CFA level 2 study notebook4 2015

comparethe direct capitalization and discounted cash flow valuation methods.. comparethenet assetvalue,relative value price-to-FFO and price-to-AFFO, and discounted cash flow approachest

BOOK 4 - ALTERNATIVE INVESTMENTS

StudySession13-AlternativeInvestments 9

StudySession14-FixedIncome:Valuation Concepts 140

StudySession15-FixedIncome:TopicsinFixedIncomeAnalysis 230

SCHWESERNOTES™ 2015 CFALEVELIIBOOK 4:ALTERNATIVE

INVESTMENTSAND FIXED INCOME

©2014 Kaplan,Inc.All rightsreserved

Publishedin2014 by Kaplan,Inc

Printedinthe UnitedStatesofAmerica

ISBN:978-1-4754-2772-1/1-4754-2772-7PPN:3200-5545

If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was

distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation

of global copyright laws Your assistance in pursuing potential violators of this law is greatly appreciated.

Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy

or quality of the products or services offered by Kaplan Schweser.CFA®and Chartered Financial

Analyst® are trademarks owned by CFA Institute.”

Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: “Copyright, 2014, CFA Institute Reproduced and republished from 2015 Learning Outcome Statements, Level I, II, and III questions fromCFA®

Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institutes Global

Investment Performance Standards with permission from CFA Institute All Rights Reserved.”

These materials may not be copied without written permission from the author The unauthorized

duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics.

Your assistance in pursuing potential violators of this law is greatly appreciated.

Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth

by CFA Institute in their 2015 CFA Level II Study Guide The information contained in these Notes

covers topics contained in the readings referenced by CFA Institute and is believed to be accurate.

However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes.

©2014Kaplan,Inc.

Page2

READINGS AND

READINGS

Thefollowing materialisa reviewofthe AlternativeInvestmentsand FixedIncome

principles designedtoaddress the learningoutcome statements setforthby CFAInstitute

STUDY SESSION 13

ReadingAssignments

AlternativeInvestments andFixed Income, CFAProgramCurriculum,

Volume5,LevelII (CFAInstitute,2014)

38.PrivateRealEstate Investments

39 Publicly Traded RealEstate Securities

40.PrivateEquity Valuation

41.A PrimeronCommodity Investing

page9

page42page 69page 117

STUDY SESSION 14

ReadingAssignments

AlternativeInvestments andFixedIncome,CFAProgramCurriculum,

Volume5,LevelII (CFAInstitute,2014)

42 The Term Structure andInterest Rates Dynamics

43.The Arbitrage-Free Valuation Framework

44 Valuation and Analysis: Bonds with Embedded Options

AlternativeInvestmentsand FixedIncome,CFA ProgramCurriculum,

Volume5,LevelII (CFAInstitute,2014)

45.Credit Analysis Models

46 IntroductiontoAsset-BackedSecurities

page230

page249

LEARNINGOUTCOME STATEMENTS(LOS)

The CFAInstituteLearning Outcome Statementsarelisted below Thesearerepeatedineach

topicreview;however,the order may have been changedinorderto getabetterfitwith the

flow ofthereview.

STUDY SESSION 13

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

38 PrivateRealEstate Investments

The candidate should be ableto:

a. classify and describe basic forms of realestate investments,(page9)

b describe thecharacteristics,theclassification,and basicsegmentsof realestate.

f estimateand interpret the inputs(forexample,netoperatingincome,capitalization

rate,and discountrate)tothe direct capitalization and discounted cash flowvaluationmethods,(page17)

g calculate the valueofa propertyusing the direct capitalization and discounted cashflow valuationmethods, (page17)

h comparethe direct capitalization and discounted cash flow valuation methods

(page25)

i. calculate the valueofa propertyusing thecostand sales comparison approaches

(page26)

j describe due diligenceinprivate equity realestate investment,(page31)

k discuss private equity realestateinvestment indices,including theirconstructionandpotentialbiases,(page31)

1 explain the roleinaportfolio, themajor economicvaluedeterminants, investmentcharacteristics,principalrisks,and duediligence of private realestatedebt

investment,(page12)

m. calculate and interpret financialratiosusedtoanalyze and evaluateprivaterealestate

investments,(page32)

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

39 Publicly TradedReal Estate Securities

The candidate should be ableto:

a. describetypesof publicly traded realestate securities,(page42)

b explain advantages and disadvantages of investinginrealestatethrough publiclytradedsecurities,(page43)

c. explaineconomicvaluedeterminants, investment characteristics,principalrisks,anddue diligence considerations for realestateinvestmenttrust(REIT)shares,(page45)

d describetypesofREITs,(page47)

e. justifytheuseofnet assetvaluepershare(NAVPS)inREIT valuation andestimate

NAVPSbasedonforecasted cashnetoperatingincome,(page51)

f describe theuseof funds from operations(FFO)and adjusted funds from operations

(AFFO)inREITvaluation,(page54)

g comparethenet assetvalue,relative value (price-to-FFO and price-to-AFFO), and

discounted cash flow approachestoREITvaluation,(page55)

h calculate the valueofaREIT share usingnet assetvalue,FFO and

price-to-AFFO,and discounted cash flow approaches, (page56)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

