Concepts Description
Private Real Estate Investments
Form of real estate Debt Equity
Private market Mortgages Direct investments (sole ownership, partnership, and other forms of
commingled funds)
Public market Mortgage‐backed securities Share of REITs and REOCs (real estate operating companies)
Real estate characteristics 1. Heterogeneity : not 2 properties are exactly the same, due to location, size, age, construction materials, tenants and lease terms
2. High unit value : real estate is indivisible → unit value is significantly higher than stocks and bonds → difficult to construct a diversified por olio
3. Active management : private real estates investment requires active property management by the owner / property management company (include : maintenance, negotiating
leases, collection of rent) → must consider management costs
4. High transaction costs : involve appraisers, lawyers, brokers and construction personnel
5. Depreciation and desirability : Building wear out overtime. Buildings may become less desirable due to location, design or obsolescence
6. Cost and availability of debt capital : high cost to acquire and develop real estate → level of interest rates and availability of debt capital affect property value.
Lower interest rate + Scarce capital = Lower real estate values
7. Lack of liquidity
8. Difficult in determining price : limited participants + lack of knowledge of local market → difficult for outsider to value property
(*) REIT overcome problems:
‐ REIT shares are actively traded → more liquidity
‐ REIT more likely to reflect market value
‐ REIT provide exposure to diversified real estate portfolio
‐ investors don't need property management expertise
Real estate classifications 1. Residential real estate : single‐family home, apartment
2. Non‐residential real estate : multi‐family, office, industrial / warehouse, retail, hospitality, parking facilities, restaurants, recreational properties
3. Farmland and timberland : produce saleable commodity + potential for capital appreciation
Benefits of real estate investment 1. Current income : from collecting rent (after paying off OPEX, financing costs, taxes)
2. Capital appreciation
3. Inflation hedge : during inflation, both rents and property value are expected to rise
4. Diversification : real estate is less than perfectly correlated with stocks and bonds' return
5. Tax benefits : favorable tax treatment in some countries
Risks of real estate investment 1. Business conditions : economic factors (GDP, employment, household income, interest rates and inflation) affect the rental market
2. New property lead time : market conditions can change significantly while approvals are obtained and property are completed. If market conditions weaken → lower demand →
affect rents anf vacancy → lower return
3. Cost and availability of capital : High interest rate + Scarce capital → lower demand for real estate
4. Unexpected inflation : ability to increase rents → provide infla on protec on to lessor. However, weak market + high vacancy rate → Real estate value may not keep up with
inflation.
5. Demographic factor : Demand for real estate is affected by size and age distribution of local market population, distribution of socioeconomic groups, and new household formation
rates
6. Lack of liquidity
7. Environmental issues : real estate values can be significantly reduced if being contaminated by prior owner / adjacent property owner
8. Lack of availability of information
9. Management expertise : manager must make operational decision (negotiating leases, maintenance, marketing and renovation)
10. Leverage → magnify impact of small decrease in NOI
11. Other undefined factors : unobservable defect, natural disasters, terrorism, etc.
(*) Some case, risk could be hedged using insurance, or shifted toward tenants
Types of commercial property 1. Office : demand heavily depend on job growth
‐ Gross lease : owner is responsible for OPEX
‐ Net lease : tenant is responsible for OPEX
2. Industrial : demand heavily depend on overall economy. Also depend on import/export activity
3. Retail : demand heavily depend on comsumer spending (which depend on overall economy, job growth, population growth, saving rate)
‐ Anchor lease receive favorable lease terms, to attract other tenants to the property
‐ Percentage lease / percentatge rent : retail tenants are required to pay additional rent once sales reach a threshold
4. Multi‐family: demand depends on population growth (especially age demographic) and cost of buying vs cost of renting
Real estate appraisals Appraisals : due to infrequent real estate transactions → appraisal is used to es mate value / assess changes in value over me → measure performance
‐ Market value : most probable sales price a typical investors is willing to pay
‐ Investment value : value / worth that considers a particular investor's motivation
‐ Value in use : value to a particular user
‐ assessed value : value used by tax authority
‐ Mortgage lending value : for the purpose of valuing collateral
Valuation approaches 1. Cost approach : buyer would not pay more for a property than cost to purchase land + current replacement cost of new building ‐ adjustments for estimated depreciation and
