REAL ESTATE INVESTMENTS

24

Basic forms of real estate investments

Private market Public market

Direct investment Indirect investment

Equity investment Debt investment Equity investment Debt investment

Lending money to Investing in REITs Investing in MBS

Purchasing a property
a purchaser

Characteristics of real estate

→Heterogeneity
Classification of real estate
→High unit value
Residential:
→ Active management
Single-family houses and multi-family
→High transaction costs
apartments
→Depreciation
Non residential: Commercial properties,
→Need for debt capital
farmland and timberland
→Illiquidity
Difficulty in price determination
24
Economic value determinants of real estate investments & Factors affecting the demand
for major property types
• Cash flow is a function of rental income, operating expenses, leverage and capital spending
• The drivers of cash flows are driven by supply & demand of spaces and other economic factors Difficulty in price
determination.

Factors affecting the demand for Commercial property types & their type of lease

Office Industrial and Retail Multi-family

• Demand depends on warehouse • Demand depends on • Demand depends
employment growth • Demand depends on consumer spending on population
• Gross lease: Owner is the overall economy • Lease terms vary growth
responsible for paying • Demand for depending on quality of • Demand also
operating expenses warehouse also the property, size and depends on cost of
• Net lease: Tenant is depends on importance of the tenant renting versus the
responsible for paying Import/export activity • Percentage lease: cost of buying
operating expenses in the economy Tenants pay additional • Increase/decrease
• Net lease < Gross • Net leases are more rent once sales reach a in interest rates
lease common certain level also affect demand
24
Reasons to invest in real Due diligence in private equity real estate investment
estate
• Current income, Capital →Have an attorney review the
appreciation, Inflation ownership history, clear title etc.
hedge, Diversification & → Review lease and rental
Tax benefits history →Review service and
• Real estates have both maintenance agreements
bond-like (fixed income → Examine copies of bills for
stream) and stock-like operating expenses →Have the property surveyed to
(capital appreciation) confirm the boundaries and find
characteristics →Review CF statement from out if there are any easements
previous owner that would affect the value
Based on empirical data,
• Risk and return of bond →Perform environmental →Verify that the property is
portfolio < Risk and return inspection of the site compliant with zoning laws,
of real estate portfolio < environmental regulations etc.
Risk and return of stock →Perform a
portfolio physical/engineering inspection →Verify payment of property
• Percentage of debt and taxes, insurance, special
equity used to finance real assessments etc.
estate does not affect
property's value
24
Private equity real estate investment indexes
Appraisal - based indices Transaction - based indices

Repeat-sales index Hedonic index

Return =
𝑁𝑂𝐼 - 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 + ( 𝑒𝑛𝑑 𝑀𝑉 - 𝐵𝑒𝑔 𝑀𝑉)
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑀𝑉
Relies on repeat sales Requires only one sale.
of the same property It includes variables
This return is equivalent to IRR such as size, age,
Regression model is quality and location of
Such an index allows investors to the property into the
used to create an index
compare the performance of real estate regression model
with other asset classes

Appraisal-based index tends to have less volatility and lag transaction-

based index This results in lower correlation with other asset classes
24

Approaches to valuing real estate properties

Sales comparison
Income approach Cost approach
approach

Value PV = of expected
Value of land + Cost of Sale prices of
future income from the
constructing new comparable
property
property - properties are
Two methods:
Adjustments for adjusted for
Direct capitalization
depreciation and differences in the
method
obsolescence subject property
DCF method
24
Inputs to direct capitalization and DCF methods
Income approach

