FINM3406 Mid Semester Exam Study

Tangible vs Intangible Real Estate

TANGIBLE:

• Land

• + Improvements on land

• Not including fittings, plants or equipment on land

INTANGIBLE:

• Easements

• Profit-a-prendre (right to take something off land that is another persons)

*Easement

right to use another person’s land for specific purposes

• driveway access, drainage utility

Bundle of Rights Theory

Ownership (private right enforceable on strangers)

Possession

Control (what is built/what happens)

Enjoyment

Exclusion

Disposal (sale/lease) / Destruction

Constraints/limits to Bundle of Rights Theory

Rights are ultimately constrained:

• Government controls ( Heritage and property law, compulsory acquisition)

• Common law (nuisance)

• Self Imposed (Contracts, leases, mortgages)

Additional out of scope

• Eminent Domain: The government has the right to acquire private property for public use, provided just compensation is paid.

• Escheat: If a property owner dies without a will and heirs, the property reverts to the state

Why do we need property?

Enclosure/Delimitation of Space

Climate Barrier/Modifier

Protection/Privacy

Characteristics of Real Estate Market

• heterogenous products

• Immobile product: land is immovable

• Localised market

• Segmented market (use/size/location etc)

• Private negotiations with high transaction costs (time consuming, costly, complex)

Ownership objectives for corporate property vs investment property

CORPORATE

• Business base

• Enabler of business (short/long term property solutions)

• Infrastructure facility

INVESTMENT

• ROI

• Diversification (location,sector,size)

• Direct

• Indirect (Real estate investment trusts)

Property Sectors

1. Residential (houses, affordable housing, retiring)

2. Industrial (warehouse, factories, plants)

3. Commercial (CBD, various grade accomodation)

4. Retail (regional/subregional, shopping centres)

5. Leisure (hotels, theme parks)

6. Agricultural (farming, mining)

7. Infrastructure (roads, hospitals, airports)

Public vs Private Real Property

PUBLIC

• Infrastructure (roads, rails)

• Services (Health, defence, law, education, recreation)

PRIVATE

• Corporate

• Investment

Reason property decision is MORE TIME CONSUMING and COMPLEX compared to other assets

• Large capital requirements

• High degree of regulatory control

• Uniqueness —

• Timeline (long term from purchase to use)

• Wasting asset —

• Limited liquidity —

• Management quality impacts value

Define an asset class

• grouping of investments

• similar characteristics

• subject to same laws and regulations

• made up of instruments with similar behaviour in market

Defensive Asset Classes vs Growth

DEFENSIVE

• Assets which broadly held their capital value and invested in for their reliable income streams

GROWTH

• invested in to provide potential capital growth

Various Asset Classes

DEFENSIVE

• Fixed interest bonds

• cash

• commodities

• futures

• financial derivatives

GROWTH

• property (although also wasting)

• Equities (stocks/shares)

Similarities between real estate and other asset classes

• Potential for appreciation

• Income generation

• Liquidity (not as liquid as others)

• Risk and Volatility

• Diversification

• Use of leverage

• Supply and demand

WEEK 2

2

Under the feudal system established after the norman invasion of 1066, what was the primary mechanism that allowed landowners to transfer property without requiring consent from the overlord?

Describe general nature of property

Any "thing" that can be used, enjoyed, possessed and has utility or value

• Real property

• Personal property

Interests in Property

"Interest" is a broad legal term used to denote a property right

Can be created by owner who pledge/encumber their property to achieve an objective without giving up full ownership

• The holder of an "interest" in real estate has some right/degree of control

• they may receive payment for the sale of such an interest

• The interest (if evaluated) may be bought, sold, used as collateral

Intangible Real Property

• Easements (the right to enter or use a section of land for a particular purpose by someone who is not the land owner)

• Volumetric Sub-division

• Leasehold of Airspace

"estate" defined in context of real property

• All a person owns

• Real estate: All real property (realty) owned as part of ones estate

Evolved, based off English Property Law:

• Describes the collection of rights/interests as part of a transaction

• Fee simple estate -> most complete form of ownership

• Leasehold estate ->rights/interests of tenants

Types of Freehold Estates

1) FEE SIMPLE ABSOLUTE POSSESSION

Holder of fee simple estate able to:

• divide fee into lesser estates

• buy, sell, borrow against

• subject to state laws which property is located

2) LIFE ESTATE:

Freehold estate lasting only as long as life of owner of estate or life of other defined person

Parties to a Life Estate

1. Grantor: person who creates life estate

2. Life tenant (grantee): a person receiving a life estate in their possession for remainder of life — they can sell their possession but will be reverted back to remainderman after grantee passes

3. Remainderman: person who has a future interest in the estate specified by grantor.

Leasehold

Crown leases: State grant of leasehold tenure

Private leases: From an owner of fee simple

Types of leasehold tenure:

• Tenant for a term (specific tenancies, periodic tenancies)

• Tenant at will (outgoing until immediate termination from either party)

• Tenant at sufferance (one who comes in with right and holds over without right, bound by terms of previous lease)

Differences between Freehold Estates vs Leasehold Estates

Distinguished off the definiteness or certainty of duration

• Freehold Estate: Lasts for an indefinite period, allowing the owner to hold the property without a set expiration date. This type of estate provides the owner with full control over the property rights and the ability to transfer or bequeath the property to heirs.

• Leasehold Estate: Has a definite end date, determined by the lease agreement. The lessee holds the right to use and possess the property for the duration specified in the lease, after which the rights revert back to the lessor (the property owner).

Ownership Connotation:

Freehold connotes ownership of property by estate holder

Reversion vs Remainder (LIFE ESTATE)

Both examples of a future estate

1. Reversion: holder of estate (grantor) conveys to a grantee a present estate in the property

• has fewer ownership rights than the grantor's own estate

• and grantor/grantor's heir retain right to take back in future the full estate once held by grantor

2. Remainder: rather than go back to grantor, the future estate will go to a third person

Doctrine of Tenure

Individuals or groups that own land hold it by way of grant from the crown (state)

Land ownership is hierarchical: monarch ultimate owner of land, landowners hold by way of tenure meaning they have certain rights and obligation attached to ownership (taxes, military service)

Doctrine of Tenure applicable in Australia

Crown in Australia only have radical title due to Native Title

Granting of land by the State is held by States not commonwealth

Provides legal framework for ownership and use of land

Provides a mechanism for spatial allocation of land:

• one parcel of land comes from State to grantee

• Grantee can grant to someone else, so on

Can be contrasted with doctrine of estates (temporal allocation of land tenure)

3 Sources of Rights and Obligations under a lease

Written contract (primary source)

Part 8 of Property Law Act:

• Tenants obligation to pay rent, keep in repair

• Landlord's right to enter

Common Law:

• Tenant right: quiet enjoyment

• Landlord obligation: Non-derogation of grant

Lease vs License

Lease creates both property and contractual rights

License creates only contractual rights

Lessee's rights to use of property can be enforced against world

Licensee's rights in relation to use of property can only be enforced against licensor

Lessees can assign lease to third party (subject to provision)

License cannot be assigned (unless associated with lease)

Lease grants exclusive possession of a premises

License non-exclusive

Impacts security of tenure if you need to occupy a property and makes your income stream as an investment less secure.