40 PrivateEquity Valuation

The candidate should be ableto:

a. explainsourcesof valuecreation inprivateequity,(page70)

b explain how private equity firms align theirinterestswith thoseof the managers of

portfolio companies, (page71)

c. distinguish between the characteristics of buyout andventurecapitalinvestments

(page72)

d describe valuationissues inbuyout andventurecapitaltransactions,(page76)

e. explain alternativeexitroutesinprivate equity and their impacton value,(page80)

f explain private equity fundstructures, terms,valuation,and duediligenceinthe

contextofananalysis of private equity fundreturns,(page81)

g explain risks andcostsof investinginprivate equity, (page86)

h interpret and compare financialperformance of private equity funds from the

perspective ofan investor,(page88)

i. calculatemanagementfees,carriedinterest, net assetvalue,distributedtopaid

in (DPI),residual valuetopaidin (RVPI),and total valuetopaidin (TVPI)ofa

private equityfund,(page91)

j calculatepre-money valuation,post-moneyvaluation,ownershipfraction,and price

pershareapplyingtheventurecapital method1)withsingleandmultiplefinancing

rounds and2) intermsofIRR.(page93)

k demonstrate alternative methodsto accountfor riskinventurecapital, (page98)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

41.A Primer onCommodity Investing

The candidate should be ableto:

a. describetypesof market participantsincommodity futuresmarkets,(page117)

b explain storability and renewabilityinthecontextof commodities and determine

whetheracommodityisstorable and/orrenewable,(page119)

c. explain theconvenienceyield and howitrelatestothe stock (inventorylevel)ofa

commodity, (page119)

d distinguishamong capitalassets,store-of-valueassets,and consumableor

transferableassetsand explain implications forvaluation,(page120)

e. comparewaysof participatingincommoditymarkets,including advantages and

disadvantages ofeach,(page121)

f explain backwardation andcontangointermsofspotandfutures prices, (page124)

g describe thecomponentsofreturn to acommodity futures andaportfolio of

commodityfutures,(page126)

h explain how the sign of the rollreturndependsontheterm structureof futures

prices, (page128)

i. compare theinsuranceperspective, the hedgingpressure hypothesis, and the theory

ofstorageand their implications for futures prices and expected futurespotprices

(page129)

STUDY SESSION 14

The topical coverage corresponds with thefollowingCFA Instituteassigned reading:

42 TheTermStructureandInterest RateDynamicsThe candidate should be ableto:

a. describe relationshipsamongspot rates,forwardrates,yieldtomaturity,expectedand realizedreturns onbonds,and the shape of the yieldcurve,(page140)

b describe the forward pricing and forwardratemodels and calculate forward andspotprices andratesusing thosemodels,(page142)

c. describe the assumptions concerning the evolution ofspot ratesinrelationto

forwardratesimplicitin activebond portfoliomanagement,(page144)

d describe thestrategyofridingtheyieldcurve,(page147)

e. explain theswaprate curve,and why and how marketparticipantsuseit in

valuation,(page148)

f calculate and interpret theswapspread foradefault-freebond,(page150)

g describe the Z-spread (page152)

h describe the TED and Libor-OIS spreads, (page153)

i explain traditional theories of theterm structureofinterestratesand describe theimplications of each theory for forwardratesand the shape of the yieldcurve

(page154)

j describe modernterm structuremodels and how theyareused,(page157)

k explain howabond’s exposuretoeachof the factors driving the yieldcurvecan

be measured and how theseexposurescanbe usedtomanageyieldcurverisks

(page159)

1 explain thematuritystructureof yield volatilities and their effectonprice volatility

(page161)Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

43 TheArbitrage-Free ValuationFramework

The candidate should be ableto:

a. explain whatismeantby arbitrage-free valuation ofafixed-incomeinstrument

(page170)

b calculate the arbitrage-free value ofanoption-free, fixed-rate coupon bond

(page171)

c. describeabinomialinterestrate tree framework,(page172)

d describe the backward induction valuationmethodologyand calculate the value ofafixed-incomeinstrumentgivenitscash flowateachnode,(page174)

e. describe the process of calibratingabinomialinterestrate tree tomatchaspecific

f comparepricing using thezero-couponyieldcurvewith pricing usinganfree binomial lattice (page178)

arbitrage-g describe pathwise valuationinabinomialinterestrateframework and calculate thevalueofafixed-incomeinstrumentgivenitscash flows along each path, (page180)

h describeaMonteCarlo forward-rate simulation anditsapplication, (page181)

The topical coverage corresponds with thefollowingCFA Instituteassigned reading:

44 Valuationand Analysis:Bonds withEmbedded Options

The candidate should be ableto:

a. describe fixed-incomesecuritieswith embedded options, (page192)

b explain the relationships between the values ofacallableorputablebond,the

underlyingoption-free(straight)bond,and the embedded option, (page193)

c. describe how the arbitrage-free frameworkcanbe usedtovalueabond with

embedded options, (page193)

d explain howinterestratevolatility alfects the value ofacallableorputable bond

(page196)

e. explain how changesinthe level and shape of the yieldcurveaffect the value ofa

callableorputablebond,(page197)

f calculate the valueofacallableorputable bond fromaninterestrate tree,(page193)

g explain the calculation anduseofoption-adjustedspreads, (page197)

h explain howinterestratevolatility affects option adjusted spreads, (page199)

i. calculate and interpret effective duration ofacallableorputablebond,(page200)

j compareeffective durationsofcallable,putable, and straightbonds,(page201)

k describe theuseof one-sided durations and keyratedurationstoevaluate theinterest

ratesensitivity of bonds with embeddedoptions,(page202)

1 compare effectiveconvexitiesofcallable,putable, and straightbonds,(page204)

m. calculate the valueofacappedorfloored floating-ratebond,(page204)

n. describedefining features ofaconvertiblebond,(page208)

o. calculate and interpret thecomponentsofaconvertible bond’svalue, (page208)

p describe howaconvertible bondisvaluedinanarbitrage-freeframework,(page211)

q compare the risk-return characteristics ofaconvertible bond with the risk-return

characteristicsofastraight bond and of the underlyingcommon stock,(page211)

STUDY SESSION 15

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

45 Credit Analysis Models

The candidate should be ableto:

a. explain probability ofdefault,loss givendefault,expectedloss,andpresentvalue

of the expectedloss,anddescribe the relative importance of eachacrossthe credit

spectrum,(page230)

b explain credit scoring and credit ratings, including why theyarecalled ordinal

rankings, (page231)

c. explain strengths and weaknesses of credit ratings, (page233)

d explain structural models ofcorporatecreditrisk,including why equitycanbe

viewedas acall optiononthecompany’sassets,(page233)

e. explain reduced form models ofcorporatecreditrisk,including why debtcan

be valuedasthesumof expected discounted cash flows afteradjustingfor risk

(page235)

f explain assumptions, strengths, and weaknesses of both structural and reduced form

models ofcorporatecreditrisk,(page237)

g explain the determinants of theterm structureof credit spreads, (page239)

h calculate and interpret thepresentvalueof the expected lossonabondoveragiven

timehorizon,(page239)

i comparethe credit analysis required for asset-backedsecuritiestoanalysis of

corporate debt,(page241)

The topical coverage corresponds with thefollowingCFA Instituteassigned reading:

46 IntroductiontoAsset-BackedSecurities

The candidate should be ableto:

a. explain benefits ofsecuritizationforeconomiesand financialmarkets,(page249)

b describe thesecuritization process,including the partiestotheprocess,the roles theyplay, and thelegalstructures involved,(page250)

c. describetypesand characteristicsof residentialmortgageloans thataretypicallysecuritized,(page252)

d describetypesand characteristicsof residential mortgage-backedsecurities,andexplain the cash flows and credit risk for eachtype,(page254)

e. explain themotivationfor creating securitizedstructureswith multiple tranches(e.g., collateralizedmortgageobligations), and the characteristics and risks ofsecuritizedstructures,(page257)

f describe the characteristics and risks of commercialmortgage-backedsecurities

outcome statements set forth by CFA Institute This topic is also covered in:

PRIVATE REAL ESTATE INVESTMENTS

Study Session 13

Thistopic reviewconcentrates onvaluationofrealestate.Thefocusisonthe three

valuation approaches used for appraisalpurposes,especially theincomeapproach Make

sure you cancalculatethevalueofa propertyusingthedirect capitalization method

andthediscountedcashflow method Makecertainyouunderstandtherelationship

between the capitalizationrateand the discountrate.Finally, understand theinvestment

characteristics and risks involved with realestateinvestments

LOS38.a:Classify and describe basic forms of realestateinvestments

CFA®ProgramCurriculum, Volume5,page7

Therearefour basic forms of realestateinvestmentthatcanbe describedintermsof

atwo-dimensionalquadrant In thefirstdimension,theinvestment can be described

intermsofpublicorprivate markets In the privatemarket,ownership usually

involvesadirectinvestmentlike purchasingproperty orlendingmoneyto apurchaser

Direct investmentscanbesolely ownedorindirectly owned through partnershipsor

commingledrealestatefunds(CREF).The public marketdoesnotinvolvedirect

investment;rather,ownership involvessecurities thatserveasclaimsontheunderlying

assets.Publicrealestate investmentincludes ownershipofarealestate investment trust

(REIT),arealestateoperatingcompany (REOC),and mortgage-backedsecurities

The second dimension describes whetheraninvestmentinvolves debtorequity An

equityinvestorhasanownershipinterest inrealestate orsecuritiesofanentitythat

ownsrealestate.Equityinvestorscontroldecisions suchasborrowingmoney,property

management,andthe exitstrategy.

