Management 170 Final- Mark Karlan

Risk vs. Return

Investments with more Risk should provide a higher Expected Return. β (beta) is a measure of the Volatility of Returns for an Investment relative to a benchmark, and α (alpha) is a measure of the Actual Return of an Investment relative to the benchmark given the level of Investment Risk.

Property Performance Information

Much less available compared to stocks and bonds. The National Council of Real Estate Investment Fiduciaries (NCREIF) produces quarterly returns for five Property Types (Office, Retail, Apartments, Industrial and Hotels), but values are based on Appraisals giving imperfect Market Value information, and the NCREIF Index is an Unleveraged Index.

Business Risk

Specific to the Property Type, Location and Market Conditions.

Default Risk

Properties are usually Leveraged. Higher LTVs cause higher Default Risk.

Liquidity Risk

Selling a Property takes time. Real Estate is an Illiquid Investment.

Diversification

A way to lower the Volatility of a Portfolio's Expected Returns.

Correlation Coefficient

Measures the relative movement of one set of numbers as compared with another, ranging from +1 (Perfectly Positively Correlated), to 0 (No Correlation at all), to -1 (Perfectly Negatively Correlated).

Inflation Hedge

Real Estate is considered a good Inflation Hedge as it is Positively Correlated with Inflation (when Inflation increases, Property Values also tend to increase).

Portfolio Diversification

Buying Properties in different Geographic Regions and of different Property Types will generally provide greater Portfolio Diversification. Reduces risk.

Global Diversification

Might reduce Portfolio Risk, but Foreign Investments may have additional risks that must be managed.

Foreign Investment Risks

1) Information Risk; 2) Legal, Tax and Property Rights Risk; 3) Currency and Interest Rate Risk; 4) Political Risk; 5) Culture/Communication Risk.

REIT Structure

Created by Congress in 1960 to allow small investors to participate in the Property Markets without paying a Corporate Tax. REITs provide Liquidity, Dividends, Diversification, and Professional Management. REIT Dividends will be Taxed to the REIT's Shareholders, but REIT losses will not be passed through to the Shareholders.

Types of REITs

Most REITs are Equity REITs that primarily own Properties, and the rest are Mortgage REITs that primarily own Mortgage Debt and MBS.

REIT Qualifications

Must be managed by a Board of Directors; must have at least 100 Shareholders; not more than 50% of a REIT's shares can be held by five or fewer Shareholders ("5/50" Rule); Shares must be Fully Transferrable; can be Public or Private. Distribution Requirements: At least 90% of a REIT's Taxable Income must be distributed as Dividends to the REIT's Shareholders, otherwise the REIT will pay Corporate Tax.

Asset Requirements

At least 75% of a REIT's Assets must be related to Real Estate, government securities or cash, and not more than 20% of a REIT's Assets can be in Taxable REIT Subsidiaries.

Income Requirements

At least 95% of a REITs Gross Income must be from Real Estate Rents, Profits from Asset Sales, Mortgage Interest income and REIT Dividends received.

Net Asset Value (NAV)

An accounting measure of a REIT's Net Worth, which may or may not accurately reflect its current Market Value if the REIT's Assets have increased or decreased in value relative to their Depreciated Cost.

Funds from Operations (FFO)

REIT Income is measured as "Funds from Operations", which is Earnings per Share (EPS) adjusted by adding back Depreciation and excluding any Profits or Losses from Asset Sales, and is a measure of its Dividend paying ability.

UPREITs

Umbrella Partnership REITs issue Operating Partnership Units (OP Units) that are Convertible into REIT Shares and allow a REIT to buy Appreciated Properties with OP Units instead of cash so Sellers of the Properties can achieve a Section 1031 tax deferred exchange. When OP Units are converted into REIT Shares, Capital Gain Taxes will be due.