obsolescence
‐ Difficult in measuring depreciation and obsolescence → most usefult for rela vely new property
2. Sale comparison approach : buyer would not pay more for a property than others paying for similar property
‐ Most useful when there are a number of similar properties recently sold
3. Income approach : value is based on expected rate of return required by a buyer to invest in the subject property
‐ Most useful in commercial real estate transactions
(*) Appraiser may allocate more/less weight to an approach, becasue of the property type or market conditions
, Valuation approaches ‐ Income Valuation method # 1 : Direct capitalisation method
approach
(*) Tentants are required to pay all expenses → ARY = cap rate
(*) Rents are expected to increase @ constant rate each year → IRR = Cap rate + Growth rate
Stabilised NOI : when NOI is not representative of NOI of similar properties due to temporary issue (e.g.: renovation) → NOI should be calculated as no impact of temporary issue
Gross income multiplier : similar to cap rate, but ignore the impact of vacancy rates and OPEX
Value = Gross income × Gross income multiplier
Valuation method #2 : DCF
‐ Discount rate = Cap rate ‐ Growth rate
‐ Terminal cap rate : estimated residual value of property using direct capitalisation method
‐ OPEX assumptions : fixed expenses can change due to inflation ; variable expenses vary with occupancy
Valuation with different Lease structure :
‐ Reversionary potential : adjust rent to current market rent @ lease expiration
+ discount rate applied to contract rent : lower than reversion rate, because contract rent is less risky
‐ Layer method :
+ Layer 1‐ Contract rent : assume to continue in perpetuity → cap rate = ARY (contract rent is less risky)
+ Layer 2 ‐ Incremental rent : higher cap rate than contract rent
Valuation approaches ‐ Cost Step 1: Estimate MV of land (sales comparison approach)
approach Step 2 : Estimate building's replacement cost (based on current construction cost and standards + builder/developer's profit)
Step 3 : Deduct physical deterioration (curable and non‐curable) functional obsolescence, location obsolescence and economic obsolescence
‐ Physical deterioration : wear and tear of the building overtime
+ Curable : if benefit of fixing ≥ cost to cure
+ Incurable :
‐ Functional obsolescence : loss in value from defects in design and impairs building's facilities (estimated by capitalising the decline in NOI)
‐ Locational obsolescence : occur when location no longer optimal. Part of the loss might already be reflected in MV of land
‐ Economic obsolescence : occur when new construction is not feasible under current economic conditions
(*) Cost approach is considered the upper limit of value since an investor would never pay more than the cost to build a comparable building
Valuation approaches ‐ Sale Value of subjected property = sales prices of comparable properties ± adjustments for differences
comparison approach Differences may relate to : size, age, location, property condition, market conditions
‐ Upward adjustments for undesirable difference with subject property
‐ Downward adjustments for desirable difference with subject property
Highest and best use Highest and best use : the use that produces highest implied land value
Implied land value = Value of property once contruction is completed ‐ Cost of constructing the improvement (including profit to the developer)
Due diligence in private equity Due diligence : to confirm the fact + conditions that might affect the value of the transaction→ lower the risk of unexpected legal and physical problems
real estate investment ‐ Lease review and rental history
‐ Confirm OPEX by examining bills
‐ Review CF statements
‐ Obtain environment report → iden fy possible contamina on
‐ Physical / Engineer inspection → iden fy structural issues + Check condi on of the building system
‐ Inspect the title and other legal documents for deficiencies
‐ Survey the property → confirm the boundaries + iden fy easements
‐ Verify compliance with zoning laws, building codes and environment regulations
‐ Verify payment of taxes, insurance, special assessments and other expenditures
Appraisal‐based indices Appraisal‐based indices: combine valuations of individual properties that can be used to measure market movements → could compare performance with other asset classes
MCREIF Property index (NPI) : popular index in US. NCREIF calculate return as follows:
. .
.
If increase in MV > CAPEX → Posi ve capital return . .
Cons of appraisal‐based indices :
‐ Actual transactions occur before appraisals → appraisal‐based indices tend to lag actual transac on → smooth the index
‐ Appraisal lag → lowe correla on with other asset classes
Transaction‐based Indices Transaction‐based indices : constructed using repeat‐sales index and hedonic index
Repeat‐sale index : rely on repeat sale of same property → regression is developed to allocate change in value each quarter
Hedonic index : require only 1 sale → regression is developed based on changes in property characteris cs (age, loca on, etc.)
