William Goetzmann
223 56 Hill House Avenue
telephone 432-5950
Secretary: Mary Ann Nelson

Real Estate Economics and Finance

Notes to a Master's Level Course



The course applies economic and financial theory to the problem of real estate investment. It provides an overview of commercial properties including office and retail; residential properties including single and multi-family; securitization including mortgages and real estate investment trusts and real estate portfolio management. Topics include quantitative approaches to property valuation, bootstrapping and simulation methods of risk analysis, location analysis, geographical diversification and agency problems, limited partnerships and conflicts among claimants, public offerings and adverse selection, real estate auctions and the winner's curse and real options.

The course is half lecture and half case discussion. There will be one case per week. All students are required to complete the first case (part I) individually. All other cases may be done in groups. Each group must prepare a three-page write up on every other case and presentation of quantitative results if called upon. Everyone must be prepared for class discussion on every case. There is a Real Estate Investment Trust Game to be played through the term. There is a video series to be viewed individually or in a group. The final will be a take-home. As an alternative to the final, you may turn in a bound, clean version of every case write-up.

The text will be Breuggerman, W. and J. Fisher, Real Estate Finance and Investments (Irwin, 1993) ISBN # 0-256-08290-1. Supplementary readings are indicated in the syllabus

Structure of the Course

  1. Introduction
  2. Methods of Valuation

Case: Angus Cartwright I

  1. The Dynamics of Real Estate

Case: Angus Cartwright II

  1. The Development Process I

Case: Olympic Tower

  1. Development Process II

Case: Costa Mesa

  1. Shopping Center Introduction

Case: Concord Center

  1. Negotiation Overview

Case: Sears Tower

  1. Partnership Introduction

Case: Professional's Fund

  1. Introduction to Housing
  2. The single family home in the investment portfolio

Case: Seabury Associates

  1. Housing securitization & the role of agencies. Housing development.

Case: Housing Futures: will they work?

  1. Real Estate Investment Trusts

Case: Debartolo REIT

  1. Commingled Real Estate Funds

Case: Taurus Realty or:

Case: The Real Estate Global Crash

Lecture 1: Introduction

Ancient History of Real Estate

Real Estate Defined by Law

Mesopotamian property rights

Ur (1,800 B.C.) residential & agricultural deeds

separation of rights, hypothecation of properties

Real Estate Finance

Mirashu clan and contingent clams

500 B.C. Nippur. 423 death of Atraxerxes

Sogdanius vs. Ochus - Darius II.

Mortgage Defaults financed revolution

What is Real Estate?

Estate as physical land and improvements (a place and thing)

A physical geographical location

Role of law

Role of technology

Role of government

Property rights (an interest)

Distinct from estate


Transferable across owners

Transferable through time

Posessatory interest: English common law.

Any interest in real estate that carries right of exclusive

possession, right to sell, lease, use or keep others off.

Other interest. e.g. easement, or right of access.


Freehold (titles transfer via deed)

Leasehold (lease contract)

Lessor holds title

Lessee granted possession

Life estate



obligation to repay via promissory note

pledge of interest conditional upon failure

What's Special About Real Estate as an Asset Class?


Location is key characteristic

Local economic issues prevail in valuation i.e. city-wide employment

Micro economic conditions might prevail i.e. street locus

Localized knowledge and expertise

Subject to local laws, restrictions and conditions

Uniqueness of location

Permanence of Land

Undeveloped -- all potential

Infinitely lived so timing is crucial

Option value to development

Land is only as valuable as the associated property rights

Building as Physical Asset

Developed -- depreciating

Development decision re. capacity choice

Hard to conceal or disguise

Long development time

Relatively expensive

Indivisibility of building/land

Uniqueness of building makes pricing difficult

Requires financing

Requires syndication

What's Important About Real Estate?

Big Business

Component of balance sheets of all businesses

as asset or lease liability

Everyone's home

Major personal asset and/or liability


6% of U.S. business directly in RE or construction

1/2 private investment in US in real estate

1/2 of that in housing

1/4 to 1/3 of all bonds are property-backed

1/3 to 1/2 of all life insurance companies assets


MBS revolution in 80's pass-throughs

High-tech revolution in 90's strips. I.O.'s

REIT IPO billions each year

Emerging derivatives market


Private US = 1.3 B, Public U.S. = 1 B

Housing = 25 M Industry = 44 M

Agriculture = 1.25 B

How it Works


Rights, primary and ancillary

Timing of Development


Office, Industrial, Retail, Residential















Alternative use

Lecture 2: Methods of Valuation


Replacement Value

Discounted Future Cash Flows

Sources of Value

Land & Other Rights

Building Leases

Options -- granted and owned

Strategic Advantage

Mortgage "Put"


