Week 1

Real Estate Finance is a crucial aspect of property investment, involving understanding various financing options, investment analysis, and risk management to maximize returns.

What is Commercial Real Estate?

  • Various types of Commercial Real Estate (CRE):

    • Office Buildings

    • Single Tenant (STNL)

    • Multi-tenant

    • Medical Office

    • Industrial Buildings

    • Large warehouses

    • Small "flex" spaces

    • Retail

    • Shopping malls

    • Neighborhood centers

    • Quick Service Restaurants (QSRs) such as fast food restaurants

    • Gas Stations/Truck Stops

    • STNL examples like dollar stores, auto parts stores, and restaurants

    • Multifamily

    • Apartment buildings

    • Student housing

    • Age-restricted communities

    • Single-Family Residential (SFR) portfolios

    • Build-for-Rent (BFR) communities

    • Hospitality

    • Hotels

      • Full Service

      • Quick Service

      • Independent

      • Flagged hotels

      • Short term rentals

    • Self Storage

    • Traditional storage properties

    • RV, boat, and outdoor storage

    • Climate-controlled storage options

    • Other CRE types include:

    • Hospitals

    • Hangars

    • RV Parks

    • Charter & Private Schools

Commercial Real Estate's Importance

Size / GDP

  • Graph representation of CRE's economic significance:

    • Commercial Real Estate compared to 1980-2015 GDP

    • Key assets: Treasury, Corporate Debt, Common Stock, Commercial Real Estate, Residential Real Estate

CRE's Role in Portfolio Market

  • Portfolio consists of US Common Stock, US CRE, US Corporate Bonds, and US Treasuries

  • Returns comparison:

    • Treasury returns represented by 10-yr US Treasury Yield

    • Corporate Bonds represented by ICE BAML US Corporate Master Total Return Index

    • Stock returns represented by Wilshire 5000 Total Market Full Cap Index

    • CRE returns represented by NAREIT All Equity REIT Returns

  • Excluded residential real estate for historical non-investability for average portfolio managers

  • Simple asset allocation strategy to match weights in the market portfolio

Portfolio Returns with and without CRE

  • Comparison from 1980-2017:

    • Market Portfolio Mean return: 11.8%

    • Portfolio without CRE Mean return: 11.2%

    • Standard Deviation with CRE: 11.0; without CRE: 10.6

    • Risk/Return Ratio with CRE: 1.08; without CRE: 1.05

  • Comparison for 1980-1996:

    • Market Portfolio Mean return: 14.7%; without CRE: 14.4%

    • Standard Deviation: 10.5 (with CRE) vs 10.8 (without CRE)

    • Risk/Return Ratio: 1.39 (with CRE) vs 1.34 (without CRE)

  • Comparison for 1997-2017:

    • Market Portfolio Mean return: 9.7%; without CRE: 8.8%

    • Standard Deviation: 10.8 (with CRE) vs 9.9 (without CRE)

    • Risk/Return Ratio: 0.90 (with CRE) vs 0.89 (without CRE)

  • Conclusion: Higher risk-adjusted returns can be achieved by including CRE

Returns on CRE Indices

  • Components of Returns:

    • Income and Price Appreciation

    • Most return derives from income component

    • Volatility primarily due to capital gains

CRE Illiquidity

  • Infrequent transactions in the CRE market noted through various studies:

    • Fisher et al. (2003) data indicates 4-18% turnover annually

    • Ghent (2021) reveals about 5% turnover annually

  • Other financial instruments like corporate bonds and treasuries have annual turnover rates of approximately 100% and 1000%, respectively

Property-Level Returns

  • Challenges in understanding individual property returns due to:

    • Data quality issues

    • Low transaction frequency

  • Main risk in investing in individual properties is transaction risk (Point made by Sagi, 2021)

Ownership of CRE

Who Owns CRE?

  • Dominance of private ownership over REIT and ownership share

  • BEA (Bureau of Economic Analysis) broad categories of ownership:

    • Primarily owned by firms using it as a production input

CRE as a Share of Firm Assets

  • Graph illustrates:

    • Non-financial corporate business still maintains a 30% asset share in real estate

Investible CRE Portfolio

  • Calculation assumptions:

    • Manager invests 25-30% of portfolio in CRE

  • If 65% of CRE is owner-occupied, investable CRE may only approximate 9% of market portfolio

  • Similar findings reported by Andonov and Rauh (2018) regarding pension fund allocations

Limits to Increasing Investible CRE

  • Potential barriers to raising the institutional share of CRE include:

    1. Delegated managers require liquidity

    • Outside investors limit prolonged holding of capital without investments

    1. Hold-up problem for end users preferring ownership over leasing

    • Long-term leases are not always a solution

    1. Preference for credit tenants by delegated managers

    • Publicly traded companies are favored to mitigate agency issues

    • Less than one-third of employment in the US is in publicly traded firms

CRE as an Asset Class: Takeaways

  1. CRE constitutes approximately 20-25% of the market portfolio

  2. Including CRE can augment average risk-adjusted returns

  3. A minimal portion of CRE is owned by REITs

  4. Illiquidity poses significant transaction risk in individual property investments

  5. The investable CRE class is considerably smaller if corporate real estate isn't considered viable

References

  • Andonov, A. and J. Rauh (2018): "The Return Expectations of Institutional Investors," Tech. rep., Stanford University.