Lease > License

Sources of Risk

Market Risk:

1. Drop in Demand

2. Oversupply

3. Unexpected inflation

Financial Risk:

4. Interest rates

5. Renewal terms

6. Insolvency

Property Risk:

7. Locality

8. Building

9. Tenants

Systematic risk vs Unsystematic risk

SYSTEMATIC (beta)

• Variance attributable to the market and influences all assets

• Cannot be diversified in away

UNSYSTEMATIC

• Asset/firm specific risk

• Unrelated to market

• Diversification is key

Wholesale Investor Types

Sophisticated Investor:

• Sufficient knowledge and experience in investment opportunities

• Net assets of atleast 2.5M

• Gross income of atleast 250k for each of last 2 FY

Professional Investor:

• Australian financial services licensee

• a body regulated by APRA outside of super

• body registered under financial corps act

• Trustees of super funds with over 10M

Wholesale Funds

20-50 investors

$500K min investment

Diversify with 10+ Assets

Open ended

Gearing:

0-30% for "core" funds

Wholesale unlisted trust funds are aimed at institutional investors

• Predominantly AU super funds

• High net worth individuals

Specific strategy takes 2 forms:

• Open ended vehicles (no fixed life, target core real estate assets, industrial, retail, office)

• Closed- end fixed life vehicles (higher risk , value added opportunities or development projects)

Clubs/Mandates Overview

Clubs: Less than 5 investors

Mandates: 1 investor

Typical Investor:

• large super funds

• insurance companies

• international institutions

$50M min investment

Diversify through 5+ Assets usually strategy specific

Term: opportunity specific

Gearing: opportunity specific (usually zero or low)

More hands on and tailored to investor

Syndicates Overview

Size: $5-$50M

100+ Investors

Typical Investors: Private investors, SMSF

'

$1K-10K min investment

Diversification ranges from 1-10+ assets

Fixed term (5-7 years)

Gearing: 40-60%

Investors hold their interest until property is sold or rolled over

Repetitive process:

• identify opportunity

• negotiate structure and investment

• purchase building

• raise debt and pool investor equity

":CORE" Fund investment strategies

Primarily invest in:

• stablised existing properties

• current cash flows

• low vacancy

• located in major areas

Wide variety of property types

Use limited leverage- low risk

CORE plus

minor component of "CORE"

• core assets in need of minor improvements

• B property in A location

• core property that includes undeveloped land

Value Add: Fund investment strategy

More risk by investing in properties:

• carry current vacancy

• upcoming major tenant roll overs

• in need of renovations

Funds create value through renovating and leasing up property

Use more leverage

Opportunistic: Investment strategy

Take on high risk by doing ground up development projects

Exposing fund to construction risks:

• entitlements

• construction delays

• cost overruns

High financial leverage

Less diversified and focus in on certain geographic areas/property types

Purchase distress property assets

Investment Management fees

• Acquisition fees (% of cost)

• Disposition fees (when asset is sold)

• Performance fees (paid to fund managers when returns exceed "hurdle rate of return")

• Management fees

(charged to the investor for entire term of fund

(Core funds charge base fees on equity capital

(Expressed annually as a %

Management fees calculated off:

• invested capital

• % cash flow distributions

• project revenues

• project costs

A-REITS (Australian Real Estate Investment Trusts)

Generate wealth in 2 ways:

-capital growth on property assets trust owns

-rental income

Fund manager is responsible for everything

Make up one of the largest sectors on the ASX

Pros and Cons of investing A-REITS

BENEFITS

-Exposure to high quality assets

-Diversification

-High yielding

-Liquidity

-Management efficiency and quality

-Low transaction cost (avoid stamp duty)

NEGATIVES

-Volatility

-Fee leakage

Australian REIT characteristics

LEGAL

-Must be registered as a Managed Investment Scheme

CAPITAL REQ

-No cap req if listed on ASX

-Cap req for a manager

LISTING

-Can be listed or unlisted

No investment restrictions

No restrictions on foreign assets

DISTRIBUTION REQ

-undistributed income on gains taxed at 46.5%

-full distribution on income and gains by REITS

REIT Distributions

-Distribute 90-100% of earnings

-No franking credits, income is not taxed at trust

-Taxed at individual income tax rate

-include a tax deferred component (represents return of capital rather than income)

-manager can decide if payments to investors are income or capital collected

Stapled vs Externally Managed (A-REIT Forms)

STAPLED (ACTIVE)

