NCREIF Index & appraisal smoothing.

• Traded REITs & public markets risk.

Exhibit 22-10

NCREIF versus NAREIT Quarterly Returns, 1985 to 2014

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Real Estate Returns, Other Investments, and the Potential for Portfolio Diversification 1

Real Estate Performance and Inflation.

Diversification by Property Type & Location.

Global Diversification. • Evolution of global REIT structures.

• CMBS markets.

• International Indices.

Socially responsible property investing.

Exhibit 22-11

NCREIF Returns by Property Type

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Exhibit 22-12

NCREIF Returns by Selected MSA

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Real Estate Returns, Other Investments, and the Potential for Portfolio Diversification 2

Diversification & global cities.

Risks of global investment. • Currency risk.

• Incomplete information.

• Different tax laws & property rights.

• Political risk.

• Communication & culture differences.

Exhibit 22-14 1

Largest Commercial Real Estate Markets

Estimated Institutional Invested Value (Office, Retail, & Industrial Only) U S D Billions

Tokyo $488

New York $281

London $276

Hong Kong $261

Los Angels $257

Paris $238

Bay Area $206

Washington D.C $170

Seoul $151

Singapore $132

Chicago $122

Exhibit 22-14 2

Sydney $121

Boston $118

Toronto $88

Seattle $84

Dallas $80

Houston $78

Osaka $77

Munich $72

Miami $71

Exhibit 22-15

GDP Growth Rates for Different Global Cities

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Real Estate Returns, Other Investments, and the Potential for Portfolio Diversification 3

Use of Derivatives to Hedge Portfolio Risk. • Derivatives allow investors to take a position in real estate without actually

buying or selling properties.

• Long & short positions.

• Overexposure & underexposure to property types.

Up Shares and Down Shares.

Exhibit 22-17 Up Shares and Down Shares

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Exhibit 22-2 Long Description

All of these measures have increased over this time period, but the greatest increase was seen by the Equity REITs and the S&P 500.

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Exhibit 22-8 Long Description

The horizontal axis displays the portfolio standard deviation (%) and is scaled from 1 to 9. The vertical axis displays the portfolio return (%) and is scaled from 1.0 to 3.0. The graph slightly hooks left before curving up and increasing to the right. The lowest portfolio return is labeled 100% NCREIF and the greatest portfolio return is labeled 100% S&P 500, which is also associated with the greatest risk.

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Exhibit 22-9 Long Description

As the portfolio standard deviation (%) increases, the portfolio return (%) also increases for both categories. However, the return for portfolios consisting of stocks, bonds, and real estate has a greater return for the same amount of risk.

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Exhibit 22-10 Long Description

NCREIF returns are typically around 2%, but have fluctuated as low as negative 8% in 2009 and as high as 5% in 2005. NAREIT returns are typically around 1%, but have fluctuated from about negative 12% to as high as 32% in 2009.

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Exhibit 22-11 Long Description

NPI for office, retail, apartment, and industrial properties all move together from 1978 to 2014. They are typically around an annual return of 10%.

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Exhibit 22-12 Long Description

This graph displays the NCREIF annual returns for the years 1978 to 2014. All of these cities have annual returns that generally move together. The typical annual return is about 10%.

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Exhibit 22-15 Long Description

The GDP growth rates for these four locations tend to vary together and average around 10%. The greatest dip occurred around 2009, where the rate was approximately negative 25% on average.

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Exhibit 22-17 Up Shares and Down Shares Long Description

The horizontal axis displays the percent change in index value over measurement period and is scaled from negative 50% to positive 50%. The vertical axis displays the net asset value and shows an arrow pointing vertically downward on the left side from 0% to 100% and is labeled net asset value allocated to down share and an arrow pointing vertically upward on the right side labeled net asset value allocated to up share scaled from 0% to 100%. A diagonal line is drawn from the bottom left to the top right. The bottom right triangle is shaded and is labeled up share value. The top (left) triangle is not shaded and is labeled down share value. A change in index value of positive 25% corresponds to a net asset value allotted to up share of 75% and a net asset value allocation to down share value of 25%.

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Chapter 23

Real Estate Investment Funds: Structure, Performance, Benchmarking, and Attribution Analysis

Private Real Estate Fund Strategy

1) The types of properties to be acquired and markets where acquisitions will be made.