  • Fisher, J., D. Gatzlaff, D. Geltner, and D. Haurin (2003): "Controlling for the Impact of Variable Liquidity in Commercial Real Estate Price Indices," Real Estate Economics, 31, 269 – 303.

  • Ghent, A. C. (2021): "What’s Wrong with Pittsburgh? Delegated Investors and Liquidity Concentration," Journal of Financial Economics, 139, 337–358.

  • Sagi, J. S. (2021): "Asset-level Risk and Return in Real Estate Investments," Review of Financial Studies, 34, 3647–3694.

Discussion Questions

  1. What is finance, and why is it important to study?

  2. Which real estate professionals utilize finance in decision making?

Underwriting

  • Definition:

    • Underwriting is a process utilized by financial services (banks, insurers, investment houses) to evaluate customer eligibility for products like equity capital, insurance, mortgages, or credit.

    • Originates from the Lloyd's of London insurance market—historically, financial bankers absorbed risks in exchange for a premium and would literally write their names under the risk details on a Lloyd's slip.

Types of Underwriting Covered in Class

  1. Bank/Lender Underwriting

  2. Investment Underwriting

  3. Development Underwriting

Discussion on Risk

  • Risk Definition:

    • Risk entails possible financial loss or uncertain outcomes in investment contexts.

Financing

  • Key Question: How will financing be managed?

  • Discussion on risk associated with financing.

Debt

  • Definition:

    • Debt is a primary type of capital representing a claim on investment earnings, seeking security through liens on involved assets, expecting repayment promises.

    • Debt investors may engage with bonds or mortgages, receiving either fixed or variable interest, with principal repayment due upon maturity. (Dictionary of Real Estate Appraisal, Fifth Edition, 2010)

Sources of Debt

  • Figure 1.7 illustrates Debt Component Distribution:

    • Savings Institutions: 796

    • ABS Issuance (CMBS): 22%

    • Government-Sponsored Enterprises: 9%

    • Commercial Banks: 43%

    • Life Insurance Companies: 9%

    • Other: 10%

    • Total U.S. Commercial Real Estate Fixed-Income Markets: $3.39 Trillion

Equity (Investment)

  • Definition:

    • Equity represents an ownership claim on property. Equity value equals property value minus total debt, which signifies a residual claim subordinate to operating expenses and creditors' claims.

    • Equity investors incur greater risk than creditors, obtaining periodic cash flows (dividends) and potentially appreciating value. (Dictionary of Real Estate Appraisal, Fifth Edition, 2010)

Sources of Equity

  • Figure 1.8 shows Equity Component Distribution:

    • Pension Funds: 20%

    • Endowments & Foundations: 20%

    • Public REITs: 17%

    • Private Financial Institutions: 1%

    • Life Insurance Companies: 2%

    • Foreign Investors: 21%

    • Private Investors: 39%

    • Total U.S. Commercial Real Estate Equity Markets: $1.63 Trillion

Discussion on Debt vs. Equity

  • Exploration of how debt and equity characteristics impact costs and decision-making in property investments.

Measures of Investment Performance

  • Key performance measures include:

    • Net Present Value (NPV)

    • Internal Rate of Return (IRR)

    • Cash-on-Cash Return

    • Capitalization Rate

    • Payback Period

    • Additional metrics as needed

What Constitutes a Good Investment?

  • Open discussion on characteristics of sound investment choices.

Three Major Investment Categories

  • Primary categories and corresponding risk profiles are:

    • Stocks

    • Bonds

    • Real Estate

Risk Profiles Over Time

  • Graph representation of annualized returns for NCREIF, S&P 500, and Bonds from 1978 to 2008.

Valuation

  • Central question: What is the payment amount for property?

  • Emphasis on the critical role valuation plays in financial success.

Four Agents of Production

  • The key agents include:

    • Land

    • Labor

    • Capital

    • Entrepreneurial Coordination

Value Creation

  • Exploration of value generation methods in real estate finance.

Valuation Methodology

  • Evaluation of appropriate valuation methods:

    • Cost Approach

    • Sales Approach

    • Income Approach

Annual Property Operating Data

  • Components of operating data analysis:

    • Potential Rental Income

    • Less: Vacancy and Credit Loss

    • Effective Rental Income

    • Plus: Other Income

    • Plus: Reimbursable Expenses

    • Gross Operating Income

    • Operating Expenses, including

    • Real Estate Taxes

    • Personal Property Taxes

    • Property Insurance

    • Payroll Expenses, Repairs, Maintenance, Utilities, Other

    • Miscellaneous Contract Services

    • Total Operating Expenses

    • Net Operating Income (NOI)

Vocabulary from Real Estate Appraisal

  • Definitions and key terms outlined, with reference to the fifth edition of the Appraisal Institute:

    • Land

    • Real Estate

    • Real Property

    • Improvements

    • Improvements to Land

    • Personal Property

    • Bundle of Rights Theory

    • Fee Simple Estate

    • Leased Fee Interest

    • Leasehold Interest

    • Other Terms:

    • Loan Types (Const, Bridge, Perm, Mezz, Equity)

    • Lender Types

    • Key Metrics (DY, DSCR, LTV, LTC)

    • Loan Terms (Term, Amort, I/O, Rate, Guarantee, PPP, Fees, etc.)