Adebtinvestor is alenderthat ownsa mortgage ormortgagesecurities.Usually,the

mortgageiscollateralized(secured)by the underlying realestate.In thiscase,the lender

hasasuperior claimover anequityinvestor intheeventof default.Sincethe lender

mustberepaidfirst,thevalueofanequityinvestor’sinterestisequalto thevalueof the

propertyless theoutstanding debt

Eachof the basic forms hasits ownrisk,expectedreturns,regulations, legalissues,and

marketstructure.

Private realestateinvestmentsareusually larger than publicinvestmentsbecause real

estateisindivisible and illiquid Public realestateinvestmentsallow theproperty to

I remain undivided while allowinginvestorsdivided ownership.Asaresult,public real

estateinvestmentsare moreliquidandenableinvestorstodiversify byparticipating in

moreproperties

Realestate mustbeactively managed.Private realestateinvestment requiresproperty

managementexpertiseonthepartofthe owneror a property managementcompany In

thecaseofaREITor REOC,the realestateisprofessionally managed;thus, investorsneedno property managementexpertise

Equityinvestorsusually requireahigherrateofreturnthanmortgagelendersbecauseofhigherrisk Aspreviouslydiscussed,lendershaveasuperior claim in theeventofdefault

Asfinancialleverage(useofdebt financing)increases, returnrequirements ofbothlenders and equityinvestors increaseas aresultof higher risk

Typically, lendersexpect toreceivereturnsfrom promised cash flows and donot

participatein theappreciation of the underlyingproperty.Equityinvestorsexpect to receive an income stream as aresultof renting thepropertyand the appreciation ofvalueover time.

Figure1summarizes the basic forms of realestate investmentandcanbeusedtoidentifytheinvestmentthat bestmeets aninvestor’sobjectives

Figure1 :Basic Forms of Real EstateInvestment

Direct investmentssuchas sole ownership,

partnerships,and other forms ofcommingledfunds

Shares of REITsandREOCs

CFA®Program Curriculum,Volume5,page 9

Realestateinvestmentdiffersfrom otherassetclasses,like stocks andbonds,andcancomplicatemeasurementandperformanceassessment.

• Heterogeneity Bondsfromaparticularissuearealike,as arestocksofaspecific

company.However, no twopropertiesareexacdy thesamebecauseoflocation,size,

age, construction materials,tenants,and leaseterms.

• Highunitvalue.Because realestate is indivisible,the unitvalueissignificantlyhigher than stocks andbonds,which makesitdifficultto construct adiversifiedportfolio

©2014 Kaplan,Inc.

Page 10

• Activemanagement.Investors instocks and bondsare notnecessarily involvedin

the day-to-daymanagementof the companies.Privaterealestateinvestmentrequires

activeproperty managementby theownerora property managementcompany

Propertymanagementinvolvesmaintenance,negotiatingleases,and collectionof

rents.In eithercase, property management costs mustbe considered

• Hightransactioncosts.Buying andselling realestateiscostly becauseitinvolves

appraisers,lawyers,brokers,andconstructionpersonnel

• Depreciationand desirability Buildingswearoutover time Also,buildingsmay

become less desirable becauseoflocation,design,orobsolescence

• Costand availability of debt capital Because of the highcosts toacquire and

develop realestate, propertyvaluesareimpacted by the level ofinterestratesand

availability of debt capital Realestatevaluesareusually lower wheninterestratesare

high and debt capitalisscarce

• Lackof liquidity Realestateisilliquid It takestimetomarket and complete the

saleofproperty.

• Difficultyindeterminingprice.Stocksand bondsof public firms usually trade

in activemarkets.However,becauseof heterogeneity and lowtransaction volume,

appraisalsareusuallynecessaryto assessrealestatevalues.Even then,appraised

valuesareoften basedonsimilar,notidentical,properties The combination of

limited market participants and lack of knowledge of the local markets makesit

difficultforanoutsidertovalueproperty.Asaresult,the marketisless efficient

However,investorswith superior information and skillmayhaveanadvantagein

exploiting the market inefficiencies

The marketforREITs has expandedto overcomemanyof the problems involved with

directinvestment.SharesofaREITareactively traded andare morelikelytoreflect

marketvalue Inaddition,investinginaREITcanprovideexposureto adiversified real

estateportfolio Finally,investorsdon’t needproperty managementexpertise because the

REIT manages the properties

Realestateiscommonly classifiedasresidentialornon-residential Residential real

estateincludessingle-family (owner-occupied) homes and multi-family properties, such

as apartments.Residential realestatepurchased with theintenttoproduceincome is

usually considered commercial realestate property.