Lessor = owner, Lessee = occupier

Contract specifies:

Term of the Lease

Base Rent

Expense Responsibility

Participating Income

Renewal Option

Expense Stops

CPI Adjustment

Office = "Net" or "Triple Net"

Tenant Pays Taxes

Tenant Pays Insurance

Tenant Pays Maintenance

Price: Asking vs. Effective Rents

Pro Forma Analysis

Example: The Century Tower

New Haven Office Building at Church and Grove

Class A Office Space

24 Floors

Ground Floor Retail


285,000 Net Leasable Area

Built in 1989, For a price of $50 million

Mortgaged & Repossessed

Fully Leased with professional offices @ $15 per square foot

Flagship Tenant at $10, other tenants at $20

Flagship Lease of 7 years, Other Leases at 3 years


Century Office Building Comparable Data
area total 285,000 Construction costs 80 22,800,000
retail 15,000 Soft Costs 10,000,000
office 270,000 Total 32,800,000
Original Price 40,000,000
Year 1 Year 2 Year 3 Year 4 Year 5
Flagship 1,350,000 1,350,000 1,350,000 1,350,000 1,350,000
Other 2,700,000 2,700,000 2,700,000 2,700,000 2,700,000
Retail 150,000 150,000 150,000 150,000 150,000
Total 4,200,000 4,200,000 4,200,000 4,200,000 4,200,000
Total Expenses 840,000 840,000 840,000 840,000 840,000
Net Operating Income 3,360,000 3,360,000 3,360,000 3,360,000 3,360,000
Debt Service 2,200,000 2,200,000 2,200,000 2,200,000 2,200,000
Before Tax Cash Flow 1,160,000 1,160,000 1,160,000 1,160,000 1,160,000
Tax Shields: P/25*.42 672,000 672,000 672,000 672,000 672,000
After Tax Cash Flow 1,832,000 1,832,000 1,832,000 1,832,000 1,832,000
0.074 Perpetuity Value 24,823,848 24,823,848 24,823,848 24,823,848 24,823,848
Cap Rate 0.0840

Discount Rates:

CAPM possibilities - systematic risk

Comparable possibilities

Cash flow risk

Building like a bond portfolio


re-investment risk & lease renewal

diversification & risk

borrower risk pass-through

Performance Measures

1) Price Per Square Foot

Gross and Rentable

2) Cap Rate


Tax effects

Lease effects


3) Equity Dividend Rate

BTCF1/ Equity Investment

4) Debt Coverage Ratio


5) NPV

6) Profitability: PV/Initial Investment

7) IRR

8) Modified IRR

Angus Cartwright Case Discussion









James DeRight


$3.2 M in Company Stock

Income = $100 K in dividends

Wants 12%

Martha DeRight

Owns Chemical Company

Corporate Income $400 K

Plenty of Cash

Wants 12%

Angus Cartwright

Investment Advisor

Real Estate Analyst


Personnel Issues

James DeRight

Risk position

Recourse debt?

bankruptcy & breakeven occupancy

Investment horizon


Martha DeRight

Risk position

Investment horizon



Alison Green

Cost $3.2 M 800 K investment

100 unit residential

Sewer moratorium

3 years old

97% occupancy

Stony Walk

Cost $2.65 M 400 K investment

50,000 square feet commercial

professional building

9 years old

97% occupancy

Ivy Terrace

Cost $2.8 M 500 K investment

80 unit residential

Land lease

Under construction

Rental guarantee at 95%

Fowler Building

Cost $3.6 M $1 M investment

55,000 square feet

80% occupancy

Under construction

Computer & consulting

Rental guarantee

Property Issues

Sewer moratorium

Developed vs. under construction

Apartment vs. professional

Proforma Analysis



sale price

lease renewals

implicit duration (who holds RE?)

NPV criterion

discount rate 12%

same for all?

IRR criterion

reinvestment of proceeds?

breakdown of IRR



price/square foot

Cap Rate: purchase to sale

AG = 1.096

SW = 1.323

IT = 1.25

FB = .97

Sensitivity Analysis

What matters most?

Margin for errorWhat happened in the DC Area?


Price/square foot $250 to $215

Office Rents $33 to $26

Cap Rates 7.3 to 7.9


Price/square foot $76.07 to $78.19

Rent/square foot $10.57 t0 $11.60

Cap Rate 8.1 to 9.2

Did these break James or Martha?


Other ownership structures?

