R38 Private Real Estate Investments

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CFA Level II Alternative Investments

Real Estate Investments

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Graphs, charts, tables, examples, and figures are copyright 2012, CFA Institute. Reproduced

and republished with permission from CFA Institute. All rights reserved.

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Contents1. Introduction

2. Real Estate Investment: Basic Forms

3. Real Estate: Characteristics and Classifications

4. Private Market Real Estate Equity Investments

5. Overview of the Valuation of Commercial Real Estate

6. The Income Approach to Valuation

7. The Cost and Sales Comparison Approaches to Valuation

8. Reconciliation

9. Due Diligence

10. Valuation in a International Context

11. Indices12. Private Market Real Estate Debt

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2. Real Estate Investment: Basic Forms

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Equity Debt

Private

Publicly

Traded

Example 1


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Characteristics

Heterogeneity and fixed locations

High unit value

Management intensive

High transaction costs

Depreciation

Need for debt capital

Illiquidity

Price determination

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Example 2


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Commercial real estate properties arecategorized by end use

Office

Industrial and warehouse

Retail

Hospitality

Multi-family

Farmland

Timberland

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Example 3

Many types of real estate

properties

Residential: single family; multi-

family

Non-residential: Commercial

property other than multi-family

properties, farmland and timber


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4. Private Market Real Estate Equity Investments

Current Income

Price appreciation

Inflation hedge

Diversification

Tax benefits

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Motivation


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Business conditions

Long lead time for new developments

Cost and availability of capital

Unexpected inflation

Demographics

Lack of liquidity

Environmental

Availability of information

Management (asset management and property management) Leverage (loan-to-value ratio)

Other risk factors

4.1 Risk Factors

Example 5


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4.2 Real Estate Risk and Return Relative to Stocks and Bonds

Example 6

4.3 Commercial Real Estate

Office

Example 7

Industrial and Warehouse

Retail

Example 8

Multi-Family

Example 9


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5. Overview of the Valuation of Commercial Real Estate

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5.1 Appraisals

Transaction data is limited; hence need to rely on estimates of value

How much to buy/sell for

Performance measurement

Definitions of value

Market value

Investment value (particular investor)

Value in use

Mortgage lending value Example 10


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5.2 Introduction to Valuation Approaches

Three Approaches

Income Approach

Cost Approach

Sales Comparison Approach

Triangulate

Highest and Best UseExample 11


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6. The Income Approach to Valuation


6.1 General Approach and Net Operating Income

NOI is roughly analogous to EBITDA in the FRA context

Rental income at full occupancy

+ other income

= Potential gross income

- Vacancy and collection loss

= Effective gross income

- Operating expenses

= Net operating incomeExample 12


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6.2 The Direct Capitalization Method

Discount rate

Growth rate

Cap rate

Cap rate from comparable

Value from cap rate

ARY = NOI / recent sales price of comparable

Stabilized NOI

Gross Income Multiplier

Example 14


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6.3 The Discounted Cash Flow (DCF) Method

Assuming constant growth of NOI

Terminal Capitalization Rate

Depends on expected future interest rates and growth rates

Example 16

NOI = 100,000 for 5 years

Year 6 NOI = 120,000 and grows at 2%

Property value also increases at 2%

Reversion: value obtained by selling property in the future

Example 17


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Example 18

UK-based example

400,000 for 2 years

ERV = 450,000

All Risks Yield = 5%

Example 19

The Layer Method

Discount increment rent at 6%

Equivalent Yield


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6.4 Advanced DCF: Lease-by-Lease Analysis

Project income from existing leases

Make assumptions about

lease renewals

operating expenses (Example 20)

capital expenditures

absorption of any vacant space

Estimate resale value (reversion)

Estimate discount rate

Example 21


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6.5 Advantages and Disadvantages of the Income Approach

Advantage: captures cash flows investors care about

Disadvantage: forecasts are prone to error

6.6 Common Errors

Discount rate does not reflect risk

Income growth is greater than expense growth

Terminal cap rate is not logical compared with implied going-in cap rate

Terminal cap rate is applied to an income that is not typical

Cyclical nature of real estate markets is not recognized

Example 22


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7. The Cost and Sales Comparison Approaches to Valuation


7.1 Cost Approach

Used for unusual properties or properties for specialized use (comparable data not

available)

Land + replacement cost

Adjust for depreciation

Physical deterioration (curable and incurable)

Functional obsolescence

Locational obsolescence

Economic Obsolescence

Exhibit 9

Example 23


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7.2 The Sales Comparison Approach Subject property and comparables

use comparables price as starting point and then makeadjustments

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7.3 Advantages and Disadvantages of the Cost and Sales ComparisonApproaches

Cost approach is more reliable for new properties and less reliable for old properties

Cost approach is most reliable for new properties with relatively modern design in a stable

market

Sales comparison approach relies on reasonable number of comparable sales

Problematic if comparable data is limited

Assumes prices paid are representative of market values


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8. Reconciliation


Reconcile difference between three approach before arriving at final conclusion

Example 25

9. Due Diligence

Verify facts and conditions which might affect value of

property:

Review leases of major tenants

Study past operating expensesEnvironmental inspection

Physical/engineering inspection

Intent to purchase but subject to due diligence

Example 26


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10. Valuation in an International Context



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11. Indices


Many real estate indices but we (investors) should be aware of how the

indices are created and inherent limitations

Seemingly low correlations between real estate and other asset classes

might be explained by limitations of how the index is created

11.1 Appraisal Based Indices

Indices often rely on appraisals because transaction data is not available

Example 27

11.2 Transaction-Based Indices

Two ways of creating:

Repeat Sales Index

Hedonic Index

Example 28

11.3 Advantages and Disadvantages

Appraisal lag

smoothing effect

volatility

Transaction-based indices can be noisy

Example 29


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12. Private Market Real Estate Debt


Investors using debt financing will expect relatively higher returns

Loan to value ratio

Debt service coverage ratio

Example 30


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Equity Dividend Rate

(cash-on-cash return)

Example 31

Example 32: Leveraged IRR

Example 33: Unleveraged IRR


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Summary

Basic forms

Characteristics

Classifications

Motivation

Risk Factors Valuation

Due Diligence

Indices

Debt

Leveraged IRR



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Conclusion

Read the summary

Review learning objectives

Examples

Practice problems

Practice questions from other sources


Documents

R38 Private Real Estate Investments