Private Real Estate Investments
Form of real estate Debt Equity
Private market Mortgages Direct investments (sole ownership, partnership, and other forms of
commingled funds)
Public market Mortgage‐backed securities Share of REITs and REOCs (real estate operating companies)
Real estate characteristics 1. Heterogeneity : not 2 properties are exactly the same, due to location, size, age, construction materials, tenants and lease terms
2. High unit value : real estate is indivisible → unit value is significantly higher than stocks and bonds → difficult to construct a diversified por olio
3. Active management : private real estates investment requires active property management by the owner / property management company (include : maintenance, negotiating
leases, collection of rent) → must consider management costs
4. High transaction costs : involve appraisers, lawyers, brokers and construction personnel
5. Depreciation and desirability : Building wear out overtime. Buildings may become less desirable due to location, design or obsolescence
6. Cost and availability of debt capital : high cost to acquire and develop real estate → level of interest rates and availability of debt capital affect property value.
Lower interest rate + Scarce capital = Lower real estate values
7. Lack of liquidity
8. Difficult in determining price : limited participants + lack of knowledge of local market → difficult for outsider to value property
(*) REIT overcome problems:
‐ REIT shares are actively traded → more liquidity
‐ REIT more likely to reflect market value
‐ REIT provide exposure to diversified real estate portfolio
‐ investors don't need property management expertise
Real estate classifications 1. Residential real estate : single‐family home, apartment
2. Non‐residential real estate : multi‐family, office, industrial / warehouse, retail, hospitality, parking facilities, restaurants, recreational properties
3. Farmland and timberland : produce saleable commodity + potential for capital appreciation
Benefits of real estate investment 1. Current income : from collecting rent (after paying off OPEX, financing costs, taxes)
2. Capital appreciation
3. Inflation hedge : during inflation, both rents and property value are expected to rise
4. Diversification : real estate is less than perfectly correlated with stocks and bonds' return
5. Tax benefits : favorable tax treatment in some countries
Risks of real estate investment 1. Business conditions : economic factors (GDP, employment, household income, interest rates and inflation) affect the rental market
2. New property lead time : market conditions can change significantly while approvals are obtained and property are completed. If market conditions weaken → lower demand →
affect rents anf vacancy → lower return
3. Cost and availability of capital : High interest rate + Scarce capital → lower demand for real estate
4. Unexpected inflation : ability to increase rents → provide infla on protec on to lessor. However, weak market + high vacancy rate → Real estate value may not keep up with
inflation.
5. Demographic factor : Demand for real estate is affected by size and age distribution of local market population, distribution of socioeconomic groups, and new household formation
rates
6. Lack of liquidity
7. Environmental issues : real estate values can be significantly reduced if being contaminated by prior owner / adjacent property owner
8. Lack of availability of information
9. Management expertise : manager must make operational decision (negotiating leases, maintenance, marketing and renovation)
10. Leverage → magnify impact of small decrease in NOI
11. Other undefined factors : unobservable defect, natural disasters, terrorism, etc.
(*) Some case, risk could be hedged using insurance, or shifted toward tenants
Types of commercial property 1. Office : demand heavily depend on job growth
‐ Gross lease : owner is responsible for OPEX
‐ Net lease : tenant is responsible for OPEX
2. Industrial : demand heavily depend on overall economy. Also depend on import/export activity
3. Retail : demand heavily depend on comsumer spending (which depend on overall economy, job growth, population growth, saving rate)
‐ Anchor lease receive favorable lease terms, to attract other tenants to the property
‐ Percentage lease / percentatge rent : retail tenants are required to pay additional rent once sales reach a threshold
4. Multi‐family: demand depends on population growth (especially age demographic) and cost of buying vs cost of renting
Real estate appraisals Appraisals : due to infrequent real estate transactions → appraisal is used to es mate value / assess changes in value over me → measure performance
‐ Market value : most probable sales price a typical investors is willing to pay
‐ Investment value : value / worth that considers a particular investor's motivation
‐ Value in use : value to a particular user
‐ assessed value : value used by tax authority
‐ Mortgage lending value : for the purpose of valuing collateral
Valuation approaches 1. Cost approach : buyer would not pay more for a property than cost to purchase land + current replacement cost of new building ‐ adjustments for estimated depreciation and
