Notes to a Master's Level Course
Overview
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
Case: Angus Cartwright I
Case: Angus Cartwright II
Case: Olympic Tower
Case: Costa Mesa
Case: Concord Center
Case: Sears Tower
Case: Professional's Fund
Case: Seabury Associates
Case: Housing Futures: will they work?
Case: Debartolo REIT
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
Divisible
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.
Time
Freehold (titles transfer via deed)
Leasehold (lease contract)
Lessor holds title
Lessee granted possession
Life estate
Finance
Mortgage
obligation to repay via promissory note
pledge of interest conditional upon failure
What's Special About Real Estate as an Asset Class?
Immobility
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
Facts
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
Securitization
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
Acres
Private US = 1.3 B, Public U.S. = 1 B
Housing = 25 M Industry = 44 M
Agriculture = 1.25 B
How it Works
Land
Rights, primary and ancillary
Timing of Development
Construction
Office, Industrial, Retail, Residential
Financing
Syndication
Bridge
Permanent
Management
Leasing
Turnover
Maintenance
Transaction
Valuation
Marketplace
Negotiation
Taxes
Demolition
Alternative use
Lecture 2: Methods of Valuation
Comparables
Replacement Value
Discounted Future Cash Flows
Sources of Value
Land & Other Rights
Building Leases
Options -- granted and owned
Strategic Advantage
Mortgage "Put"
Leases
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
Parking
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
Example
| 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 | ||
| Rents | ||||||
| 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
convertability
re-investment risk & lease renewal
diversification & risk
borrower risk pass-through
Performance Measures
1) Price Per Square Foot
Gross and Rentable
2) Cap Rate
NOI1/Price
Tax effects
Lease effects
Depreciation
3) Equity Dividend Rate
BTCF1/ Equity Investment
4) Debt Coverage Ratio
NOI/MTG PMT
5) NPV
6) Profitability: PV/Initial Investment
7) IRR
8) Modified IRR
Angus Cartwright Case Discussion
Overview
Personnel
Properties
Market
Goal
Analysis
Solutions
Personnel
James DeRight
Retired
$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
Compensation?
Personnel Issues
James DeRight
Risk position
Recourse debt?
bankruptcy & breakeven occupancy
Investment horizon
Diversification
Martha DeRight
Risk position
Investment horizon
Diversification
Properties
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
Assumptions
vacancy
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
Comparables
price/unit
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?
Office
Price/square foot $250 to $215
Office Rents $33 to $26
Cap Rates 7.3 to 7.9
Residential
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?
Diversification?
Sensitivity Analysis
Best-Case, Worst-Case, Expected-Case Analysis
Varying Assumptions:
Discount Rate
Vacancies
Rents
Simulations
Dynamic models
Structural model
vacancies
rents
absorbtion
new construction
Bootstrapping
Randomization with replacement
Create a pseudo-history
Measures of risk
Shortfall analysis
Variance
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
Inventory
Vacancy
Absorbtion
Vacancy Rate
Years of Supply
Demand Factors
Employment in Finance, Insurance and Real Estate
Forecasting Demand
Cycles in the Market
Wheaton
Rational Anticipation of Demand and Supply
Limits of Rational Expectations:
Cobwebb Models
Cobbweb
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:
Architect
Design & Cost/Benefit
Project Oversight
Liability
Design/Development
Construction Documents
Engineer
Feasiblity of Construction Documents
Specifications of Materials
Liability
Contractor
Oversight of sub-Contactors
Electrical, Masonry, Carpentry, Plumbing, Roofing etc.
Lawyers
Complex Deals & Contingencies
Structure Liabilities
Regulators
Planning and Zoning Boards
Tax Authorities
Consultants
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 |
Marketing
Lease Negotiations With Primary & Secondary Tenants |
Property Maintenance
Tenant Mix Lease Renegotiation |
Appraisal
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
Form
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:
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.
Rules
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
Highways
Orange County
Retail/Office
Civic Authorities
Transportation
The Market
Southern California Economy
Overbuilt?
Cycles?