Lecture 3: The Dynamics of Real Estate Markets

Sensitivity Analysis

Best-Case, Worst-Case, Expected-Case Analysis

Varying Assumptions:

Discount Rate




Dynamic models

Structural model




new construction


Randomization with replacement

Create a pseudo-history

Measures of risk

Shortfall analysis


Frequency of trouble

Distribution of final sales price

Angus Cartwright 2

Application of Bootstrapping

Did the Cartwrights guess right?

How has the market changed?

Bootstrapping changes in rents

assume rents change each years

assume rents are fixed for three years

How do you handle the stretegic choice to lease?

Stochastic dominance

probability of shortfall is everywhere lower.

Correlation across rents and capital appreciation

Correlation across different markets

Is there within-city diversification?

Further Application of Bootstrapping in Real Estate and Banking

Cash-flow models and debt coverage

Modelling loan portfolios

1) historical default records

2) salvage value of default

Macroeconomics of Office Markets




Vacancy Rate

Years of Supply

Demand Factors

Employment in Finance, Insurance and Real Estate

Forecasting Demand

Cycles in the Market


Rational Anticipation of Demand and Supply

Limits of Rational Expectations:

Cobwebb Models


Supply response to price

Demand response to price

Wheaton and Di Pascuale

Is there a natural vacancy rate?

Why or why not?Vacancy and the Capacity Choice

Spence (1977) and Bulow, Geanakopolis and Klemperer (1985)

Industrial Setting

Established firm faces prospective entrant

Choice of capacity to construct is a strategic one

Sometimes, overcapacity will deter entrant

Issues in office building development

Demand - absorbtion, local economy

Supply - competition

Location - central or marginal

Design - suits demand? cost issues

Financing - construction & permanent

Construction - timing and overuns

Leasing - primary tenant, timing

Management - maintaining market share

Lecture: The Development Process: I

Motivated By Demand

Highest and Best Use

The Developer as Entrepreneur

Skills: Vision, Market Knowledge, Fungability, Management

Compensation: Fee, Profit on Sale, Long-term Equity Position

Risk: Non-Diversified on Sale

Comittment: Personal Guarantee, Non-Compete

Project Cost vs. Long-Term Hold

Create Location vs. Capitalize on Location

Site Evaluation: Transportation, Access, Local Need, Construction constraints, Zoning Issues.

Joint-Venture Partner

Equity Financing

Timing and Contingency Financing

Construction Lender

Commercial Bank Seeking Short-Term Borrower

Often Requires Take-Out, or Permanent Financing

Seeks Equity Contribution From Developer

Permanent Lender

Institutional Lender E.g. Insurnace Company

Early U.S. Mortgage-Backed Securities

Seeks Favorable Loan to Value & Debt Coverage

Development Team:


Design & Cost/Benefit

Project Oversight



Construction Documents


Feasiblity of Construction Documents

Specifications of Materials



Oversight of sub-Contactors

Electrical, Masonry, Carpentry, Plumbing, Roofing etc.


Complex Deals & Contingencies

Structure Liabilities


Planning and Zoning Boards

Tax Authorities


Feasibility Consultants: Estimate and Quantify Demand

Program Consultants: Programming For Specific Use

Energy Consultants: Maximize Efficiency

The Process:

Planning Construction Lease-Up Management Sale Demolition
Feasibility Study

Zoning Approvals

Team Formation

Architectural Design

Contractor Management

Cost & Material Control


Lease Negotiations With Primary & Secondary Tenants

Property Maintenance

Tenant Mix

Lease Renegotiation


Marketing the Property

Assessment of Demolition Costs & Alternate Use
Seek Equity & Debt Financing Based on Pro-Forma Equity Contributions & Loan Renegotiations Revise Pro-Forma According to Market Conditions Equity Participation Returns Terms of Sale
Equity Financing Construction Loan Permanent Financing Permanent Financing Disposition of Mortgage

Real Estate Auctions

RTC disposal of assets

Contract bids

Loan bids


Sealed bid

Open cry, Ascending bid

Auction Theory

Sealed bid and "Winner's Curse"

Ascending bid (English) and information revelation

Vickery equivalence:

Second Price and English

Empirical Results

Winner's Curse pervasive

Minimized by English auction

uncertainty decreased by English auction

Case Study: Olympic Tower

1985 Market

70% complete office building

28 Floors Class A

Primary tenant = Metro Bank @16/sq. ft.