Direct chaptalization method DCF method

𝑁𝑂𝐼
𝑅𝑒𝑛𝑡
𝐶𝑎𝑝 𝑟𝑎𝑡𝑒 Using GIM
𝐴𝑅𝑌

NOI: Cap rate: r-g Gross Income

All risk yield Forecast NOI over
Rental Cap rate can multiplier (GIM):
(ARY): holding period and
Income at full also be Sale price/Gross
Rent1/Comparabl terminal value at the
occupancy derived from Income. It can be
e sale price. end then discount them
+Other comparable derived from
This valuation is back to no
Income - transactions comparable
Vacancy and used in case of
Cap rate: NOI1 transactions If no growth is expected,
collection loss net lease because
/Comparable Vo = Gross income then cap rate = disc rate
-Operating NOI = Rent
sale price X GIM
expense
24
→When tenant pays all expenses, the rate used to value the property is ARY
Steps for DCF analysis:
→Adjustments are required when the contract rent (passing or term rent) is
not equal to current market rent (open market rent) 1. Project income from
existing leases
→Such issue is dealt with 'term and reversion approach
2. Make assumptions
→Under this approach, contract rent and reversion are appraised separately about lease renewals
using different cap rates 3. Make assumptions
about operating
→Discount rate on contract rent < Reversion rate, because contract rent is less expenses
risky 4. Make assumptions
about capital
→Layer method: Similar to 'term and reversion approach' except that one expenditure
layer is contract rent that is considered to be perpetual and the second layer is 5. Make assumptions
the increase in rent
about vacancy
→The two methods result in different valuation 6. Estimate resale value
7. Select appropriate
→Equivalent yield: Mathematical (not simple) average of two cap rates. It is discount rate
the rate at which two methods result in same valuation
24
Important points in cost and sales
comparison approaches Private real debt investments
• Cost approach is appropriate for
unusual properties for which Using debt(leverage) magnifies returns
comparable are not easily +leverage: Investment Return > Interest Paid
available. With leverage, there is also an increase in risk
• It is also appropriate for new
properties. Financial ratios used to analyze and evaluate private real estate investments

• Sales comparison approach is

appropriate when the market is Debt service coverage Equity dividend rate
Loan-to-value (LTV) =
active. ratio (DSCR) 𝐿𝑜𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡 (Cash-on-cash return)
𝛮𝛰𝛪 𝐶𝐹
=𝐷𝑒𝑏𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 𝐴𝑝𝑝𝑟𝑎𝑖𝑠𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 = 𝐸𝑞𝑢𝑖𝑡𝑦
• In theory, all approaches must
produce the same outcome.
However, in practice that is not
the case. Leveraged IRR: Consider CFs over holding
period, sale price and outstanding loan
• Therefore, appraiser must
reconcile the differences to
arrive at a conclusion
24

Types of publicly traded real estate securities

Mortgage-backed securities
Real estate investment trusts (MBS)
Real estate operating companies
(REITs)
(REOCs)
Asset-backed securitized debt
Equity REITs: obligations that receive CF from
Ordinary taxable real estate
Tax-advantaged companies or an underlying pool of mortgage
ownership companies
trusts that own, operate and loans
develop income- producing real Can be commercial (CMBS) or
Engage to a large extent in the
estate residential (RMBS)
development of real estate, with
an intent to sell rather than to
Mortgage REITS: Invest in loans MV of real estate debt securities
lease
that are secured by real estate > MV of real estate equity
securities
24
Types of REITS
Retail REITS
Industrial REITS Storage REITS Hotel REITS
• Aka shopping center
• Invest in properties that • They own and • They lease properties
REITS
are used as operate self-storage to management
• Small retailers pay
warehouses, properties (mini- companies
greater of fixed rent
distribution centers, warehouses) • RevPAR: Average room
and % of sales
manufacturing facilities • They are gross rate x Average
• Anchor retailers
and small offices leases occupancy
either pay fixed rent
• They are long-term • Rented on monthly • Affected by business
or own their
leases basis cycle
premises
Health care REITS
Residential REITS
Office REITS • Invest in nursing homes,
• Aka multi-family REITS
hospitals, medical office
• Invest in multi- buildings etc.
• Invest in rental apartments
tenanted office
properties • Unaffected by recession.
• They are gross leases
However, affected by
• They are net leases demographics, government
• They are one-year leases
funding etc.
24

Net asset value per share (NAVPS)

MV of assets MV of liabilities
NAVPS =
No. of shares outstanding

If existing appraisals are not available, value of operating real estate is estimated by capitalizing NOI (rent)

Expected NΟΙ
Value =
Cap rate

Non-cash rent: Difference between average rent over the term of contract and cash rent actually paid

If MPS > NAVPS then, REIT is overvalued IF MPS < NAVPS then, REIT is undervalued
24 Last 12-month NOI: 200,000
E.g. Last 12-month NOI = $200k Non-cash rent: (8,000)
Non-cash rent = $8k Full-year adjustment for acquisitions: 2,000
Full-year adjustment for Pro forma cash NOI for last 12 months: 194,000
acquisitions = $2k
Next 12 months growth in NOΙ (2%) 3,880
Next 12-month growth in NOI = 2%
Cap rate = 6% Estimated next 12 months cash NOI: 19,880
Cash and equivalents = $50k Cap rate: 6%
AR = $30k Estimated value of operating real estate: 3,298,000
Land = $40k Cash and equivalents: 50,000
Prepaid/Other assets = $15k
AR: 30,000
Debt = $1min
Other liabilities = $225k Land: 40,000
No of shares outstanding = 48k Prepaid/other assets: 15,000
Estimated gross asset value: 3,433,000
Debt: (1,000,000)
Other liabilities: (225,000)
Net asset value: 2,208,000
No. of shares outstanding: 48,000
NAVPS: 46
24
Relative value approach to valuing REIT stocks