obsolescence
‐ Difficult in measuring depreciation and obsolescence → most usefult for rela vely new property
2. Sale comparison approach : buyer would not pay more for a property than others paying for similar property
‐ Most useful when there are a number of similar properties recently sold
3. Income approach : value is based on expected rate of return required by a buyer to invest in the subject property
‐ Most useful in commercial real estate transactions
(*) Appraiser may allocate more/less weight to an approach, becasue of the property type or market conditions
, Valuation approaches ‐ Income Valuation method # 1 : Direct capitalisation method
approach
(*) Tentants are required to pay all expenses → ARY = cap rate
(*) Rents are expected to increase @ constant rate each year → IRR = Cap rate + Growth rate
Stabilised NOI : when NOI is not representative of NOI of similar properties due to temporary issue (e.g.: renovation) → NOI should be calculated as no impact of temporary issue
Gross income multiplier : similar to cap rate, but ignore the impact of vacancy rates and OPEX
Value = Gross income × Gross income multiplier
Valuation method #2 : DCF
‐ Discount rate = Cap rate ‐ Growth rate
‐ Terminal cap rate : estimated residual value of property using direct capitalisation method
‐ OPEX assumptions : fixed expenses can change due to inflation ; variable expenses vary with occupancy
Valuation with different Lease structure :
‐ Reversionary potential : adjust rent to current market rent @ lease expiration
+ discount rate applied to contract rent : lower than reversion rate, because contract rent is less risky
‐ Layer method :
+ Layer 1‐ Contract rent : assume to continue in perpetuity → cap rate = ARY (contract rent is less risky)
+ Layer 2 ‐ Incremental rent : higher cap rate than contract rent
Valuation approaches ‐ Cost Step 1: Estimate MV of land (sales comparison approach)
approach Step 2 : Estimate building's replacement cost (based on current construction cost and standards + builder/developer's profit)
Step 3 : Deduct physical deterioration (curable and non‐curable) functional obsolescence, location obsolescence and economic obsolescence
‐ Physical deterioration : wear and tear of the building overtime
+ Curable : if benefit of fixing ≥ cost to cure
+ Incurable :
‐ Functional obsolescence : loss in value from defects in design and impairs building's facilities (estimated by capitalising the decline in NOI)
‐ Locational obsolescence : occur when location no longer optimal. Part of the loss might already be reflected in MV of land
‐ Economic obsolescence : occur when new construction is not feasible under current economic conditions
(*) Cost approach is considered the upper limit of value since an investor would never pay more than the cost to build a comparable building
Valuation approaches ‐ Sale Value of subjected property = sales prices of comparable properties ± adjustments for differences
comparison approach Differences may relate to : size, age, location, property condition, market conditions
‐ Upward adjustments for undesirable difference with subject property
‐ Downward adjustments for desirable difference with subject property
Highest and best use Highest and best use : the use that produces highest implied land value
Implied land value = Value of property once contruction is completed ‐ Cost of constructing the improvement (including profit to the developer)
Due diligence in private equity Due diligence : to confirm the fact + conditions that might affect the value of the transaction→ lower the risk of unexpected legal and physical problems
real estate investment ‐ Lease review and rental history
‐ Confirm OPEX by examining bills
‐ Review CF statements
‐ Obtain environment report → iden fy possible contamina on
‐ Physical / Engineer inspection → iden fy structural issues + Check condi on of the building system
‐ Inspect the title and other legal documents for deficiencies
‐ Survey the property → confirm the boundaries + iden fy easements
‐ Verify compliance with zoning laws, building codes and environment regulations
‐ Verify payment of taxes, insurance, special assessments and other expenditures
Appraisal‐based indices Appraisal‐based indices: combine valuations of individual properties that can be used to measure market movements → could compare performance with other asset classes
MCREIF Property index (NPI) : popular index in US. NCREIF calculate return as follows:
. .
.
If increase in MV > CAPEX → Posi ve capital return . .
Cons of appraisal‐based indices :
‐ Actual transactions occur before appraisals → appraisal‐based indices tend to lag actual transac on → smooth the index
‐ Appraisal lag → lowe correla on with other asset classes
Transaction‐based Indices Transaction‐based indices : constructed using repeat‐sales index and hedonic index
Repeat‐sale index : rely on repeat sale of same property → regression is developed to allocate change in value each quarter
Hedonic index : require only 1 sale → regression is developed based on changes in property characteris cs (age, loca on, etc.)
