Real Estate

Classification

Global INdustry Classfication Standard (GICS)

• Firms engaged in operation, developing, or servicing real estate investments
• Real estate investment trusts (REITs)

Sensitivity To Business Cycle

• Defensive (e.g. health care REITs)
• Cyclical (e.g. industrial and office REITs)

Statistical Factors

• Property classes: Ranking based on a combination of location, age, quality, income levels, and recent property appreciation

Purpose of Use

• Commercial: Lease or rental (Residential or non-residential use)
• Residential

Investment Characteristics of Commercial Property

The root purpose is to earn rental income

• Residential Use
  • Include single-family detached house or multi-family properties
  • Tenants may enjoy protections as limits on rent increases or evictions and leases are usually for a much shorter term than for non-residential properties.
• Non-residential Use
  • More closely related to economic use
  • More attached to structrual volatility
  • Office: lower development risk when built for the needs of key tenants (e.g. medical office) or major tenant commits to occupy a large portion of space. (Decrease demand due to remote work)
  • Hospitality: diverse by size, clientele, and available amenities.
    • Hotels for business travel are very cyclical
    • Hotels for tourists depend on the level of consumer confidence and siposable income
    • Destination resorts are luxurious and carry high fixed costs
  • Industrial and warehouse: designed for special industrial use and may be difficult to convert (Increasedemand due to e-commerce)
  • Retail: proximity to workers and residents affects occupancy, rents, and property prices (e.g. shopping malls, restaurants)
  • Senior housing faciolities: provide non-medical amenities (increase due to aging population)

Cash flow analysis

• Gross potential rental income (GPRI) assuming full occupancy:

$$GPRI=\text{Market rent}\times \text{Rentable space}$$

• Gross rental income (GRI)

$$GRI=\text{Current rent}\times \text{Rentable spcae}$$

• Loss to lease; $GPRI-GRI$
  • Positive: current lease to low
  • Negative: excess supply and possible failing lease rate.
• Effective gross rental income (effective GRI)

$$\text{Effective GRI}=GRI+\text{other revenue}-\text{vacancy loss}$$

• Net operating income (NOI)

$$NOI=\text{Effective GRI}-\text{Operating expenses}-\text{Property maintenance allowance}$$

Description	GBP
Gross potential rent income	5,672,000
Less: Loss to Lease	-116,500
Gross rental income	5,555,500
Less: Vacancy & collection cost	-342,600
Less: Concession & Adjustments	-281,000
Add: Other income	134,710
Add: Expense recovery from tenants	610,300
Effective gross rental income	5,676,910
Less: Operating & Leasing expenses	-3,704,510
Less: Property maintenance allowance	-456,000
Net operating income	1,516,400

Real Estate Investment Forms

	Debt	Equity
Private	- Mortgage Debt	Direct Ownership
	- Construction Loans	• Sole ownership
	- Mezzanine Debt	• Joint ventures
		• Limited partnerships
		Indirect Ownership
		• Real estate funds
		• Private REITs
Public	- MBS / CMBS / CMOs	- Publicly traded shares of construction, operating, or development companies
	- Covered Bonds	- Public REITs
	- Mortgage REITs	- UCITS / Mutual Funds / ETFs
	- Mortgage ETFs

Risk classification

Strategies	Characteristics
Opportunistic	✓ New development ✓ Equity-like return
Value-add	✓ Take vacant spaces, upgrade and reposition properties
Core-plus	✓ Minimum renovation ✓ Relatively stable cash flows
Core	✓ Invest in stable income-generating properties ✓ Use diversified public REITs
Senior debt	✓ Use mortgage or investment grade CMBS

Benefit of Real Estate

• Current income and Capital appreciation
  • Step-up clauses: pre-determined future rent rise
  • Indexed rents: change based on market variables
  • Overage rent clauses: higher rent if sales exceed the target
• Inflation hedge
• Diversification
• Tax benefit
  • Tax shield due to depreciation
  • REITs can effectively avoid double taxation

Risk of Real Estate

• Economic factors: Change in economic activity, demographics, relative supply, and the cost of capital
• Property management, obsolescence, technological change, zoning law, and environmental factors.

Real Estate Cycle

Economic Drivers

• GDP growth
• Job creation and wage growth
• Lower interest rates

Phases	Recovery	Expansion	Oversupply	Recession
Features	Business cycle trough	Higher wages and confidence	Economic soften	Economic slowdown
	Tight credit conditions	Easy credit conditions	Construction projects continue to completion	Tight credit conditions
	Little or no new construction	Start new construction and upgrades	Property glut	Construction halt
	Deferment in household formation	Increasing occupancy rates, lease rates, rents, prices	Falling occupancy, rents and property prices	Further declining occupancy, rents, prices
	Decreasing leases, rents, and prices

$$\text{Loan-to-value(LTV)}=\frac{\text{Mortagage debt outstanding}}{\text{Current property value}}$$

• Debt service coverage ratio (DSC)

$$\text{DSC}=\frac{\text{Net operating income}}{\text{Debt}}$$

• Equity return measure

$$\begin{gathered} \text{Equity dividend rate}=\frac{\text{Pre-tax cash flow}}{\text{Property purchase price-Mortagage loan}} \\ =\frac{\text{NOI}-\text{Debt Service}}{\text{Property purchase price-Mortagage loan}} \end{gathered}$$

Phases / Measures	Recovery	Expansion	Oversupply	Recession
Interest rate	Reach a bottom and begin to rise	Rising	Peak and begin to fall	Low
NOI	Reach a bottom and begin to rise	Rising	Peak and begin to fall	Falling
DSC	Reach a bottom and begin to rise	Increase	Peak and begin to fall	Decrease
LTV	Peak and begin to fall	Decrease	Reach a bottom and begin to rise	Increase

Due Diligence

• Market overview
• Current lease
• Future lease outlook
• Financial review
• Documentation re4view
• Property inspection and service agreement

Valuation

Direct Capitalization (GGM)

$$\begin{gathered} \text{cap rate}=r-g \\ \text{value}=\frac{NOI}{\text{cap rate}} \end{gathered}$$

DCF

$$\text{value}=\sum _{i=1}^n\frac{NOI}{(1+r{)}^i}+\frac{\text{Terminal value}}{(1+r{)}^n}$$

where terminal value can be obtained by GGM:

$$\text{Terminal Value}=\frac{NO{I}_n(1+g)}{r-g}$$

Cost approach

Replacement cost: includes land acquisition, property construction cost, and developer's expected profit

Adjustment (down): deduct depreciation expense and consider age, location, or other factors that lower property value

Sales Comparison approach

• Capture comparable properties' trading prices
• Adjust unit prices for differences
• Calculate the arithmetic mean of adjusted

Real Estate Indexes

Appraisal-based indexes

We calculate the Holding period return (HPR):

$$HPR=\frac{NOI-\text{Capital expenditures}+(M{V}_{End}-M{V}_{begin})}{M{V}_{begin}}$$

• Reason: Infrequent appraisals and difficult to capture changes of transaction prices timely
• Outcomes: underestimated volatility, correlation, and ovestated Sharpe ratio
• Adjustment: unsmooth or use transaction-based index

Transaction-based indexes

• The combnination of actual transactions
• Repeat sales indexes: Rely on repeat sales of same property
• Hedonic indexes: User independent regression variables to reflect value

Other indexes

• REITs indexes
• MBS indexes
• Covered bond indexes