Non-residentialrealestateincludes commercial properties, other than multi-family

properties, and other properties suchasfarmland and timberland

Commercialrealestateisusually classified byitsenduseand includes multi-family,

office, industrial/warehouse, retail,hospitality, and othertypesof properties suchas

parkingfacilities,restaurants,and recreational properties.Amixed-use developmentisa

propertythatserves morethanoneenduser

Somecommercial properties requiremore managementattentionthan others For

example, of all the commercialproperty types,hotelsrequirethemostday-to-day

attentionandare morelike operatingabusiness.Becauseof higher operationalrisk,

investorsrequire higherratesofreturn onmanagement-intensive properties

I Farmland and timberlandareunique categories(separate from commercial realestate

classification)because eachcanproduceasaleable commodityaswellashave the

potentialforcapitalappreciation

LOS38.c:Explain the roleinaportfolio,economicvaluedeterminants,investment characteristics,andprincipalrisksof private realestate.

LOS38.1: Explainthe rolein aportfolio,the majoreconomicvalue

determinants, investment characteristics,principalrisks,and duediligenceofprivate realestatedebtinvestment

CFA®ProgramCurriculum, Volume5,page 13

Currentincome.Investors mayexpect to earn incomefromcollectingrentsandafter

paying operatingexpenses,financingcosts,andtaxes.

Capitalappreciation Investorsusuallyexpect propertyvaluesto increaseovertime,whichformspartoftheirtotalreturn.

Inflation hedge Duringinflation, investorsexpectboth rentsandpropertyvaluesto

rise

Diversification Realestate,especially private equityinvestment,isless than perfectlycorrelated with thereturnsofstocksandbonds.Thus,addingprivaterealestate investment to aportfoliocanreducerisk relativetotheexpectedreturn.

Taxbenefits Insome countries,realestate investors receivefavorabletax treatment.For

example,in theUnitedStates,the depreciablelifeofrealestate isusuallyshorterthan

the actual life.Asaresult,depreciationexpense ishigher, and taxableincome islowerresultinginlowerincometaxes.Also,REITs donotpaytaxesinsome countries,which

allowinvestors toescape double taxation(e.g.,taxation atthecorporatelevelandthe

individuallevel).

PRINCIPAL RISKSBusinessconditions.Numerouseconomicfactors—suchasgrossdomestic product

(GDP),employment, householdincome,interestrates,and inflation—affecttherentalmarket

Newpropertyleadtime.Market conditionscanchange significantly whileapprovalsare

obtained, while thepropertyiscompleted,and whenthepropertyisfullyleased.During

theleadtime,ifmarketconditionsweaken, theresultant lower demandaffectsrentsand

vacancyresultinginlowerreturns.

Costand availabilityofcapital Realestate must competewith otherinvestments for

capital.Aspreviouslydiscussed,demandfor realestateisreduced when debt capital

©2014 Kaplan,Inc.

Page 12

isscarceandinterestrates arehigh Conversely, demandishigher when debtcapital

iseasily obtained andinterestratesarelow.Thus,realestatepricescanbe affected by

capital market forces withoutchangesindemandfromtenants.

Unexpected inflation Some leasesprovide inflation protection byallowingownersto

increaserentorpass through expenses because of inflation Realestatevaluesmaynot

keepupwith inflation when marketsareweak andvacancyrates arehigh

Demographic factors The demand for realestateisaffectedby thesizeandage

distribution of the local market population, the distribution ofsocioeconomic groups,

andnewhousehold formationrates.

Lackof liquidity Because of thesizeand complexity ofmostrealestate transactions,

buyers and lenders usuallyperform due diligence, which takestimeandiscostly.Aquick

sale will typically requireasignificant discount

Environmentalissues.Realestatevaluescanbe significantly reduced whena property

has been contaminated byapriorowner oradjacentproperty owner.

Availability of information.Alackof information when performingpropertyanalysis

increasesrisk The availability of data dependsonthecountry,but generallymore

informationisavailableasrealestateinvestmentsbecomemoreglobal

Management expertise Property managers andassetmanagersmustmake important

operational decisions—suchasnegotiatingleases,property maintenance,marketing, and

renovating theproperty—whennecessary

Leverage Theuseof debt (leverage)tofinancearealestatepurchaseismeasuredby

the loan-to-value(LTV) ratio.Higher LTV resultsinhigher leverageand, thus,higher

risk because lenders haveasuperior claimintheeventof default Withleverage,asmall

decreaseinnetoperatingincome (NOI)negatively magnifies theamountof cash flow

availabletoequityinvestorsafter debtservice

Otherfactors Other riskfactors,suchasunobservedpropertydefects,naturaldisasters,

andactsofterrorism,maybe unidentifiedatthetimeof purchase

Insome cases,risks thatcanbe identifiedcanbe hedged usinginsurance.In othercases,

riskcanbe shiftedtothetenants.Forexample,aleaseagreementcould require the

tenant toreimburseanyunexpected operatingexpenses

The Roleof Real EstateinaPortfolio

Realestateinvestmenthas both bond-like and stock-like characteristics.Leases are

contractualagreementsthat usually call for periodic rentalpayments,similartothe

couponpaymentsofabond Whenalease expires, thereis uncertaintyregarding renewal

andfuture rentalrates.This uncertaintyisaffected by the availability of competing

space,tenantprofitability, and thestateof the overalleconomy,justasstockprices are

affected by thesamefactors Asaresult,the risk/return profile of realestate asanasset

class, isusually between the risk/return profiles of stocks and bonds

I RoleofLeverageinReal EstateInvestment

Sofar,ourdiscussionof valuation has ignored debt financing Earlierwedeterminedthat the level ofinterestratesand the availability of debt capital impact realestateprices