The Parcel
Approvals
Land Lease: Comparables
The Competitors
Segistrom
The Developer
Curci
Strengths
Weaknesses
The Financier
Copley
Strengths
Weaknesses
The Deal
Current Motivation
Future Position
The Future
Retail: Introduction to Shopping Centers
Historical Evolution
Urban to Suburban
Settlement Patterns
Taxonomy of Stores
Variety
Specialty
Limited Line
Department
Mass Merchandise
Discount
Warehouse
Types of Shopping Centers
| Name | Radius | Building Area | GLA |
| Convenience/
Neighborhood |
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
Rationale:
Anchors for Draw
Shops for Impulse
Finance:
Anchors own or lease cheaply
Specialty shops pay percentage
Gravity Models
William Reilly (1929)
"Retail Score Inversely Proportional to Distance"
Geographical Settlement Patterns
Applications:
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
DISTANCES IN MILES (OR MINUTES)
| TRACT | A | B | C | FROM MAP |
| 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
DISTANCE |
| A | 1,250 | 1,818 | 1,908 | |
| B
|
598 | 678 | 1,353 | |
| C | 814 | 946 | 1,207 |
|
| TOTAL | 2,612 | 3,340 | 4,465 |
1,250/2,612
| MKT. SHARE | 1 | 2 | 3 | SCORE A
SCORE =% ABC |
| A | .48 | .53 | .43 | |
| B | .21 | .20 | .30 | |
| C | .31 | .28 | .27 | |
| 1 | 1 | 1 |
MKT. SHARE X TRACT SALES
| POTENTIAL SALES | 1 | 2 | 3 | TOT |
| A | 214K | 319K | 116K | 650K |
| B | 94K | 121K | 80K | 295K |
| C | 139K | 163K | 73K | 374K |
| 448K | 603K | 270K |
Valley Shopping Center Case
Participants
Eastman Dillon
Syndicator
Partners as participants
Winmar
Larry Smith
Valley Shopping Center Realty Corporation
Construction Loan
Mortgage
May
Lease arrangements
percent rents
Wards
Lease arrangements
84th Street Leasing
Role?
Payments
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
Lecture: Negotiation of Real Estate Transactions Setting:
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
Lessons:
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
Process
I. Estimation of Reserves
Sears
O&Y
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
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
Sales
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
"Syndicate" is a group of investors doing businees as a unit:
History:
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:
Players:
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
Trends:
1960's and 1970's
High marginal tax rates
Inflation
Capital Appreciation
1980's
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
Example:
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
Background
Phoenix Sun Belt City
LTD. Partner story
Strategy of principal
Properties
Auction sales
Current operations
Price/Sq. Foot?
Track Record
Luck or Skill?
Conflicts of Interest
Retirement of shares
Timing of sales
Refinancing
Other partnerships
Lecture: Introduction to Housing
Ownership of single family homes in the US
The housing market
Housing transactions
Governmental role
Houser
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
Hedonic:
"price" of characteristic may change through time, i.e. # of bathrooms price increased.
RSR:
You use a smaller, and possibly biased sample. Lots of coefficients to estimate, and so standard errors
are bigger.
Applications:
Regional appraisals: Loan to value ratios for lending
Regional trends
New derivative securities
Housing as an investment
Who buys?
How?
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
maintenance
preference-matching
cognitive dissonance
Investment characteristics of housing
Major investment
levered investment
non-diversifiable
Comparison to othee asset classes
| SUMMARY STATS FOR HOME INVESTMENT: 1971-1989 | Correlations | ||||||
| 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
Issues:
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
Default
Prepayment
Risk and return in housing
Default risk:
Late payments
Non-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
Problems:
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
Duration:
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?)
CREILS
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
Homeowners
Municipalities (Property Taxes)
Mortgage Guarantors
Long Side
Investors seeking diversification
Problems:
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
So:
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
Properties
most, not all of DeBartolo Shopping Ctr. empire
regional diversification
economies of scale
good performers
end of growth period?
cyclical business?
Management
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
Background
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
Rebound
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
fees
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
Trends:
Early 20th C. to today
English and Dutch international investment
Remains of colonial empires
Recent
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:
TIAA/CREF
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:
Rules
Overview of the case
REIT investment game
Winners
Secrets
Strategies
Wrap-up