FNCE 128

Commercial Real Estate (CRE)

Real estate used for business or investment purposes, such as office, retail, industrial, and multifamily properties.

Why is CRE difficult to value?

CRE trades infrequently, data is limited, properties are heterogeneous, and transactions occur in private illiquid markets.

Why is CRE important to institutional investors?

It provides income, diversification, and exposure to a large asset class.

What are examples of institutional investors in CRE?

Pension funds, insurance companies, sovereign wealth funds, REITs, and private equity funds.

What is the investible universe of CRE?

The portion of CRE that investors can realistically buy, sell, or invest in.

Why is corporate-owned CRE not always investible?

Corporations often use it for business operations and hold it long term rather than trade it frequently.

REPE

Real Estate Private Equity; private investment funds that buy, manage, and sell real estate assets.

REIT

Real Estate Investment Trust; a company that owns or finances income-producing real estate and is often publicly traded.

Why are REITs easier to study than private CRE?

REITs are publicly traded, so their data is more available.

Private CRE indices

Indices based on property-level returns, such as NCREIF, RCA CPPI, and CoStar CCRSI.

Public CRE indices

Indices based on REIT-level returns, such as NAREIT and CRSP/Ziman.

NCREIF

A private commercial real estate index based on institutional property returns.

NAREIT

A public REIT index used to measure publicly traded real estate performance.

Why are REIT returns more volatile than private CRE returns?

REITs trade in public markets and often use leverage.

Why are private CRE returns smoothed?

Appraisals and infrequent transactions cause prices to adjust slowly.

What is serial correlation in private CRE returns?

Current returns are strongly related to past returns because prices adjust slowly.

Main components of CRE return

Income return and price appreciation.

Income return

Return earned from property income, such as rent.

Price appreciation

Return earned from increases in property value.

Main takeaway about CRE returns

CRE earns a large portion of returns from stable income rather than rapid price appreciation.

Why is CRE considered illiquid?

Properties are costly and slow to buy or sell.

Why is CRE heterogeneous?

Each property differs by location, quality, tenant mix, lease terms, and physical characteristics.

Major CRE property types

Office, retail, multifamily, industrial, and specialized properties.

Examples of specialized property types

Hotels, self-storage, senior living, and development projects.

Office demand factors

Employment in professional services, technology, finance, insurance, real estate, and medical sectors.

Retail demand factors

Household income, population, age, and consumer spending.

Multifamily demand factors

Household growth, migration, income, homeownership rates, mortgage rates, apartment rents, and house prices.

Industrial demand factors

Warehousing, distribution, manufacturing, shipping, trucking, data centers, and transportation access.

Space market

The market for the right to use real property.

Who demands space in the space market?

Tenants, households, and firms that need space for consumption or production.

Who supplies space in the space market?

Property owners and landlords.

What does the space market determine?

Rent and occupancy.

Rent

The price paid to use real estate space for a specified period.

Occupancy

The portion of space that is leased or used.

Vacancy rate

The percentage of space that is unrented.

Absorption

The amount of space leased over a period, often used as a demand indicator.

Space market segmentation

The division of real estate markets by geography and property type.

Why are space markets local?

Buildings are immobile and users require specific locations.

Why are space markets segmented by property type?

Different users need different types of space, and buildings are costly to convert.

Why does the Law of One Price not apply well to CRE?

CRE is local, immobile, segmented, and not traded in a frictionless integrated market.

Law of One Price

Identical assets should sell for the same price in a frictionless market.

Asset market

The market for ownership of real estate cash flows.

What does the asset market determine?

Property values and cap rates.

How does the asset market differ from the space market?

The space market is local and determines rents; the asset market is more capital-driven and determines values.

Cap rate

Net operating income divided by property value.

Cap rate formula

Cap Rate = NOI / Property Value.

Property value formula

Property Value = NOI / Cap Rate.