REIT Growth Drivers

1) Increase the Net Operating Income from their existing Properties by increasing Rents and Occupancy Levels; 2) Acquire additional Properties; 3) Renovate or Expand existing Properties or Develop new Properties on excess Land; 4) Provide Property Services through Taxable REIT Subsidiaries (Leasing or Property Management); 5) Financial Engineering (Property Debt or REIT Corporate Leverage).

Fannie Mae and Freddie Mac

The Federal National Mortgage Association ("Fannie Mae" - created in 1938, privatized in 1968) and the Federal Home Loan Mortgage Corporation ("Freddie Mac" - created by the Emergency Home Finance Act of 1970) are the largest buyers of Home Loans in the United States. Together, they buy almost half of all residential home loans. During the global financial crisis, Fannie Mae and Freddie Mac were nearly bankrupt and placed under the conservatorship of the Federal Housing Finance Agency ("FHFA" - created by the Housing and Economic Recovery Act of 2008).

Ginnie Mae

Government National Mortgage Association ("Ginnie Mae" - HUD Act of 1968) is a wholly owned U.S. government corporation within the Department of Housing and Urban Development (HUD). Ginnie Mae guarantees Mortgage Backed Securities.

Conforming Loans

Mortgage Loans that Conform to Fannie Mae and Freddie Mac Underwriting Guidelines for Loan Size (for 2022: $647,200, or $970,800 in certain high cost areas of the country), Creditworthiness (FICO score), DSCR, LTV, and other criteria.

Non-Conforming Loans

Mortgage Loans that Do Not Conform to all the Underwriting Guidelines of Fannie Mae and Freddie Mac.

Subprime Loans

Mortgage Loans that fall below the Underwriting Guidelines for Creditworthiness (FICO score), DSCR, and/or LTV. Not related to Loan Size.

Seasoned Mortgages

Mortgage Loans that have been paying monthly Principal and Interest on time. The longer the payments stay current, the more "Seasoned" the Mortgage.

Residential Mortgage Backed Securities ("RMBS") and Commercial Mortgage Backed Securities ("CMBS")

Created when pools of Residential or Commercial Mortgage Loans are Tranched into Securities for sale to other Investors in the Capital Markets. Default Risk and Prepayment Risk.

Default Risk

When the Default Rate on the pool of Mortgage Loans underlying the Mortgage Backed Securities is higher than was projected at the time of the MBS offering.

Prepayment Risk

When the Prepayment Rate on the pool of Mortgage Loans underlying the Mortgage Backed Securities is higher than was projected at the time of the MBS offering.

Collateralized Mortgage Obligations ("CMOs")

Debt Securities that are issued using a pool of Mortgage Loans as Collateral, where the Issuer retains Ownership of the Loans.

Collateralized Debt Obligations ("CDOs")

Any Debt can be Collateral for the Securities. Principal Only Tranches ("POs"), Interest Only Tranches ("IOs"),

Floaters and Inverse Floaters

Unique Securities that can be created to appeal to different Investors.

Land Development

A highly Fragmented, Competitive and Local business.

Land Acquisition

Option Agreements are often used to give Time to the Land Developer to pursue the Entitlement Process. Periodic Option Payments can be made over an extended time frame (monthly, quarterly, annually), and if the Developer ultimately exercises the Option the Option Price for the Land will be paid at the closing of the Land Acquisition.

Zoning and Land Use

City or county Land Use Plans specify the allowed uses for each Land parcel (e.g. Residential, Commercial, Industrial, Agricultural, Special Purpose, ...) with subcategories for allowed density of use. The local Land Use Plan is usually updated every 5-10 years, and the local Zoning Code can be revised, in whole or in part, whenever necessary.

Entitlement Process

The process by which the Land Developer applies to the local authorities to convert Unentitled Land to Land that is Entitled to be Subdivided and Developed for a particular purpose and size (Office, Apartments, Shopping Center, Warehouse, Hotel, etc.) Developing a project that is inconsistent with the local Zoning Code and Land Use Plan requires a Variance from the local Planning Authorities.