Permanent financing: Fast Forward Credit, non-binding

The Loan

Union National Bank

history: 6 deals w/ Jersey

$41 Million request

$27 M. at close, $13 M. in lease-up

36 month - 60 month period

10.5% rate

1st Mortgage Lien

$4 Million personal guarantee

The Auction

Seller = Cyalater (S&L)

Buyer = Jersey Associates

NY, NJ, DL developer, growing firm, no Baltimore expertise.

Price = $31.65 Million

Bank Considerations

Default Risk

Take-out Loan

Future Business

Adverse Selection

Financing Rate

The REIT Game

This is an investment game based upon publically traded REIT's and REIT mutual funds. The object of the game is to select a portfolio of REITS that performs well.


Selections are made by groups.

You are to invest $100,000 in pretend money in publically traded REITS.

Short sales are possible.

The first portfolio selection is due in class on Thursday, December 7.

The final evaluation of the portfolio value will be on the last day of class, using closing prices from the day before.

Portfolio changes are to be reported in writing to my mailbox, or in class.

Weekly valuations are due on Thursdays, for comparison.

Non-invested money is assume to be put into 3 month t-bills at the rate as of February 9th.

The winning group takes no final exam. If they choose to take the final, or to turn in all the cases in lieu of the final, they will receive an alternate, unspecified prize that will be good.

Lecture: The Development Process II

Large-Scale Portfolios

Diversification vs. Expertise

Insurance Companies and Liability Structures

Principal-Agent Theory (Ross, 1973)

Imperfect Information -- non-overlapping information

Unobservable Actions & Efforts

Problem -- payoffs differ

Problem of economic incentives

Principal's Goals:

Delegation. To use agent's personal expertise

Extract "rents" i.e. full profits from task

Motivate agent to maximize agent's expected value

Assume risk-neutrality

Agent's Goals:

Maximize labor value. Full compensation.

Set risk-return from project to meet personal goal

Insure future work

Contract & Solutions:

Full disclosure?

Selling project to agent?

Depend upon available information

Incentive compatibility

Agency Problems as costs

Monitoring Costs

Inefficiency and Leakage

Time delays

Diversification cost-benefit

Examples in Development

Developer and Financier

Information differential: Local economy

Incentive differential: Risk aversion, timing

Moral Hazard Risk

General and Limited Partners

Information differential: Project

Incentive differential: Risk aversion, timing

Moral Hazard Risk

Developer and Labor

Information differential: Labor Effort

Incentive differential: Risk aversion, timing

Effort risk

Homeowners and Lender

Information differential: Upkeep

Incentive differential: expenses

Adeverse selection risk

Contract solutions

Costa Mesa Case

The Location


Orange County


Civic Authorities


The Market

Southern California Economy



The Parcel


Land Lease: Comparables

The Competitors


The Developer




The Financier




The Deal

Current Motivation

Future Position

The Future

Retail: Introduction to Shopping Centers

Historical Evolution

Urban to Suburban

Settlement Patterns

Taxonomy of Stores



Limited Line


Mass Merchandise



Types of Shopping Centers

Name Radius Building Area GLA


6 min. 30-100 KSF same
Community 15 min. 100-500 KSF same to 400 KSF
Regional 30+ min 500-1,000 KSF 300-800 KSF
Super-Regional 45 min. world >1,000,000 SF no limit

Shapes of Shopping Centers


Anchors for Draw

Shops for Impulse


Anchors own or lease cheaply

Specialty shops pay percentage

Gravity Models

William Reilly (1929)

"Retail Score Inversely Proportional to Distance"

Geographical Settlement Patterns


How many customers will come to the store?

Where should we locate our store?

What kind of store will work?

Example: Connecticut Retail Location Analysis


1 3.2 4.2 4.3
2 2.2 3.9 3.7
3 2.1 1.7 2.8
SQ 4,000 2,300 3,500 EST. & PROJ.

SCORE 1 2 3 SQ


A 1,250 1,818 1,908

598 678 1,353
C 814 946 1,207

TOTAL 2,612 3,340 4,465





A .48 .53 .43
B .21 .20 .30
C .31 .28 .27
1 1 1


A 214K 319K 116K 650K
B 94K 121K 80K 295K
C 139K 163K 73K 374K
448K 603K 270K

Valley Shopping Center Case


Eastman Dillon


Partners as participants


Larry Smith

Valley Shopping Center Realty Corporation

Construction Loan



Lease arrangements

percent rents


Lease arrangements

84th Street Leasing



Contingent payments

Limited Partnership

General Partners:

Three EDUS partners

share residual above 8 1/2 %

Limited Partner A:

Senior Equity

600K for 50%

8 1/2 % first claim

1/2 percent rents

Limited Partner B:

Junior Equity

400K for 50% + 200K

share residual above 8 1/2 %

1/2 percent rents

Market Report

Definition of Trade Area

Differentiation of Comparison vs. Convenience

Analysis of Competition

Valley Shopping Center Gravity Model Analysis
distances Adams Arapahoe Boulder Denver Jefferson Square Feet
Valley 34 31.5 20 7 27 500
Westminster 37.8 32.2 19.3 2.25 24.37 1200
Lakeside 43 30.1 21.4 2 20.4 589
Proposed 31.25 33.75 22.75 9.75 29.75 900
Score (Square ft. /distance)
Adams Arapahoe Boulder Denver Jefferson
Valley 15 16 25 71 19
Westminster 32 37 62 533 49
Lakeside 14 20 28 295 29
Proposed 29 27 40 92 30
Sum 89 99 154 992 127
Market Share
Adams Arapahoe Boulder Denver Jefferson
Valley 17% 16% 16% 7% 15%
Westminster 36% 38% 40% 54% 39%
Lakeside 15% 20% 18% 30% 23%
Proposed 32% 27% 26% 9% 24%
Population 178 150.8 109.3 521 205
Food 320 $56,960 $48,256 $34,976 $166,720 $65,600
Drug 65 $11,570 $9,802 $7,105 $33,865 $13,325
Variety 25 $4,450 $3,770 $2,733 $13,025 $5,125
Hardware 20 $3,560 $3,016 $2,186 $10,420 $4,100
Liquor 35 $6,230 $5,278 $3,826 $18,235 $7,175
General M. 195 $34,710 $29,406 $21,314 $101,595 $39,975
Apparel 70 $12,460 $10,556 $7,651 $36,470 $14,350
Furniture 75 $13,350 $11,310 $8,198 $39,075 $15,375
Other 45 $8,010 $6,786 $4,919 $23,445 $9,225
Total 151,300 128,180 92,905 442,850 174,250
Sales Potential Adams Arapahoe Boulder Denver Jefferson Potential Sales
Valley 25,014 20,474 15,057 31,901 25,432 117,877
Westminster 53,999 48,069 37,446 238,195 67,623 445,332
Lakeside 23,299 25,240 16,576 131,528 39,651 236,295
Proposed 48,988 34,396 23,826 41,226 41,545 189,981

Lecture: Negotiation of Real Estate Transactions


Uniqueness of buildings

Lack of comparables for pricing

Differential values for use

Negotiation Theory:

Howard Raiffa and distributive bargaining

Negotiation of the sale of a property

Rb = Highest price buyer will pay

Rs = Lowest offer seller will accept

Experimental Evidence

Seller moves first:

415 < 425 = (300+550)/2

std. of mean = 52, so out of 100 trials, difference is significant.

Agreement occurred most often when mid-point fell in zone of agreement

Mechanism Design:

Suppose each reveals reserve?

Both players lie, makeing overlap in zone of agreement less frequent

Thus mechanism is inefficient, i.e. gains from trade exist, but are not realized.

Repeated Games:

Trade-off one-shot benefit for long-term reputation

Multi-dimensional games:

Zones of agreement are easier to find


I. Prepare Reservation Price

II. Determine Dimensions of Negotiation that Matter

III. Calculate Price Trade-Offs in Several Dimensions

III. Guess Adversary's Reserve and Trade-Offs

IV. Don't Make First Move

V. Use "Split the Difference Approach, Conditional Upon a Reasonable First Bid.

VI. Be Persistant in Finding a Mutually Beneficial Solution

VII. Avoid Bulwaerism

Sears Tower: Real Estate as a Corporate Asset

Corporate Finance

What % of Sears was the Tower?

How did it Relate to Lines of Business?

Are There Synergies?

What did Tower Do to Beta?

What Did Tower Due to D/E?

Sears Objectives

Raise Money to Fight Takeover (why?)

Realize Value on Undervalued Assets

Why undervalued?

Not put to highest and best use?

Transfer pricing problems?

What of pr. value?

Methods: Sell Tower, Move Out

Why not just move out?

Why Not borrow?

What About Efficient Market Theory?

What about building liquidity?

Sears Strengths:

Tallest Building

High Rents

2% Vacancy

(Tax loss carry-forwards assumed)

Sears Weaknesses

Pre-announced strategy and price

Need to move out of building

older property

few bidders

O&Y Objectives

Further diversification

Control of major property

get a bargain

reputational effects

O&Y Strengths

Japanese out of contention

private company

hard bargainers

O&Y weaknesses

London project


I. Estimation of Reserves



II. Dimensions of Negotiation

III. Quantification of trade-offs

IV. Who moved first?

V. How did negotiation progress?

What Happened?

