Real Estate Features
What you'll learn
- LOS 31.aCompare important real estate investment features for valuation purposes.
Private real estate investments include direct debt and equity investments in real estate. The real estate industry is composed of firms that develop, service, or operate real estate. Among the kinds of real estate investments are real estate investment trusts (REITs), which own and operate real estate investments and distribute dividends to their shareholders, and real estate operating companies (REOCs), which are taxable companies that own and operate real estate properties with few restrictions.
Classifications
Real estate investment types, in increasing order of risk and return, include the following:
Senior debt. First mortgages, and investment grade commercial mortgage backed securities (CMBS).
Core. Stable income producing properties, diversified public REITs, and sale and leaseback arrangements.
Core plus. A property that is functional and generating income, but has the potential to be improved through Minimal refurbishment, cash flow stabilizing, and tenant repositioning.
Value add. e.g., A property that could be improved through upgrades or repositioning. This category also includes sub investment grade CMBS.
Opportunistic. New development/redevelopment, and distressed debt.
One method of classifying real estate is by sensitivity to the business cycle. Defensive investments, such as health care facilities, are relatively immune to fluctuations in the overall economy. Industrial and office properties are more cyclical investments.
Another way to classify real estate is by assigning the investment to Classes A through D based on the statistical factors that influence real estate values. Class A properties are newer, high quality construction with top features, while Class D properties are the oldest, with poor quality construction and no amenities. Class A properties offer high current income but limited capital appreciation potential, while lower property classes offer more opportunity for redevelopment and capital appreciation.
Figure 31.1 outlines multifamily property classes.
Figure 31.1: Multifamily Property Classes
| Class A | Class B | Class C | Class D |
|---|---|---|---|
| Built within the past 10 years or substantially renovated | Built within past 20 years, or older property renovated | Built within past 30 years, or older property renovated | Built over 30 years ago, and located in a less desirable location |
| Top exterior and interior amenities relative to the market | Dated interior and exterior amenities relative to market | Dated exterior and limited interior amenities relative to market | Minimal exterior or interior amenities |
| High quality construction using highest quality materials | Good quality construction and only limited deferred maintenance | Deferred maintenance on aging construction | Low quality construction, poor condition, and limited remaining usability |
Figure 31.2 summarizes the primary modes of real estate investing.
Figure 31.2: Basic Forms of Real Estate Investment
| Market | Debt | Equity |
|---|---|---|
| Private | Mortgage debt; Construction loans; Mezzanine debt | Direct Ownership: Sole ownership; Joint ventures; Limited partnerships. Indirect Ownership: Real estate funds; Private REITs |
| Public | MBS/CMBS/CMOs; Covered bonds; Mortgage REITs; Mortgage ETFs | Publicly Traded Shares: Construction; Operating; Development; Public REITs; UCITS/mutual funds/ETFs |
Source: Reproduced from the Level II CFA Curriculum learning module, “Overview of Types of Real Estate Investment,” with permission from CFA Institute.
Financial Metrics
Net operating income (NOI) is the financial metric used most in real estate. Conceptually, it is similar to EBIT in accounting. As shown in Figure 31.3, NOI is the amount of income remaining after subtracting vacancy and collection losses and other operating expenses (e.g., insurance, property taxes, utilities) from gross potential rental income.
Gross potential rental income reflects current market rents, while gross rental income is based on current rents (based on existing signed leases). NOI is calculated before subtracting financing costs and income taxes.
Figure 31.3: Net Operating Income
Calculate NOI using the following information:
| Property input | Value |
|---|---|
| Property type | Office building |
| Property size | 20,000 square meters |
| Market rent for similar | €250 per square meter |
| Other income | €75,000 |
| Vacancy and collection loss | 5% of potential gross income |
| Property taxes and insurance | €350,000 |
| Utilities and maintenance | €875,000 |
| Interest expense | €400,000 |
| Income tax rate | 40% |
Solution
| Calculation | Amount |
|---|---|
| 100% occupancy rent | €5,000,000 [= 20,000 m² × €250/m²] |
| Other income | 75,000 |
| Gross potential income | €5,075,000 |
| Vacancy and collection losses | (253,750) [= 5,075,000 × 5%] |
| Operating expenses | (1,225,000) [= 350,000 + 875,000] |
| NOI | €3,596,250 |
Note that interest expense and income taxes are not considered operating expenses.
Lenders often use the debt service coverage ratio (DSCR) and the loan to value (LTV) ratio to determine the maximum allowable loan amount on a specific property:
Debt service (the loan payment) includes both interest and principal. Principal payments reduce the outstanding balance of the loan. (Though in the case of an interest only loan, debt service does not reduce the outstanding balance.)
Interest rates can be fixed, variable, or have a fixed rate period followed by a variable rate period (referred to as an adjustable rate loan).
The ratio (e.g., DSCR, LTV) that indicates the lowest amount of allowable debt will determine the maximum loan amount.
A real estate lender has agreed to make a 10% interest only loan on a property that was recently appraised at €1,200,000, provided that the debt service coverage ratio is at least 1.5 and the LTV does not exceed 80%. The property’s NOI is €135,000. Calculate the maximum loan amount.
Solution
Using the LTV, the property will support a loan amount of €1,200,000 appraised value × 80% LTV = €960,000.
Using the DSCR, the property will support a debt service payment of 135,000 NOI / 1.5 = €90,000. The corresponding loan amount is 90,000 payment / 10% interest rate = €900,000.
In this case, the maximum loan amount is €900,000, which is the lower of the two calculated values.
With a loan of €900,000, the LTV is: (900,000 loan amount / 1,200,000 appraised value) = 75%. The DSCR is: (135,000 NOI / 90,000 payment) = 1.5.
When debt is used to finance real estate, equity investors often calculate the equity dividend rate. This metric, also sometimes called the cash on cash return, measures the percentage return on the cash invested by the equity investors:
where:
The equity dividend rate only takes one period into account. It is not the same as IRR (which measures return over the entire holding period, and includes return from capital appreciation). The equity dividend rate is a pretax metric for the investor.
After tax return considers the impact of taxes (net of depreciation tax shield) on the investor’s return. After tax return is analogous to ROE. Tax allowance rates for depreciation vary by jurisdiction.
The depreciable base of a real estate investment excludes the cost of land, which is typically not depreciated.
Returning to the previous example, suppose that the property is purchased for the appraised value of €1,200,000, of which €300,000 is the value of the land. The investor’s tax rate is 20%, and the depreciation method for tax purposes is straight line over 30 years.
Calculate the following:
1. Equity dividend rate.
2. After tax return.
Solution
1. The €1,200,000 property was financed with €900,000 of debt and €300,000 of equity. First year cash flow is: (€135,000 NOI − €90,000 debt service payment) = €45,000.
Thus, the equity dividend rate is: (€45,000 first year cash flow / €300,000 equity) = 15%.
2. Depreciation = (€1,200,000 − €300,000) / 30 = €30,000.
Tax = t × (NOI − interest expense − depreciation) = 0.20 × (€135,000 − €90,000 − €30,000) = €3,000.
After tax return = (€45,000 − €3,000) / €300,000 = 14%.
Principal Risks
The two primary categories of risks affecting real estate investments are as follows:
1. Economic and competitive factors. These influence the broad real estate asset class. Such risks include changes in economic activity, changes in demographics, and the cost and availability of capital.
2. Property level risks. These are unique to individual properties. They include obsolescence (requiring extensive remodeling), rezoning, environmental factors (such as earthquakes, floods, wildfires, and energy efficiency mandates), and issues related to managing the property such as maintaining and leasing it.