Land Financing

Difficult to obtain, Low LTVs, generally Recourse to the Borrower and with Tight Conditions from the Lender to assure Repayment.

Release Schedule

The Time frame within which the Lender expects the individual Land Parcels in a Land Development Project to be Sold according to Release Prices agreed to in the Land Loan documents so that the Loan will be Repaid.

Release Prices

The pre-agreed Minimum Prices at which the Developer can Sell individual Land Parcels and obtain the Lender's Release from its blanket Mortgage Lien for the Land parcels Sold.

Onsite Improvements

Land grading, internal paving, private streets, lighting,

landscaping, etc.

Offsite Improvements:

Public roads, street lighting, traffic lights, sewer line extensions, parks and schools, etc.

Project Development

Acquiring a Land Site; Financing and Construction of a Building (Office, Apartments, Shopping Center, Warehouse, Hotel, Self Storage, etc.); Leasing and Managing the Property; then Selling, Exchanging or Refinancing. Mixed-Use Development: A Combination of Real Estate uses in a single Project.

Development Decision Factors

Global, national and local Economic Forecast; Supply and Demand for space (i.e. Tenant demand); Competition from other Current and Planned Developments; Capital Markets (i.e. Financing Cost and availability).

Project Feasibility

A Feasibility Study should be done to forecast Tenant Demand, Rent Levels, Construction Costs, Project Timing, Exit Strategies, and future Sales Price, and evaluate the Risks. Location is always a key factor in the analysis.

Construction Financing

Covers the Hard Costs and Soft Costs of Construction. Construction Loans are disbursed in Draws after Costs are incurred, are typically Recourse to the Developer, are usually Short Term (maturing after Construction is expected to be completed), and Floating Rate with Construction Interest Capitalized into the outstanding Loan Balance. Construction Lenders want a Permanent Lender ("Take-Out" Lender) in place to pay off and replace the Construction Loan when Construction is completed and various Leasing targets have been achieved. A Stand-By Lender is a Permanent Lender who doesn't intend to actually fund their loan.

Project Development Issues

Building- Footprint, Envelope, Façade, Stacking Plan; Traffic Mitigation Plan; Property Taxes; Permitting: Zoning Codes, Building Codes.

Permitting

The process of obtaining local Government Approvals (e.g. city planning, city council) to Permit the proposed Development. The Project must comply with local Zoning Codes and Building Codes (or obtain a Variance) for a Building Permit to be issued. The Permitting process involves Negotiation with city planners and their staff.

Zoning Codes

Allowable Uses; Maximum Floor Area Ratio (FAR); Height Restrictions; Minimum Lot Size; Minimum Parking Ratios, Building Setbacks, etc. Zoning Codes specify what may be Permitted to be built as of right and may include incentive zoning, inclusionary zoning, and/or cumulative zoning.

Building Codes

City staff must approve the Architectural and Engineering Designs and Specifications for the Project, including the Site Plan, Elevations and Project Renderings. Code Compliance is enforced by city inspectors during Construction before a Certificate of Occupancy ("C of O") will be issued by the local authority after Project Completion in compliance with all Building Codes and Zoning Codes.

Lease vs. Own Analysis

Decision factors include- Space needed (relative to the size of the Property); Time needed (Short Term or Long Term); Risk from Property Ownership; Control and Management of the Property; Maintenance and Special Purpose Buildings; Tax considerations from Depreciation; impact on the Financial Statements (Balance Sheet and Income Statement); access to and Cost of Capital.

Residual Value

A Property's projected future Residual Value (aka "Exit Value") may not be an important part of a company's Purchase Decision. Instead of acquiring a Property that it needs to run its business, a company could negotiate a Lease with an "Equity Kicker" or a Purchase Option that might provide future value.