NOI

Net operating income; property income after operating expenses but before debt service and taxes.

What happens to property value when NOI increases?

Property value increases, holding the cap rate constant.

What happens to property value when the cap rate increases?

Property value decreases, holding NOI constant.

What happens to cap rates when risk increases?

Cap rates increase.

What happens to property value when risk increases?

Property value decreases.

What happens to cap rates when expected rent growth increases?

Cap rates decrease.

Why does expected growth lower cap rates?

Investors are willing to pay more today for stronger future income.

Kinked supply curve

A real estate supply curve that is fixed in the short run but more elastic in the long run.

Why is real estate supply inelastic in the short run?

New construction takes time, and existing buildings cannot quickly disappear.

Why is real estate supply more elastic in the long run?

Developers can add new space if rents justify construction.

LRMC

Long-run marginal cost of adding new real estate supply.

Replacement cost rent

The rent level needed to make new development financially feasible.

Rising LRMC

Development costs rise as more supply is added, often due to land scarcity.

Flat LRMC

New supply can be added at roughly constant cost.

Falling LRMC

Development costs or location value decline as demand weakens.

What usually drives rising LRMC?

Land scarcity and increasing location rents.

What can drive falling LRMC?

Declining demand or loss of centrality.

Why are real estate markets cyclical?

Supply adjusts slowly and demand can change quickly.

4Q model

A model linking the space market, asset market, construction, and stock of real estate.

What connects the space market and asset market in the 4Q model?

Development and construction.

Why is development risky?

It requires large upfront costs, long timelines, and future rents may change before completion.

Future value

The value of an investment after it grows over time.

Future value formula

FV = PV(1 + r)^t.

Present value

The current value of future cash flows discounted at a required rate.

Present value formula

PV = FV / (1 + r)^t.

Discount rate

The required rate of return used to convert future cash flows into present value.

Compounding

Earning returns on both the original investment and prior returns.

Discounting

Converting future cash flows into today’s dollars.

Rule for matching time periods

The interest rate and number of periods must use the same time unit.

Annuity

A finite series of equal payments made at regular intervals.

Ordinary annuity

An annuity where the first payment occurs at the end of the period.

Annuity due

An annuity where the first payment occurs at the beginning of the period.

How do you adjust for an annuity due?

Multiply the ordinary annuity value by (1 + r).

NPV

Net present value; the present value of cash inflows minus the initial investment.

NPV decision rule

Accept the project if NPV is greater than zero.

IRR

Internal rate of return; the discount rate that makes NPV equal zero.

IRR decision rule

Accept the project if IRR is greater than the required return.

Why is NPV preferred over IRR?

NPV is more reliable, especially with nonconventional cash flows or mutually exclusive projects.

DCF analysis

Discounted cash flow analysis; valuing an investment by discounting expected future cash flows.

First step in DCF analysis

Draw a timeline.

Why draw a timeline?

To correctly match cash flows with the period in which they occur.

Economic base analysis

Analysis of regional industries to determine whether local trends support growth or decline.

Why does economic base analysis matter for real estate?

Real estate is immobile, so property performance depends heavily on local economic conditions.

Agglomeration

The clustering of industries or firms in a region because of shared benefits.

Location quotient (LQ)

A measure comparing an industry’s local employment share to its national employment share.

Location quotient formula

LQ = (Local industry employment / Total local employment) / (National industry employment / Total national employment).

LQ greater than 1

The industry is more concentrated locally than nationally and may be a regional driver.

LQ equal to 1

The industry has the same local concentration as the national economy.

LQ less than 1

The industry is less concentrated locally than nationally.

Why use multiple years of employment data for LQ?

One year may not show the full trend.

Gross lease

A lease where the landlord pays operating expenses.

Net lease

A lease where the tenant pays some or all operating expenses.

Triple-net lease

A lease where the tenant pays rent plus most operating expenses, taxes, insurance, and maintenance.