-consist of one trust unit and one share in the fund management company

-stapled, meaning cannot be traded separately

-Trust holds assets, company carries out funds management functions

-company and trust valued seperately

-company valued on EBITDA

EXTERNALLY MANAGED (PASSIVE)

-Management taken on by seperate entity to trust

-slowly collapsing

-often conflicts of interest between trust and company

-Can provide better resourcing and management services

Modern Portfolio Theory (MPT)

MPT assumes investors are risk averse:

-Investors will choose investment with lower risk

-Investors will accept higher risk if there is higher return

Total (accumulation) Return

Accounts for two categories ( income and capital)

-Income: interest paid by fixed income investments, distribution dividends, or net income of direct property

-Capital return: Change in market price of asset

Capital Return

Cap Return = (Current Price - Initial Price / Initial) x100

Income Return

Income Return = (Net Income over period held / Cap Value at beginning of period) x100

Total Return

Capital and Income Return over Cap Value at beginning period

True return to the investor of their money

Initial Yield

Income yield for the asset

Ratio of current passing rent to the current property value

IY= Passing rent/ Property Value

Reversionary Yield

market yield for the asset

Ratio of market rent to the current property value

RY= Market rent/ property value

Asset Yield vs Asset Return

Yield does not take into account capital loss/gain

Return gives a clear financial position indicator to investor

Yield used to indicate market value of investment

Return is used to compare financial attractiveness of different investments

Portfolio Returns

Weighted average of expected returns from each asset in portfolio

Acquisition Process

1st step: Initial Review of an asset

Purpose of Due Diligence Provess

4-6 weeks

Allows for detailed analysis of financial, legal and technical review of asset

Divestment Criteria

Reposition of fund

Cyclical Play (buy low, sell high)

Closed end fund (divest of asset at end of fund)

Cap requirements

Disposal Process

1st: Internal Approvals

WEEK 4

4

Aim and Importance of Real Estate Valuation

To establish and accurate and reliable assessment on the value of the bundle of rights that a person has in a property

Why is it important?

• Buying or selling property

• Financing

• Property tax assessment

• Insurance

• Annual Reporting

property valuer

Will evaluate property as at date they were asked to assess it

Do not give predictions of future pricing, only present or past

Value is property valuer's opinion

The valuation report

Include:

• Certificate of Valuation

• Outline of primary method of valuation

• Detailed description of any sales evidence relied upon

• Outline of any assumptions/ limitations

Most comprehensive part is usually about the subject property:

• includes land, location, zoning, title, condition etc

Land Value Components

Comprises:

• Private benefit infrastructure, services individual properties paid for by local gov (e.g roads, parks, sewerage)

• Social infrastructure paid for by gov through tax (schools, hospitals, public transport)

• Urban externalities

Impacted by external factors:

• Betterment: capitalised value of urban externalities and social infrastructure

• Blight: infrastructure development or planning policy decisions that diminish land value

Real Estate as an "inelastic asset"

• Scare and limited resource

• long lead time to increase supply to respond to increased demand

• changes in price don't always have direct impact on supply or demand

Real estate market as "imperfect market"

• Information asymmetry

• High transaction costs

• Limited competition (zoning restrictions and availability of infrastructure)

• Emotional factors

• Price paid for real estate may not be its true market value

Different Types of Values

FAIR MARKET VALUE

• price a willing buyer will pay a willing seller in a transaction in an open market

LIQUIDATION VALUE

• takes into account the costs of getting property in condition to sell as well as disposal activity

Determined under two conditions:

1. (orderly transaction with a typical marketing period

2. (forced transaction with shortened marketing period

MARKET VALUE

• Estimated amount for which an asset should exchange on valuation date in an arm's length transaction after proper marketing

EXISTING USE VALUE

• Current way an asset is being used

• May be the highest/best use

• tends to be for specialised properties with limited market and used for financial reporting (e.g plants, mills, roads, airports)

STATUTORY VALUATION

• Assessment of notional "unimproved" value to assess rates and land tax

• Compulsory acquisition compensation assessments

Steps to conduct a valuation

1 - Define the Problem (everything being valued)

2- Determine most probable use (highest and best use?)