However,thepercentageof debt and equity used byan investortofinance realestatedoesnotaffect theproperty’svalue

Investorsusedebt financing (leverage)toincreasereturns.Aslongastheinvestment

returnisgreaterthan theinterestpaidtolenders,thereispositive leverage andreturns aremagnified Ofcourse,leveragecanalso workinreverse.Becauseof thegreateruncertainty involved with debtfinancing, riskishighersincelenders haveasuperiorclaimtocash flow

LOS 38.d: Describe commercialpropertytypes,includingtheir distinctive

investmentcharacteristics

CFA®ProgramCurriculum, Volume5,page 19

Commercial PropertyTypes

The basicproperty typesusedto create alow-riskportfolio includeoffice,industrial/

warehouse, retail,andmulti-family Someinvestorsinclude hospitality properties

(hotelsandmotels)eventhough the propertiesareconsidered riskiersinceleasesare not

involved andperformanceishighlycorrelated with the business cycle

Itisimportanttoknow that with allproperty types,locationiscriticalindeterminingvalue

Office Demandisheavily dependentonjob growth, especiallyinindustriesthatare

heavyusersof office space like finance andinsurance.The average length of office leases

variesglobally

Inagross lease,theowner isresponsible for the operating expenses, andina netlease,

thetenantisresponsible Ina netlease,thetenantbears the risk if the actual operating

expensesare greaterthan expected.Asaresult,rentundera netleaseislower thanagross lease

Someleases combinefeatures from both gross andnetleases.Forexample, theowner

might pay the operating expensesinthe firstyearof the lease.Thereafter, any increase in

theexpenses ispassed throughtothetenant.Inamulti-tenant building, theexpensesareusually prorated basedonsquarefootage

Understandinghow leasesarestructuredisimperativeinanalyzingrealestate

Retail Demandisheavily dependenton consumerspending.Consumerspendingis

affectedbythe overall economy,job growth,population growth,and savingsrates.Retail

leasetermsvarybythequalityof theproperty aswellasthesizeandimportance of the

tenant.Forexample,ananchortenantmay receivefavorable leaseterms to attractthem

totheproperty.Inturn,the anchortenantwill draw othertenants totheproperty.

Retailtenants areoften requiredtopayadditionalrent oncesales reachacertainlevel

This unique featureisknownas a percentageleaseor percentage rent.Accordingly, the

lease willspecifya minimum amountofrent tobepaid without regardtosales The

minimumrentalsoserves asthestartingpoint forcalculatingthepercentage rent.

Forexample, imaginethataretail leasespecifiesminimumrentof$20per square foot

plus5%of salesover$400 per squarefoot If saleswere$400 per square foot,the

minimumrentandpercentage rentwould be equivalent($400salesper squarefoot x

5% =$20per squarefoot).Inthiscase,$400isknownasthe naturalbreakpoint If

sales are$500per square foot,rentper square foot isequalto$25[$20 minimumrent +

$5percentage rent ($500-$400) x 5%].Alternatively,rentpersquarefootisequalto

$500salesper squarefoot x 5% = $25 becauseof thenaturalbreakpoint

Multi-family Demand dependsonpopulation growth, especiallyintheage

demographicthattypicallyrents apartments.Theagedemographiccanvarybycountry,

typeofproperty,andlocale.Demandisalsoaffected by thecostofbuyingversus the

costof renting, whichismeasuredby theratio ofhomepricesto rents.Ashomeprices

rise,thereisashift toward renting.An increase in interestrateswill also make buying

moreexpensive

LOS38.e:Comparetheincome,cost,and sales comparisonapproachesto

valuingrealestateproperties

CFA®ProgramCurriculum,Volume5,page 25

REALESTATE APPRAISALS

Sincecommercial realestatetransactionsareinfrequent, appraisalsareusedto estimate

valueor assesschangesin valueover timein orderto measureperformance.Inmost

cases,thefocusofanappraisalismarket value;thatis,themostprobable salespricea

typicalinvestor iswillingtopay.Other definitionsof value includeinvestmentvalue,

the valueorworth that considersaparticularinvestor’smotivations;valuein use,the

valueto aparticularusersuchas amanufacturerthatisusing theproperty as a partof

itsbusiness;and assessed value thatisused byataxing authority.For purposes ofvaluing

collateral,lenderssometimesuse a moreconservativemortgagelending value

ValuationApproaches

Appraisersusethree different approachestovalue realestate:thecostapproach, the sales