2) How the fund will be operated.

3) When properties are to be sold.

4) How the fund strategy will align with the real estate investment requirements of investors.

General Explanation of Possible Provisions in Fund Offerings

• Properties/Markets/Acquisitions.

• Fund Structures/Characteristics.

• Fund Management/Performance/Reporting.

Exhibit 23-1A Examples of Possible Provisions in Real Estate Investment Fund Offerings 1 A. Properties/Markets/Acquisitions

(A.1) Property Fund Strategy

(A.2) Possible Markets

(A.3) Possible Sub-Markets

(A.4) Possible Property Categories

Core Global CBD Multifamily

Core-Plus Domestic Suburban Retail

Value-Added Gateway Cities Urban Office

New Secondary Cities Infill/ Uptown/ In Town

Industrial/ Distribution

Existing Tertiary Cities Undeveloped Land

Hotel

Opportunistic Blank Other Mixed-Use

Other Blank Blank Other

Exhibit 23-1A Examples of Possible Provisions in Real Estate Investment Fund Offerings 2 B. Fund Structures/Characteristics

(B.1) Fund Structures (B.2) Investor Entry/Exit (B.3) Debt/Leverage (B.4) $ Size and Values of Properties In Fund

Commingled Minimum Investment Leverage Restriction: Expected $ Size of Fund

Open End Requirements Acquisitions Maximum % Value for any Single Property to total Fund Value (that is, Single Asset Exposure)

Closed End Admission of New Assumption of Debt Blank

Expected Life of Fund Investors % Maximum L/V for any Single property

Maximum % Value for Any Property Classification (A.4) to Total Fund Value

Finite Life Redemptions: % Maximum Total Debt to Total Fund Value

Blank

Fund Renewal Options Queuing Policy Blank Blank

Fund Liquidation Reinvestment Policy Blank Blank

Property Appraisals: Annually, Quarterly, Internal, External Transfer of Interests

Blank Blank

Exhibit 23-1A Examples of Possible Provisions in Real Estate Investment Fund Offerings 3 C. Fund Management/Performance/Reporting

(C.1) Additional Fund Management Provisions

(C.2) Manager Fees (C.3) Performance Reporting (C.4) Performance Benchmarks

Advisory committee Acquisition Fees Operating Results NCREIF Index

Disclosures Management Fees Income ODCE Index

Investor Capital: Disposition Fees Appreciation “Minimum Real Return”

Commitments Promotes Returns Blank

Contributions ‘’Catch-Ups” Distributions Blank

Blank Carried Interests IRR and TWR Blank

Blank Blank Investment Multiple Blank

Exhibit 23-1B Real Estate Investment Styles

Blank Core Value-Added Opportunistic

Fund Structure Generally Open-End Primarily Closed-End; Few Open-Ended

Closed-End

Indices NPI NPI+400BP NPI+600BP

Return Projections Less than 10% 10%-14% 15%+

Income Return (% of Total Return)

70%+ 40%-60% 0%-50%)

Property Types Industrial, Multifamily, Office, Retail

Expanded (e.g., seniors housing, student housing, and medical office)

All

Property Life Cycle Stabilized, Leased Identifiable Deficiency Distressed, Development

Occupancy 80%+ N/A N/A

Development None Modest Significant

Leverage <35% Up to 75% Up to 100%

Markets Primary/Secondary, Domestic Primary/Secondary/Tertiary, Domestic

Primary/Secondary/Tertiary, Domestic & International

Fund Management

Commitments.

Capital Contributions.

Investment Management Fees.

• Acquisition Fees.

• Disposition Fees.

• Management Fees.

• Performance Fees.

Other Fund Management Fee Structures

• A percentage of net operating income.

• A percentage of cash flow distributions.

• Project revenues.

• Project costs.

Reporting Fund Performance

How should performance and investment returns for the fund be calculated and reported to investors for the quarter?

Exhibit 23-3 Real Estate Investments Funds Flow

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Calculating Returns

Solving for i we have:

  i 1

 + − = − 

 

MVEE CF CC

MVBE

Taking values from Exhibit 23-3:

 $453 $5 $225 i 1 5.91%

$220

 + − = − = 

 

Note:

• MV = Market Value.