Corporate Real Estate Financing

The Acquisition of Property for Company use can be Financed with either Mortgage Debt or unsecured Corporate Borrowing. Mortgage Debt will generally be preferred if it is cheaper than the company's unsecured Borrowing Cost.

"Capital" Lease

Formerly, if a Lease Term exceeded 75% of an Asset's remaining economic life, or if the Present Value of future Lease Payments was the majority of the Property's FMV at Lease Commencement (90%+), or if Property Ownership was likely to be Transferred to the Lessee upon Lease Expiration (e.g. a Purchase Option substantially below FMV), then the Lease was treated as a "Capital" Lease and reported as if that part of the Asset was Owned by the Lessee.

"Finance" vs. "Operating" Lease

Under the recent ASC 842 of the FASB, the Present Value of all Lease Payments for Leases over one year must be Capitalized and reported on the Balance Sheet as a Right-of-Use Asset and a Lease Liability, and annual Lease Payments will be reported as an Expense on the company's Income Statement. If the Lease Term is one year or less, Lease Payments will only be reported on the company's Income Statement and not on the Balance Sheet.

Sale-Leaseback

A company might Sell a Property it owns and simultaneously Lease it back on a Long-Term basis to obtain Cash while retaining Use of the Property. The company might negotiate a Repurchase Option into the Lease to give it the possibility to re-acquire that Property in the future. Selling a Property and Leasing it back in a Sale-Leaseback transaction, with the Lease written so that it will be reported as an Operating Lease, is a form of Off Balance Sheet Financing for the company.

"Hidden" Corporate Real Estate Value

Companies are required to report Property Values at the Lower of Depreciated Cost or Market Value. This can lead a publicly traded company to become an Acquisition Target when the Market Value of its Properties substantially Exceeds the reported depreciated Book Value.

Exit Strategies

To realize the increased Equity value created from an appreciated Property, an owner may Sell, Exchange or Refinance the Property.

Hold/Sell Analysis

Analyze the Marginal Rate of Return from Holding the Property for an additional period of Time as compared to Selling the Property currently.

Property Sale

Sell for Cash and Pay Off all outstanding Debt and pay all federal, state, and local Taxes on any Capital Gain.

Installment Sale

Sell on an Installment Sale basis receiving the Sale Price over Time and paying a proportional amount of the Capital Gain Tax with each Installment received. The amount of Installment Sale Income to be reported each year upon which Tax must be paid is a function of the Ratio between the "Gross Profit" on the Sale (i.e. Sale Price minus Adjusted Tax Basis) divided by the "Contract Price" as defined in IRS Form 6252. An Installment Sale is a form of Seller Financing.

Section 1031 Exchange

Trade the Property for "Like Kind" Property in a U.S. Internal Revenue Code Section 1031 exchange transaction to Defer the Taxes on any Capital Gain but with the Exchange Property receiving a Substituted Tax Basis. Section 1031 requires that the Exchange Property be Identified within 45 days of the Prior Sale closing date, and the Exchange Property must be Acquired within 180 days of the Prior Sale closing date. "Unlike" Property acquired in a Section 1031 transaction is called "Boot" and is subject to Capital Gain Taxes on the Sale. "Boot" includes Cash, Personal Property, and any "Unlike" Real Property received in the transaction. See IRS Form 8824.

Refinancing

Replacing an existing Loan with a new Loan. If you Refinance with a larger Loan you will not pay any Tax on the additional Loan Proceeds received in connection with the Refinancing. If Interest Rates have fallen, it might be possible to Refinance with a larger Loan while reducing the annual Borrowing Cost, but Points, Appraisal Fees and other Loan Costs must be considered.

Renovation

As an alternative to a Sale, a 1031 Exchange, or a Refinancing, the Property may be held and Renovated to increase Rents, increase Occupancy, and/or reduce Operating Costs, all of which should increase the Net Operating Income and thereby increase the Property Value. But in addition to the estimated Renovation Costs, the Time, Effort and Opportunity Costs related to the Renovation must also be carefully considered.