comparisonapproach, and theincomeapproach

I The premise of thecostapproachisthatabuyer wouldnotpaymorefora propertythan

itwouldcost topurchase land andconstruct acomparable building Consequently,under thecostapproach, valueisderived by adding the value of the landtothecurrentreplacementcostofanewbuilding less adjustments for estimateddepreciation andobsolescence.Becauseof the difficultyinmeasuringdepreciation andobsolescence,

thecostapproachismostuseful when the subjectpropertyisrelativelynew.Thecostapproachisoften usedforunusual propertiesor propertieswhere comparable

transactionsarelimited

The premise of the sales comparison approachisthatabuyer would payno morefor

a propertythan othersarepaying for similar properties With the sales comparisonapproach, the sale prices of similar (comparable) propertiesareadjusted for differenceswith thesubjectproperty.The sales comparison approachismostuseful when thereareanumberof properties similartothe subject that have recentlysold,asisusually thecasewith single-family homes

The premise of theincomeapproachisthat valueisbasedonthe expectedrateofreturn

required byabuyertoinvest inthe subjectproperty.With theincomeapproach, value

isequaltothepresentvalueof thesubject’sfuture cash flows Theincomeapproachis

mostusefulincommercial realestatetransactions

Highestand Best UseTheconceptof highest and bestuseis important indetermining value The highest andbestuseofa vacantsite isnotnecessarily theusethat resultsinthe highest total valueonce aproject iscompleted.Rather,the highest and best useofa vacantsite is theusethat produces thehighestimplied land value The implied land valueisequaltothevalueof thepropertyonceconstruction iscompleted less thecostof constructing theimprovements, includingprofittothe developertohandleconstructionand lease-out

Example: Highest and bestuse

An investor isconsideringasitetobuild eitheranapartmentbuildingorashopping

center.Onceconstruction iscomplete, theapartmentbuilding would havean

estimated valueof €50 million and the shoppingcenterwould haveanestimated value

of€40 million.Constructioncosts,including developer profit,areestimatedat€45

millionfor theapartmentbuilding and€34millionfor the shoppingcenter.Calculatethe highest and bestuseof thesite

Theshoppingcenter isthehighest andbestusefor thesitebecausethe €6 million

implied land value of the shoppingcenterishigher than the €5 million implied land

valueof theapartmentbuildingasfollows:

Apartment Building ShoppingCenter Value whencompleted

Less: Construction costs

Impliedland value

€40,000,000 34,000,000

€50,000,000 45,000,000

€6,000,000

€5,000,000

Notethat the highest and bestuseis notbasedonthe highest value when theprojects

arecompletedbut, rather,the highest implied land value

LOS38.f:Estimateandinterprettheinputs (forexample,netoperating

income,capitalizationrate,and discount rate)tothe directcapitalizationand

discounted cash flow valuation methods

LOS38.g:Calculatethe value ofa propertyusing the direct capitalization and

discounted cash flow valuation methods

CFA®ProgramCurriculum,Volume5,page 27

Theincomeapproach includestwodifferent valuation methods: the direct capitalization

method andthediscounted cashflowmethod Withthe directcapitalizationmethod,

valueisbasedoncapitalizingthefirstyear NOIofthepropertyusingacapitalization

rate.With the discounted cashflowmethod,valueisbasedonthepresentvalueof the

property’s futurecash flowsusinganappropriate discountrate.

ValueisbasedonNOIunder bothmethods.AsshowninFigure2,NOI istheamount

ofincomeremaining aftersubtractingvacancyandcollection losses,andoperating

expenses(e.g.,insurance, property taxes,utilities,maintenance,and repairs)from

potentialgross income NOI iscalculated before subtracting financingcostsandincome

taxes.

Figure2:NetOperatingIncome

Rentalincomeif fully occupied

+ Other income

= Potential grossincome

— Vacancy andcollection loss

= Effectivegross income

- Operatingexpense

= Net operatingincome

Example:Net operatingincome

m

Calculatenetoperatingincome (NOI)using thefollowinginformation:

PropertytypePropertysizeGrossrentalincomeOtherincome

Vacancy and collection lossPropertytaxesandinsuranceUtilities andmaintenance

Interest expenseIncometax rate

Net operatingincome

Notethatinterest expenseandincometaxes are notconsidered operatingexpenses

TheCapitalizationRate

Thecapitalizationrate, orcaprate,andthediscountrate are notthesame ratealthoughtheyarerelated.Thediscountrateisthe requiredrateofreturn;thatis,the risk-freerate

plusarisk premium

Thecaprateisappliedtofirst-yearNOI,and the discountrateisappliedtofirst-year

andfutureNOI.So,ifNOIandvalue isexpectedtogrowat a constant rate,the caprate

islower than thediscountrate asfollows:

cap rate=discountrate -growthrate

Using the previousformula,we can saythe growthrateisimplicitly includedin thecap

rate.

The caprate canbedefinedasthecurrentyieldonthe investmentasfollows:

NOIlcaprate=

valueSincethe caprateisbasedonfirst-yearNOI,it issometimescalledthegoing-incaprate.

