c1_d1_doc1_bnpd01

Technical Document 1: Real Estate Finance

Types of Real Estate Investments There are four main types of real estate investments that can be presented in two dimensions depending on the type of ownership and the type of market. In the first group, the investment can be described in terms of public or private markets. When the investment is private, ownership usually involves a direct investment like purchasing property or lending money to someone who purchases property. Direct investments can be either directly or indirectly owned through partnerships or commingled real estate funds (CREFs). On the other hand, the public market does not necessitate a direct investment in real estate or lending money to someone. In most cases, the ownership involves securities that serve as claims on the underlying real estate. Public real estate investment comprises ownership of a real estate investment trusts (REITs), a real estate operating companies (REOCs), and mortgage-backed securities (MBSs). The second group describes whether an investment involves the use of either debt or equity. An equity investor has an ownership in real estate or securities of an entity that owns real estate. Equity investors make important decisions such as borrowing money and managing the property. A debt investor is a lender that owns a mortgage or securities that use mortgages as a collateral. Usually, the mortgage is collateralized (secured) by the underlying real estate. In the case of default, the equity investor is a residual claimant, whereas the debt investor is a superior claimant. Since the lender must receive his investment first, the value of an equity investor's ownership is equal to the value of the real estate less the total outstanding debt. Real Estate Valuation Methods At least four evaluations methods are commonly used to value real estate assets.

- The most common method is the use of comparable transactions. Real Estate specialists have databases of transactions which reflect the characteristics of the asset (number of square meters, type of building, purpose office, commercial or residential use-, timeworn, geographic location, size, property rights conveyed), the date of the transaction, the financing terms, the economic conditions related to the asset such as its operating expenses, the expenditures made immediately after purchase, and the price. These databases enable realtors to estimate the price of a building they have to sell. The comparable transactions method is widely used for residential buildings. In such a case, the value of a building is derived by analyzing the market for transactions of similar properties and comparing those properties to the subject property. It assumes that real estate assets are substitutable and that the real estate market is a fair and competitive market. Once adjusted, the prices must be converted into the price per an appropriate unit of comparison such as square meter for houses or offices, cubic meter for warehouses, seat for cinemas, or room for hotels. The price of a new property is then simply given by the product of the number of appropriate units by the price per unit.

- The second method, called the direct cost approach, considers the amount of money that would be spent in order to replace the existing property with a similar one, but with current technologies materials and standards. It is based on the principle of substitution: an investor should not pay more to buy an existing property than he would accept to pay to build a new one. The value of an existing property is equal to the cost of reconstruction minus the depreciation of the property plus the value of the land on which it has been built. For example, if it costs 200,000 Aces to build a house on a lot worth 50,000 Aces, then the value of a comparable existing house which may be depreciated by 10% because of normal wear and tear is: 2000,000 10%*200,000 + 50,000 = 230,000 Aces

- The third method is called the direct capitalization method and relies on the NOI, the net operating income. It is a cash flow valuation. This method is commonly used to value commercial or office purpose buildings as they are income producing assets. The propertys present value depends on the cash inflows from holding the property which are anticipated in the future. The NOI approach considers that a real estate asset is first of all an income producing asset and should be thus evaluated as any financial asset. As a consequence, the market value of a property should equal the discounted present value of the expected future cash flow of its rents. This method is particularly well adapted for large properties like rented apartment complexes, office buildings, or hotels. The NOI based valuation method considers that the real estate asset lasts forever.

Several steps are necessary to follow when using this cash flow evaluation method: o First, determine the Potential Gross Income: this income represents the total

income from the property under full occupancy o Second, compute and deduct:

The non-recoverable expenses which are necessary to operate the building

The value of vacancy (an office building or a hotel is rarely fully rented or booked)

o Third, add the miscellaneous income from the property (for example the income you may derive from selling snacks in a Cinema in addition to selling the tickets)

o After the first 3 steps, you obtain the effective Gross Income o Fourth, estimate the operating expenses which include all the necessary

expenses to operate and maintain the building. Taxes are not included. o Fifth, determine the NOI (Net Operating Income) from the property. The NOI

equals the effective gross income less operating expenses of the property. o Sixth, select the appropriate capitalization rate. This rate is the conversion

factor applied to the income stream to convert it into an indication of the propertys market value. This rate reflects the relationship between a single

years NOI and the total property value. The capitalization rate is an equivalent of the discount rate used in the standard discounted cash flow method.

o Finally the value of the property is given by the following formula: ! = !!! + Where R is the capitalization rate, G is the growth rate of rentals, t indicates the time period, and d is the depreciation rate. The latter reflects the buildings loss in value over time due to wear and tear. The depreciation rate d is specific to real estate finance. It is by no way equal or similar to a discount rate that may be used to discount cash flows when computing a present value. Neither is it equal to the annual depreciation cost that a company uses in accounting.

- The fourth method is a standard discounted cash flow valuation. It is the most comprehensive approach, as it combines discounting the projected cash flows over a fixed period of time and the terminal value based on the NOI and the capitalization rate (third method). Contrary to the NOI approach, this method considers that income streams are finite. The steps to be followed are the following:

o First, compute the net income (NI) over the time horizon: NI is equal to NOI minus interest expenses, depreciation and taxes;

o Second, compute the stream of available cash flow (ACF) over the time horizon: ACF is equal to NI plus depreciation minus principal mortgage payment (if the purchase of the building is financed with a mortgage).

o Third, compute the terminal value using the NOI approach. o Fourth, compute the value of the property by summing up the present value of

the ACFs over the time horizon and the terminal value which have been discounted using the appropriate cost of capital (the discount rate)..

Finally, compute the net present value (NPV) of the project by deducting the present value of the investment costs (cash outflow) from the value of the building. Sale and Leaseback A sale and leaseback is an arrangement between two parties where the seller of an asset (most commonly tangible long-term asset such as real estate) leases back from the purchaser the same asset that he sold immediately following the deal. In these types of deals, the purchaser of the asset becomes the lessee, while the seller becomes the lessor. These types of deals most commonly occur when the selling company needs to unfold cash tied to long-term assets in order to fund other potentially profitable investments. The asset, though, is still vital to the selling company in order to maintain its operations. From tax perspective, the seller has the obligation to pay a corporate income tax on the difference between the sale price and carrying amount of the asset on its balance sheet. The lessor generally enters an investment with guaranteed yield (regular payments) for a specified time period.