• BE = Beginning Equity.

• EE = Ending Equity.

• CF = Cash Distributions (CD) and all net Cash Flows (All inflows – outflows).

• CC = Capital Contributions.

• i = Internal Rate of Return.

Modified “Dietz” Return Formula

DR − +

= −

MVEE MVBE CFj MVBE CFW

Note:

• MVEE is the market value of fund at the end of the period.

• MVBE is the market value of fund at the beginning of the period.

• CFj is the net positive cash flow received by investors in the fund (distributions less contributions) during the jth day.

• CFj is the sum of all net positive cash flow during all days in the period.

• CFW is the time weighted cash flow calculated as ( )N

. N

−CFj j The net positive cash flow

for each day is weighted by the remaining days in the period.

• N = total number of days in the period.

• The sign would be negative if CF was defined as net investment, that is contributions to the fund by investors.

Other Issues

• Calculating Returns at the “Property Level”.

• Comparing Returns: Fund Level versus Property Level.

• Returns: Before and After Fees.

Calculating Historical Returns

Two general approaches:

1. Time-Weighted Return (“TWR”).

2. Internal Rate of Return.

What is the best measure of fund performance?

Exhibit 23-4A IRR Example

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Exhibit 23-4B TWR versus IRR

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Exhibit 23-5 When to Use IRR versus TWR

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Exhibit 23-6

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Investment Multiple

( )Current Net Asset Value of Fund + Cumulative Distributions Equity Multiple

Contributions =

Target Returns and Benchmarks

• NFI – ODCE.

• NCREIF-NPI.

• 10 Year U.S. Treasury Yield (Nominal Constant Maturity).

• CPI Adjusted–Required Real Returns.

Attribution Analysis

• Superior begin underline selection end underline is value added by a transactions team, superior asset/property management practices and executing an effective disposition policy.

• Superior begin underline allocation end underline is value added from buying and selling in the right market locations.

Exhibit 23-7 Example 1- Attribution Analysis

Example 1

Weak property selection, good sector allocation strategy

Note the following:

Fund return = 2.75% Benchmark return = 2.50%.

Despite under-performing the benchmark in both sectors, the fund held a higher proportion of the better-performing sector.

SUCCESS from STRATEGY

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Exhibit 23-7 Example 2- Attribution Analysis

Example 2

Good property selection, poor sector allocation strategy

Fund return = 2.25% Benchmark return = 2.50% Difference = −.25%.

Fund best benchmark in both sectors, but it allocated too much of the portfolio to the sector that performed poorly.

The benchmark had less allocated to sector that performed poorly.

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Exhibit 23-9 Sector Attribution- The Basic Math

R-B = Blank Total excess return Blank

S-B Selection effects Benchmark weight applied to return difference

+A-B Allocation effects Benchmark return applied to weight difference

+(R-S)−(A-B) Cross product terms Difference in weights × difference in returns

( ) ( )− f f b bW R W R

( )− .b f bW R R

( )− .f b bW W R

( ) ( )− − .f b f bW W R R

Evaluating Risk Differences 1

• Differences in risk.

• Differences in the ability to select individual properties.

• Differences in the allocation of the portfolio by sector (property type or location) compared to the benchmark.

Evaluating Risk Differences 2

• Sharpe Ratio.

• Beta.

• Capital Asset Pricing Model.

• Treynor Ratio.

• Tracking Error.

• Information Ratio.

• Jensen’s Alpha.

Exhibit 23-10: Frequently Used Measures of Fund Risk Fund Risk Measures

Measure Definition

Sharpe Ratio (Avg. fund return – risk-free rate)/std. dev. of (fund returns – risk free rate)

Beta (Covariance between fund returns and benchmark returns)/(Variance of benchmark returns)*

Treynor Ratio (Ti) (Avg. fund return – risk-free rate)/beta

Tracking Error Std. dev. of difference in returns for fund versus benchmark

Information Ratio Avg. of difference in returns for fund vs. benchmark/tracking error

Jensen’s Alpha Difference between actual fund return and fund return expected from CAPM**

Also calculated by the coefficient of a linear regression of the fund returns against the benchmark returns. Capital Asset Pricing Model (CAPM): Expected Return = Risk-Free Rate + Beta x (Market Return — Risk-Free Rate)