Risk

The higher the Variability of Expected Returns, the greater the Risk of an Investment. The lower the Variability of Expected Returns, the lower the Risk.

Risk Averse

Investors are generally Risk Averse, which means they require a higher Expected Return (probability weighted mean return) as compensation for incurring more Risk (i.e., higher Variability / Volatility / Uncertainty of Expected Returns).

Risk vs. Return

This is the key Investment consideration. When comparing potential Investments, their Internal Rate of Return (IRR) or projected Net Present Value (NPV) must be viewed in light of the Risks associated with each potential Investment.

Investment Risks

Economic Risk (global, national, and local), Business Risk, Financial Risk, Interest Rate Risk, Liquidity Risk, Inflation Risk, Management Risk, Environmental Risk, Legislative Risk, Pandemic Risk, etc.

Due Diligence

The Process of identifying the various Risks and potential Returns of an Investment by evaluating all the relevant and available Information to assess and determine whether the potential Returns are sufficient for you in light of those Risks. Due Diligence on a Property would include a review and analysis of a Market Study, the Rent Roll, major Leases, Physical Inspection, Design and Engineering, Title and Survey, Zoning and Code Compliance, Taxes, Insurance, Litigation, etc.

Sensitivity Analysis

Modifying key Assumptions about future Investment

Performance (e.g., Rent Levels, CPI, Vacancy Rates, exit Cap Rate, Sale Timing), often done two at a time, to see their impact on the IRR and Equity Multiple. The Assumptions can be changed to model various scenarios in light of the potential Risks. The Sensitivity Analysis will show how sensitive the Expected Return (e.g., IRR, NPV or Equity Multiple) is to changes in your Assumptions.

Partitioning the IRR

Determining the portion of the Investment Return that comes from the annual Cash Flow and the portion that comes from the Sale/Residual Value.

Financial Leverage

Allows an Investor to use less Equity to acquire an Investment, potentially achieve a higher Leveraged Return on Equity, and benefit from the Tax Deductibility of Mortgage Interest. Investors who desire a higher Leveraged Return on Equity might borrow at a higher LTV ratio, but as the LTV increases, Risk increases.

Positive and Negative Leverage

Positive Leverage is when the Return on Equity is higher with Debt than without, and Negative Leverage is when the Return on Equity is lower with Debt than without. With Positive Leverage, the higher the LTV ratio, the higher will be the Leveraged Return on Equity. With Negative Leverage, the higher the LTV ratio, the lower will be the Leveraged Return on Equity.

Loan Underwriting

The Loan to Value Ratio (LTV) and Debt Service Coverage Ratio (DSCR) are two of the key elements of a Loan Underwriting. Although the maximum LTV ratio and minimum DSCR levels vary with Mortgage Market conditions, Lenders are always more secure with a lower LTV ratio and a higher DSCR. Prepayment Penalties, Yield Maintenance, Loan Lockouts: Mortgage Loan terms that make it costly or impossible for a Borrower to Payoff or Refinance a Loan before the contract Maturity Date.

Interest-Only Loan

Borrower pays only Interest on the Loan, with no Principal Amortization, and a Balloon Payment due at Maturity. Also called a "Bullet Loan".

Negative Amortizing Loan

When the Payment Rate on a Loan is less than the Accrual Rate (i.e. Interest amount then due), there will be Negative Amortization and

the Loan Balance will increase. Might be used when Interest Rates are very high.

Participating Loan

The Lender receives additional Interest, based on a formula, typically related to Gross Income, NOI, or Cash Flow, that is called a Participation or "Equity Kicker" but the Lender does not have any Ownership Interest in the Property.

Convertible Mortgage

When the Lender has the right to convert part or all of the Loan Principal to an Ownership Interest in the Property at a specified time.

