Real Estate Finance and Investments: Lecture 1

Real Estate Investment Decisions

Investment Analysis

Immediate sacrifice; possibility of future awards More opportunities than resources Incomplete information Rank in terms of least expected risks Real estate earns presence in financial investing world in 1950’s

and 1960’s Currently, computerized modeling helps make more informed

and risk-hedging decisions in real estate investing

Others Who Invest in Real Estate

Institutional Investors– Pension Funds– Real Estate Investment Trusts (REIT’s)

Foreign Participation– Exchange Rates– Relative Interest Rates

Why Invest in Real Estate?

TWO FORMS OF VALUE AND RETURN TO INVESTING IN REAL ESTATE:

1. Periodic Cash Flow

2. Market Appreciation / Equity Build

Why Invest in Real Estate?

Price Determined By:

1. Amount and timing of anticipated cash flows

2. How much will be received, and when

3. Degree of confidence with which expectations are held

4. Investors’ tolerance for bearing risk

5. Attractiveness of alternative investment opportunities

Basic Types of Real Estate

Residential– Multi-Family, Single-Family

Commercial– Land (All Types)– Retail– Agricultural / Industrial– Office– Special Purpose

Types of Investors

– Passive Can make NO operating decisions

– Active Make operating decisions of the underlying assets

– Equity Purchasing asset for expected cash flows and market

appreciation– Debt

Purchasing debt for expected streams of income (interest from debt service)

Types of Investors (examples)

Loan Origination;

Construction Lending

Permanent loans

Loan purchases on secondary

mortgage market

Direct ownership of rental property; purchase or development

Pass-through certificates

Mortgage REIT’s

MBS’s – Residential and/or Commercial

Shares in real estate corporation

Limited partnership shares

Equity REIT

Debt (streams of interest) Equity (cash flow & apprec.)

Active(makes

operating decisions)

Passive (makes no operating decisions)

Performance of Real Estate Investments

Data sparse and contradictory– Yield indices computed quarterly by appraisal

estimates– Indicators smoothed; eliminates true measure of

volatility

CREF’s and REIT’s

Commingled Real Estate Fund (CREF) – “Real Estate Pension Fund of the 1970’s”

– CREF acquires real estate and monitors its operation on behalf of institutional investors

– Brueggeman, Chen, Tibodeau: Real estate outperformed S&P 500 and Ibbotson Assoc between 1972 – 1983. After adjusting for risk, real estate found to be better on yields.

– Gilberto compared 1,200 large REIT’s w/ S&P’s 500 for 1978-1989; found advantage shifted to common stocks

Real Estate Finance and Investments: Lecture 1

Key Definitions and Concepts

Market Value

Most probable price at which a property would sell for in a competitive market as of a specific date, had it been exposed to the market for a reasonable time prior to that date.

--The Appraisal Institute--Informed Buyers/Sellers--No Duress Situation

Most Probable Selling Price

Most likely price at which a property will sell, given the market conditions then prevailing and the financing arrangements available

--Used in determining Transaction Range

Transaction Range

Price range within which a transaction can occur and leave both the buyer and the seller better off than before (win-win situation)

Lower End: Present owner’s investment valueHigher End: Prospective Buyer

SELLER Perspective

Vp

Vs

$490,000

$475,000

Most Probable Selling Price > Minimal acceptable price to Seller

Most Probable Selling Price (market set)

Minimum Acceptable Price

to Seller

BUYER Perspective

Vb

Vp

$510,000

$490,000

Maximum acceptable price to Buyer > Most Probable Selling Price

Maximum Buyer will Pay

Most Probable Selling Price (market set)

Transaction Range

Vb

Vs

$510,000

$475,000

Maximum Buyer will Pay

Minimum Acceptable Price

to Seller

Investment Value

Worth to a present or specific prospective owner; unique to the individual and need not be closely related to most probable selling price

Reflects an investor’s assumptions about the asset’s future ability to produce revenue, about the likely holding period, selling price, tax consequences, available financing, etc.

Real Estate Finance and Investments: Lecture 1

Investment Decision Process

EQUITY INVESTOR

DEBT INVESTOR

Steps in Investment Decision Process

1. Estimate the stream of expected benefits

2. Adjust for timing differences among expected streams of benefits flowing from investment alternatives

3. Adjust for differences in perceived risk associated with the alternatives

4. Rank alternatives to the relative desirability of perceived risk-return combinations they embody

Value of Expected Benefits Stream

Benefits expected to be received in the far distant future add less to a property’s investment value than do those whose anticipated receipt is more imminent.

– Time Value of Money– Expected benefits: Periodic Cash Flow, Future Sale (market

appreciation recognized)

Investment Value = Present Value of Equity Position PLUS Present Value of the Debt Position

Investment Decisions

Purchaser’s investment value > acquisition cost = Increase in Purchaser’s net worth

Market Value > Seller’s investment value = Increase in Seller’s wealth position

Real Estate Finance and Investments: Lecture 1

Investor Objectives and Risk

Investor Objectives and Risk

Minimize Risk and Maximize Return Potential

Investors seek financial return as a reward for committing resources and as compensation for risk

Emotion: Risk takers vs. Risk avoiders

Attitudes Towards Risk

Risk

Return Risk Neutral

Risk Averting

Risk Seeking