Taxes were a major barrier

Sears took AEW offer of a convertible mortgage, $750 m

Did this make sense from a corporate perspective?

Leverage helps or hinders?

Did it make senses from a real estate perspective?

Value of the convertible feature?

Changes Sears motivations

Lecture: Real Estate Syndication

"Syndicate" is a group of investors doing businees as a unit:


Ancient: Mesopotamia, Greeece, Rome

Medievil: Commenda, Compania

Renaissance: Trading Companies

Basic Features:

One or more partners has full liability. Some partners may have limited liability.

Benifits and costs are apportioned

In real estate:


Syndicator= deal packager.

raises money

evaluates manager

risks reputation, and takes fee over time

"best efforts" undewriting

takes a fee: 15%

Broker = salesman

markets the partnership units

takes fee: 8%

Manager = entrepreneur

has expertise with development of property management

makes business decisions

takes fee: annual fixed fee

Investor = passive role

invests money

Has preferences about risk, return and tax benefits

pays fees

Ltd. partnerships markets


1960's and 1970's

High marginal tax rates


Capital Appreciation


Integrated financial services

Asset allocation

Basic mechanisms

divide ownership by classes of shares

subdivide into units

primary market = subscription

secondary market may exist

roll-up may occur


Lincoln Towers

M.J. Raynes Company

1980's acquisition for 500 million

syndications for tax purposes and captial appreciation

sources of value:

ltd. partnership sales of occupied apartments

unoccupied apartments

sales to residents

Tax law change in 1986

first source of value disappeared

appreciation of residential property stopped

Professional's Fund


Phoenix Sun Belt City

LTD. Partner story

Strategy of principal


Auction sales

Current operations

Price/Sq. Foot?

Track Record

Luck or Skill?

Conflicts of Interest

Retirement of shares

Timing of sales


Other partnerships

Lecture: Introduction to Housing

Ownership of single family homes in the US

The housing market

Housing transactions

Governmental role


Loan guarantor

Lending regulator

Methods of housing valuation and indexation

I. Hedonic regression

A linear model of price conditional upon characteristics

Pi,t = a + b1Ci,1+ b2Ci,2+... +bkCi,k+ z1Di,1+zsDi,2+...+zTDi,T +ei,t

where Ci,j = quantity of characteristic j contained in asset i. Also a dummy indicator variable qith value 1 of asset i is in the jth category or 0 otherwise.

Di, takes on the value 1 if t = .

This captures the time effects. Thus z is an estimate of the average price at time .

bi = is the "price" of that characteristic, and may be interpreted as the effect on the price of the home.

II. Repeat-sales regression

A linear model of returns conditional upon holding period.

log(Pi,s/Pi,b )= b1Di,1+bsDi,2+...+bTDi,T + ei,t

where Di,t is a dummy variable with value 1 if the house is in the investment portfolio (i.e. t is between time b and time s for house i).

Thus, coefficient bt may be interpreted as the log return for the housing portfolio in period t.

No control for quality difference necessary

Index Problems


"price" of characteristic may change through time, i.e. # of bathrooms price increased.


You use a smaller, and possibly biased sample. Lots of coefficients to estimate, and so standard errors are bigger.


Regional appraisals: Loan to value ratios for lending

Regional trends

New derivative securities

Housing as an investment

Who buys?


How long?

What do they care about?

Private value component and public value component

How do you sell?

The search process

Benefits of owner-occupied housing



cognitive dissonance

Investment characteristics of housing

Major investment

levered investment


Comparison to othee asset classes

Mean STD home STD A C D S
Atl 7.0 3.5 9.5 1
Chi 7.0 4.8 10.5 -.01 1
Dallas 9.6 6.5 11.7 .06 .12 1
Sf 11.5 8.5 12.7 .04 .20 .19 1
S&P 12.1 18.5 -.18 -.11 .01 -.04
LTG 8.7 12.8 -.15 -.11 -.24 -.29
Inf. 7.0 3.6 .31 .03 .24 .30

Mean-Standard Deviation Space

Efficient frontier with an all-equity investment in a home in Atlanta over the period 1971- 1985.

MVP is mostly home.

With leverage at 80%, expected return of hous goes up, and still the mvp has 20% in the home.

Regional Diversification

Single-Home Risk

Effects of Leverage

Additional concern for investor:

Transactions risk and the sale of the home:

Uncertainty around the sale = 5% to 8% of value.

Regional diversification of housing in the U.S.