Mezzanine Loan

A Loan that is often Secured by the Owner's Equity in a Property, rather than by a Mortgage on the Property itself. Usually requires an Inter-Creditor Agreement between the Mezzanine Lender and the First Mortgage Lender.

Preferred Equity

An Investment in the Ownership Interest of a Property, that is not a Mortgage, with a Preferred Return that takes Priority over other Equity Investors.

Sale-Leaseback

An alternate means of Monetizing a Property where the Seller retains Use of the Property for the duration of the Lease Term. With a Repurchase Option in the Lease, the Seller may reacquire Ownership of the Property in the future.

Investment Benefits

Cash Flow (after Taxes), Price Appreciation, Diversification.

Real Estate Cycle

The Real Estate industry is Cyclical, with periods of Growth and periods of Decline in Rents, Occupancy and Property Values. The industry is very large and highly competitive, with many owners and limited concentration of ownership.

Investment Strategies

Risk/Return focus (Core, Value-Added, or Opportunistic), Property Type (e.g. Office, Retail, Apartments, Hotels), and/or Geographical focus.

Market Analysis

Supply/Demand analysis or Property Type and Local Market, and local Absorption projections to forecast future Occupancy Rates and Rent Levels.

Leverage

The use of Debt to acquire or own Property.

Loan to Value Ratio (LTV)

Mortgage Balance divided by Property Value (or Price).

Debt Service Coverage Ratio (DSCR)

Annual NOI divided by Mortgage Payments. A higher DSCR shows a greater ability for the Borrower to make Mortgage Payments.

Net Operating Income (NOI)

Rent and other Property Income minus Operating Expenses. NOI is often Capitalized to determine the Market Value of a Property.

Before Tax Cash Flow

NOI minus Debt Service and Capital Expenditures (Cap Ex).

After Tax Cash Flow

Before Tax Cash Flow minus Taxes. The Government is your partner in every Investment through its power to Tax the annual Income and Capital Gains from Sale. Federal, State, Local and all other Taxes must be considered.

Taxable Income

Net Operating Income minus Interest and Tax Depreciation.

Tax Depreciation

The amount of the Purchase Price allocated to the Improvements, exclusive of the Land, is the Depreciable Cost Basis of the Property. The Depreciable Cost Basis can be Amortized as Tax Depreciation over 27.5 years for Residential Income Properties and 39 years for Non-Residential Income Properties.

Mortgage Interest Deduction

The Interest portion of the monthly P&I Payments is Tax Deductible for primary and secondary Homes on Loans totaling up to $750,000.

Unleveraged Returns vs. Leveraged Returns

The Internal Rate of Return (IRR), Return on Equity (ROE) and Equity Multiple from an Investment before and after the effect of Mortgage Financing. The Leveraged returns should generally be higher than

the Unleveraged returns to account for the additional Risk from the use of Leverage.

Market Value

The Price at which a willing Buyer and a willing Seller, each without undue pressure, would Buy and Sell a particular Property, as of a particular Date.

Appraised Value

An estimate or opinion of Property Value, for a particular Purpose as of a particular Date, by a particular Appraiser.

The three primary Appraisal Methods are

Sales Comparison, Capitalization of Income, and Replacement Cost. Each of the three Appraisal Methods should, in theory, produce a similar Valuation.

Sales Comparison (or Comparable Sales)

Compares recent Sales of highly Comparable Properties that are similar in Location, Size, Age, Construction Quality, and other factors. This is generally the only method used for Residential Properties, and one of the three methods used to appraise Commercial Properties.

Capitalization of Income

Gross Rent Multiplier, Capitalization of Net Operating Income, and Discounted Present Value (DCF) of projected future annual NOI.

Gross Rent Multiplier

Annual Rental Income × Gross Rent Multiplier = Price (or Value). The Gross Rent Multiplier must be derived from the GRMs on Sales of Comparable Properties. This simple method is often used for valuing Apartments.