Exhibit 23-13: The Relationship between Fund Performance (Return) for a Specific Level of Beta

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Exhibit 23-3 Real Estate Investments Funds Flow Long Description

A rectangle in the center of the flow chart is labeled Fund I, Calculate IRRs and TWRs and compare to benchmarks. Distributions Pref. return go to investors in exchange for contributions. Management fees for promotions go to the fund manager. Funds flow in from Investment A and B, which comes from Property A, B, and C, which are different property types, different geographic areas, and have unique property characteristics. The lender uses leverage and the JV partner (e.g., the operator or developer) is given an ownership percentage for promotion of Investment B. Cash balances, other investments (securities and debt), and other income and expenses contribute to Fund I.

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Exhibit 23-4A IRR Example Long Description

Time line showing a negative $500,000 purchase price at time 0 and cash flows of $50,000, $40,000, $30,000, and $50,000, at years 1, 2, 3, and 4. A cash flow of $60,000 and a resale price cash flow of $600,000 occur at year 5.

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Exhibit 23-4B TWR versus IRR Long Description

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Exhibit 23-5 When to Use IRR versus T W R Long Description

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If the valuation frequency is low and the control of cash flows is high then use the IRR. Private equity venture capital, opportunistic real estate, and development projects. If the valuation frequency is high and the control of cash flow is high use IRR and TWRR. If the valuation frequency is low and the control of cash flows is low use IRR, TWRR. If the valuation frequency is high and the control of cash flows is low use TWRR. CORE real estate, public traded stocks, and bonds.

Exhibit 23-6 Long Description

The horizontal axis displays risk and ranges from low to high. The vertical axis displays return and ranges from low to high. Low returns are public and/or private strategies. High returns are typically private strategies. In order of increasing risk and increasing return are: styles that focus on income, such as fixed income and core (stabilized, income-producing properties, diversified public real estate securities). Limited income and more focus on appreciation is classified as: value-added (re- leasing/re-tenanting, redevelopment and repositioning). Finally, styles that focus on appreciation are: opportunistic (distressed situations, development, and emerging markets).

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Exhibit 23-7 Example 1- Attribution Analysis Long Description

The graphs are entitled Example 1, Weak property selection, good sector allocation strategy. The first bar graph displays the total return (%) for Sector A and B. In both cases the benchmark beats the fund. The second bar graph displays the sector allocation (%) for Sector A and B. The fund tilts to the better sector. For sector A, the fund is 70% and the benchmark is 40%. For sector B, the fund is 30% and the benchmark is 60%. Note the following: Fund return = 2.75%, Benchmark return = 2.50%. Despite under-performing the benchmark in both sectors, the fund held a higher proportion of better performing sector.

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Exhibit 23-7 Example 2- Attribution Analysis Long Description

The graphs are entitled Example 2, Good property selection, poor sector allocation strategy. The first graph is of total return (%) for Sector A and B. The fund beats the benchmark in both sectors. The second graph shows the sector allocation (%) for Sector A and B. Sector A is made up of 30% fund and 60% benchmark. Sector B is made up of 70% fund and 40% benchmark. The fund tilts to the wrong sector. Note the following: Fund return = 2.25%, Benchmark return = 2.50%, Difference = negative 0.25%. The fund beats benchmark in both sectors, but it allocated too much of the portfolio to the sector that performed poorly. The benchmark had less allocated to the sector that performed poorly.

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Exhibit 23-13: The Relationship between Fund Performance (Return) for a Specific Level of Beta Long Description The horizontal axis displays beta and the vertical axis displays return. A line with a positive slope is drawn starting at the risk-free rate. Horizontal dashed lines are drawn at the risk-free rate, the benchmark return, and the fund return. The point on the line above an x value of the benchmark beta is labeled benchmark. The value fund beta is shown on the horizontal axis and a point labeled Fund is on the horizontal line labeled fund return. The vertical distance between 0 and the risk-free rate is the risk-free contribution. The vertical distance between the risk-free rate and the benchmark return is the benchmark (market) risk premium. The vertical distance between the benchmark return and the line that describes this relationship is the fund risk premium. The vertical distance between the line that described this relationship and the fund return is the manager's value added to the return (alpha).

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