3- Define most probable buyer (Likely buyers and behaviour)

4- Select valuation Method (how its likely to be valued, e.g acitivity, income cost etc.)

5- Review/Adjust for external factors (accurate property and market data)

6- Value Conclusion and Limiting Conditions (Final estimate with assumption and limitations defined)

Direct Comparison Method of Valuation

• Simplest

• Used when evidence is comparable enough to allow direct comparison

• most popular in non income producing properties

• Challenge is adjusting for items not comparable

Summation Method of Valuation

Collation of value through addition of components of property

(e.g land, building, other improvements)

Used mainly as a check method

• Land valued as if it was vacant

• Building and improvements is their added value to land

Before and After Method of Valuation

• Used to assess compensation in compulsory acquisition/easement

• the difference in value before and after the imposition

• Requires two seperate valuations

• Can also be used in sub-dividing properties

Hypothetical Development Method of Valuation

Used for under-developed land with potential for development:

• highest and best use as development site

Method starts at end and works backwards

Suitable only for single phase development

Hypothetical Calc:

Value of finished product = land value+development costs+finance costs+profit

Discounted Cash Flow Method of Valuation

Present Value of future cash flows

• based on subjective assumptions

• allows cash flow flexibility

• for complex and variable income properties

• dangerous due to lots of assumptions

Units of Production Method of Valuation

Common for rural properties

Carrying capacity, best area value

Applied to specialised commercial properties

• room rate in hotel

• hotel liquor consumption

Capitalisation Method of Valuation

Used for investment class properties (widely accepted for estimation of market value)

Future sustainable annual net income of property is converted to a value by a market derived multiplier

Assumption that level of income will remain constant in perpetuity

Capitalisation Rate Overview

Also referred to as yield or "all risk rate"

Represents all current and future expectations to be derived from a property

Can be used as a benchmark for the comparison of investments

BENEFITS: simple to use and easy to compare with other assets

CHALLENGES: integrity/ availability of market data to derive rate

Capitalisation Method Calculation Process

CV= Net Annual Sustainable Income / cap rate

Valuer needs to establish:

• open market rental rate applicable to property

• cap rate through recent sales evidence

Cap Rate relationship with Years purchase

Years purchase is the reciprocal of cap rate

1/cap rate = Years purchase

Property Income

Net Rent:

• Gross rent payable less outgoings incurred

Leasee will pay additional sum for outgoings specified in lease

Some costs are responsible of owner (land tax, capital costs)

Establishing Annual Net Sustainable Income

• Critical examination of lease documents to establish the passing rental rates

Compare those rates to that market rent applicable if being let at time of valuation

Market rental considered as potential/future sustainable income and is this rental used to calculate net income

Valuer must also capture potential other income property is capable of producing (e.g parking, naming rights etc.)

Establishing the Cap Rate

Through analysis of comparable recently sold properties

If 2 of 3 factors of the basic capitalisation formula are known, the third can be calculated (CV=NI/i)->(i=NI/CV)

Therefore, if sale amount (CV) or Net operating income (NI) is known for comparables, cap value (i) can be calculated

Shortcomings of capitalisation method

DATA ERRORS (much data for comparables are confidential, highly sensitive to data errors)

RELIABILITY OF INFO (limited scope of truly reliable info from valuer/colleagues, other available data may come from buildings with different age, condition, location etc.)

ASSUMPTION OF SUSTAINABLE NET INCOME (assumes income level will "settle down" in perpetuity)

SELECTION OF CAP RATE (minor error in process has major impact)

What is WALE?

Weighted Average Lease Expiry

• measures the average time remaining on leases in a property or portfolio, weighted by rental income or area.

• A higher WALE indicates lower vacancy risk, stable cash flow, and higher valuation. — Preferred

• For investors, landlords, and lenders to assess income security