What causes low correlations?

Regional Housing Indices

Clustering based upon returns

Which returns move together?

Geographical proximity is major effect

Housing and Lending: Default Risk


Fairness of access to loans for housing

Targeted, pro-active lending

Housing loan markets in the U.S.

Federal Agency insurance

Diversification through MBS

Risk characteristics of loans



Risk and return in housing

Default risk:

Late payments


Lender as credit evaluator

qualifying for a loan

estimating default probability

estimating collateral value

Discount rates and loans

What if you set a hurdle rate?

e.g. only accept loan if default rating is low enough to attain a 12% discount rate.

effect: credit rationing

plenty of loans that are good deals at 13%

credit rationing leads to discrimination

e.g. discriminate on the basis of probability of default

What if the banks were discriminating by race?

They reject good loans, allowing other opportunities.

The evidence:

Boston Fed Study (1992)

Data: loans that were denied

Approach: to predict rejection via characteristics that captured economic risk. Use race of borrower and see if it were significant

White = 11% rejection, Black = 17% rejection


outliers, omitted variables, especially underwriting standards

Other approaches:

Neighborhood level rejections

1 - 0 for rejection explained by underwriting variables and race characteristics of the neighborhood

Another approach in Houston:

Use default rates to see if they are properly priced.

Lecture: Mortgage-Backed Securities: Prepayment risk

Federal Agency Mortgage-Backed securities

Ginnie-Mae (1970) MBS pass-throughs

Feddie Mac (1983) Collateralized Mortgage Obligations

Cash flows from mortgages:

Principal + Interest = Level Payment

Held until refinancing, sale or amortization

Interest-rate response: The flattening at low rates due to refinancings


A one-year zero-coupon bond

A ten-year zero coupon bond

Small changes in r make a big difference to the value of the zero.

CMO (Collateralized Mortgage Obligation)

Preferred Habitat Theory: Cut Slices Vertically!

Each tranch or slice, gets paid after the principal of preceding tranche is retired. Tranches 1:3 get interest payments while previous tranches are being retired.

Tranche 1: 1- 2 Years

Tranche 2: 2-3 Years

Tranche 3: 3-6 Years

Tranche 4: 4-10 Years

Note the behavior of the Z bond! Very sensitive to interest rates.

IO and PO securities:

Cut slices according to principal and interest

IO only gets interest (what happens to value when rates drop?)

PO only gets principal (what happens when rates drop?)


Real Estate Swaps

Real Estate Futures: Will they work?

Proposal: Case, Shiller and Weiss and CBOT

A futures contract, settled in cash, not delivery

Short Side


Municipalities (Property Taxes)

Mortgage Guarantors

Long Side

Investors seeking diversification


Annual settlement and homeowner payments

Index quality

Variation around the index

Other contracts:

Homeowners Insurance

Lecture: REITS

Real Estate Companies (Past and Present)

19th century land companies

Early 20th century Mortgage Bond Companies

1970's Formation of REIT structure

Divided Exclusion to "Qualified" REITS

How to Qualify:

Owned by 100 or more people

Less than 50 % held by fewer than 5 people

75% of asset value must be real estate, cash or govt. sec.

no more than 10% of voting rights of any one issue

95% of income from rents, dividends, interest or gains from sale

no more than 30% of income from sale of recently purchased assets. Recent = 6 months for stock, 4 years for properties.

Distributions must exceed 95% of taxable income

Mortgage Reits

Hold mortgages

Example: Rockefeller Center REIT

Rising interest rates in early 70's killed many mortgage REITs

Similar to S&L crisis: high short-term cost of funds, low-longterm asset payouts.

Equity Reits

Hold Equity positions in property

May be levered or unlevered

May be liquidating or non-liquidating

Equity REITs and the asset beta of real estate

Unlevering equity REITS: Asset beta for equity REITs about .3

Regression on S&P 500

Param Est Std Error T-Statistic

Intercept 0.00 0.00 1.36

S&P Industrials 0.50 0.09 5.38

E/E+D = .6 so asset beta is .3

Summary Stats:

13.30 geometric mean

14.62 arithmetic mean

17.15 annual std.

S&P stocks geometric mean: 11.70


Alpha for Equity REITs of:

13.30 - [7.2 + .5(11.7-7.2)] = 8.85

Pretty Good!

Information and REIT appraisal

Damadoran and Liu (1993)

Stock prices respond to the decision to appraise properties: signaling works!

Decision to appraise elicits trading by insiders. Market incorporates their forecasts.

De Bartolo REIT: A Lemons Problem?