Funds from operations (FFO) Adjusted funds from operations (AFFO)

Measure of operating income of REITS/REOCS More accurate measure of current economic income
Calculated as: Accounting net earnings+ Aka cash available for distribution (CAD)/funds available
Depreciation expense+/- Deferred tax expenses+/- for distribution (FAD)
Gains or losses from sales of property and debt Calculated as: FFO - Non-cash rent - maintenance - type
restructuring capital expenditures and leasing costs

Approaches to REIT/REOC valuation

Relative value
DCF
NAVPS Frequently used: P/FFO and P/AFFO
Investors use two-
Based on MV of assets Factors that impact these ratios:
stage/ three-stage
and liabilities • Expectations for growth in FFO/AFFO
DDM with near-
Largest component of • Risk associated with underlying real estate
term/intermediate-
intrinsic value of a • Risk associated with company's capital structures
term/long-term
REIT/REOC and access to capital (higher leverage
growth forecasts
→lower FFO/AFFO)
24
INVESTING IN REAL ESTATE THROUGH PUBLICLY TRADED SECURITIES
ADVANTAGES DISADVANTAGES
Greater liquidity Investors may be able to replace one property for a similar
property without having to pay taxes. REITs do not qualify
for such benefits
Lower investment requirement Less control for minority shareholders
Limited liability High maintenance costs
Ability to invest in superior quality and range of properties Stock market determined price
Active professional management UPREIT/DOWNREIT conflict
Diversification Low rate of income retention, reducing future income
growth
REITs use debt market to refinance their debt. In periods of
weak credit availability they may have to issue equity at
disadvantageous price.
Additional advantages of REITS compared with REOCS: Additional advantage of REOCS compared with REITs:
Tax advantage Operating flexibility
Predictable earnings
High income payout ratios and yields
24
Valuation issues in buyout and VC transactions
VALUATION METHODOLOGIES
Valuation issue Buyout VC

DCF Using DCF method Frequently used Less frequently used (CFs
are uncertain)
Using relative value Used to check the value Difficult to use (no
Real options
approach from DCF analysis comparable companies)
Level of debt High Low
Venture capital
Pre-money valuation (PRE): Value of a company before making investment
Post-money valuation (POST): Value of a company after making investment VC
Relative value
investor's proportionate ownership: Investment/POST
POST PRE + INV
Replacement cost
Required Rate of Return on VC Investments
LBO is not a valuation technique, • VC firms target an expected hurdle return.
but a way to determine the • The failure rate of VC Investments, especially early-stage VC investments, is
impact of capital structure, much higher than that of growth equity or buyouts.
purchase price and other • Thus, the target return on investment is 10x to 30x more as compared to the 2
parameters on returns the PE to 2.5 times in the Buyout space.
firm expects from the deal
24
Stage Financing
Option Pools
• Stage financing is a key mitigator of the risk that is fundamental to venture capital:
• To attract and incentives
significant uncertainty about growth and profitability prospects.
employees, start-ups grant
• Because the earlier-stage investors take on higher risk, the return for those
their employees the option
investors has to be higher
to purchase shares.
• Valuations, specifically pre-money valuations, at which later rounds of financing
• When these options are
are raised, provide insight into the performance of an otherwise illiquid asset
exercised, they will naturally
class.
have a dilutive effect, so VC
• Venture capital investments tend to be minority stake investments. This is partly
firms tend to calculate the
because the founders might not be willing to give up control but also because
per-share price on a fully
entrepreneurs are essential in the initial stages of business development. So, the
diluted basis.
dilution of initial investors through the subsequent financing rounds is common.
• The basis of the dilution is
• It is typical to use convertible preferred equity in later-stage financing. Because
contractually defined.
the capital that comes in at later stages is less risky than earlier-stage financing. In
• By calculating the share price
addition, to mitigate risk further, later-stage capital tends to have a preferred
on a fully diluted basis, VC
dividend.
investors are effectively left
• If the investee company performance is as expected and the returns are high, the
untouched by the dilution
preference shares will be irrelevant. However, if things do not go as planned, the
effect. Instead, the original
accumulated dividend is treated as junior debt, diminishing the value held by
shareholders, i.e. founders,
earlier equity investors while preserving the value for Preferred Dividend share
absorb the effects of dilution.
holders.