Valuation Issues:

1) Properties

2) Management

3) Capital Structure

4) Ownership Structure


most, not all of DeBartolo Shopping Ctr. empire

regional diversification

economies of scale

good performers

end of growth period?

cyclical business?


expert in one property type

Ed jr. is the head

successful developers

why should they sell now?

why dilute their ownership?

Capital Structure

high leverage compared to industry

this affects systematic risk

unlevering and levering the industry for cost of capital

cap rate of 7.5 to 8% implies a industry of:

8 = riskless rate + industry(equity risk premium)

riskless rate = 5%, equity risk premium = 8%

so beta of industry is: 3/8 (less than .5 measured by regression!)

suppose industry leverage = .3, and DB leverage is .5

then DB levered is 3/8 * .5/.3 = 5/8, and cost of equity capital is:

5 + 5/8*8 = 10%

This is higher than the figure used by Green Street Advisors to arrive at $17/share, and it gives about $15 per share as a value.

Corporate Structure: UPREIT

Umbrella partnership REIT

REIT part-owned by DeBartolos and public. Board of outside directors, and run by old friend of DeBartolo

REIT owns shares in a ltd. partnership other shares also owned by De Bartolos

Partnership owns properties

Management partnership owned by DeBartolos

Conflicts of Interest

Ownership of other properties (tax purposes of quality holdouts?)

Uncertainty about abuse of control is a risk. Thus,

DeBartolo and public discount at different rates, and get different numbers.

DeBartolo might not sell holdings, since public vaualtion (due to private information and control) is lower than his own.

Comingled Funds: Institutional Interest in Real Estate

Comingled Fund as a "Real Estate Mutual Fund"

Buy shares and redeem them at appraisal value

Annual appraisals

Compensation on aset value of the fund

Focus on institutional investors

Real estate as inflation hedge

returns between stocks and bonds

long-duration assets

Diversification model

Historically sponsored by insurance companies

Long-term expertise in mangement

Sell shares in accounts in which they also invest

Reliable reputation


1980's boom in real estate

Pension fund RE % went from 2% to 6%

Sold on diversification

Downturn in the late 1980's

Slow to take write-downs

Liquidity crisis


Real Estate at the bottom?

How a Cref Works

q1 q2 q3 q4 q1
Prop1 Appraised Appraised
Prop2 Appraised
Prop3 Appraised
Prop4 Appraised

Appraisals smooth returns

Trick to "unsmooth" them

Moral Hazard Issues

Taurus Realty

Case: Diversification across regions and property-types.

1) Performance Evaluation

Comparison to past risk and return mixes

Were they below the frontier?

If so, why?

bad luck

bad selection


bad information for benchmarking

Issue: What data to use as a benchmark?

Approach: Re-create Taurus portfolio with your own inputs. Compare to ex-post frontier.

2) Proposal: sell off 1/3 of commercial properties and reallocate

Is this a good idea?

Approach: Find four points that identify your options

in mean-variance space. Does one dominate? Why?

3) Suppose You sell off equity portions. What happens?

Assume that you cannot re-allocate to other regions. You must put the money back into farm or residential. This decreases the percentage of commercial. Do you like this?

Lecture: International Real Estate Markets

Forces of globalization of markets

1) Peace

2) Legal Framework

3) International diversification

global companies with global pensions & assets

asset allocation

4) Application of development skills to new frontiers


Early 20th C. to today

English and Dutch international investment

Remains of colonial empires


Japanese overseas investment

The Real Estate Crash

U.S. office markets

1986 tax law change

easy credit of the 1980's

constriction of bank credit

Global markets offer clues

Returns follow GNP trends

Single major factor one component

explains 44% of variance

International Real Estate Diversification

Does mean-ariance work?

Extreme input uncertainty

Another approach:

What clusters move together?

US moves separately from UK

A pacific rim group is a possibility

Sensitivity analysis possible

Global Real Estate Case and Course Wrap-Up

Global Real Estate Case:


Liabilities = Teacher Pensions

Assets = Financial Securities

Asset Allocation Issues:

1) What is the volatility of the proposed JHY portfolio?

2) What do you anticipate will be the expected return over the next five years.

3) Can you suggest better allocations across the countries?

4) Is it possible to "time" your investment to avoid losses?

5) Are there countries that might be more attractive, currently?

6) How do these international real estate investments relate to your clients' liabilities? Are they a good hedge against U.S.-based future income? Why or why not?

7) Plot the indices for each of the four cities. Do they tell you anything about the potential for future returns and diversification?

Final Exam:


Overview of the case

REIT investment game