Byrearranging the previous formula,we can nowsolveforvalueasfollows:

If thecaprateis unknown,itcanbe derivedfromrecentcomparabletransactionsas

follows:

NOIt

caprate=

comparable sales price

Itisimportanttoobserve several comparabletransactionswhen deriving thecaprate.

Implicitinthecapratederivedfrom comparabletransactions areinvestors’ expectations

ofincomegrowth and risk.Inthiscase,the caprateissimilartothe reciprocal of the

price-earningsmultiple for equitysecurities

Example: Valuation usingthedirect capitalization method

Imagine thatnetoperatingincomeforanoffice buildingisexpectedtobe$175,000,

andanappropriatecaprateis8% Estimatethe market valueof thepropertyusing the

direct capitalization method

Answer:

The estimated market valueis:

NOhl $175,000

=$2,187,500V0 =

8%

caprate

Whentenantsarerequiredtopay all expenses, the capratecanbe appliedto rentinstead

of NOI Dividingrentby comparable sales price givesustheall risks yield(ARY) Inthis

case,theARY isthecaprateand will differ from the discountrateifaninvestorexpects

growthin rentsand value

value= V0 =0

ARY

Ifrents areexpectedtoincreaseat a constant rateeachyear,the internalrateofreturn

(IRR)canbe approximated by summing thecaprateand growthrate.

Stabilized NOI

Recall thecaprateisappliedtofirst-year NOI If NOIisnotrepresentative of the

NOIof similar properties because ofa temporary issue,the subjectproperty’sNOI

should be stabilized.Forexample, supposea propertyistemporarily experiencing high

vacancyduringamajorrenovation.In thiscase,the first-year NOI should bestabilized;

NOIshouldbe calculatedasif therenovation iscomplete Once the stabilized NOIis

capitalized, the lossin value,as aresultof thetemporarydeclinein NOI, issubtracted

inarrivingatthe valueof theproperty.

I Example: Valuation duringrenovation

OnJanuary1of thisyear, renovationbeganonashoppingcenter.Thisyear,NOI

isforecastedat€6 million Absentrenovations,NOIwould have been€10million

After thisyear, NOI isexpectedtoincrease4% annually Assuming allrenovationsarecompleted by the sellerattheirexpense, estimatethe valueof theshoppingcenter asofthe beginning of thisyearassuminginvestorsrequirea12%rateofreturn.

The total valueof the shoppingcenteris:

ValueafterrenovationsLoss invalue duringrenovations

value= gross incomexgross incomemultiplier

Ashortfallof thegross incomemultiplieristhatitignoresvacancyratesand operating

expenses Thus,if thesubjectproperty’svacancyrateand operatingexpenses arehigher

than those of the comparabletransactions,an investorwill paymorefor thesamerent.

©2014 Kaplan,Inc.

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Discounted Cash Flow Method

Recallfromourearlierdiscussion,wedetermined the growthrateisimplicitly included

inthecaprate asfollows:

caprate=discountrate-growthrate

Rearranging the above formulawe get:

discountrate=caprate +growthrate

So,wecan saytheinvestorsrateofreturnincludes thereturnonfirst-year NOI

(measuredby thecap rate)and the growthin incomeand valueovertime (measuredby

thegrowthrate).

=raterequired by equityinvestorsfor similar properties

=growthrateof NOI(assumedtobeconstant)

r- g =caprate

g

Professor’sNote: This equation should lookveryfamiliartoyoubecauseit’s just amodifiedversionoftheconstantgrowth dividend discountmodel,also knownas

the Gordon growthmodel,fromthe equity valuation portionofthe curriculum

Ifnogrowthisexpectedin NOI,then thecaprateand the discountrate arethesame.In

thiscase,valueiscalculated just likeanyperpetuity

Terminal Cap Rate

Using the discounted cash flow(DCF)method, investorsusually project NOI fora

specific holding period and thepropertyvalueatthe endof the holding period rather

than projecting NOIintoinfinity Unfortunately, estimating thepropertyvalueat

the end of the holding period, knownasthe terminal value(alsoknownasreversion

orresale),ischallenging.However, sincethe terminal valueisjust thepresentvalueof

the NOI received by thenext investor, wecanusethe direct capitalization methodto

estimatethe valueof thepropertywhen sold In thiscase, weneedtoestimatethefuture

NOIandafuturecaprate,knownasthe terminalor residualcaprate.

The terminalcaprateisnotnecessarily thesame asthe going-incaprate.The terminal

capratecouldbehigherifinterestratesareexpectedtoincrease inthefutureorifthe

growthrateisprojectedtobe lower because thepropertywould then be older and might

be less competitive.Also,uncertainty about future NOImayresultinahigher terminal

caprate.The terminalcapratecould be lower ifinterestrates areexpectedtobe loweror

if rentalincomegrowthisprojectedtobehigher.These relationshipsareeasily mastered

using the formulapresented earlier (caprate=discountrate-growthrate)

I Sincethe terminal valueoccursin thefuture, itmustbe discountedto present.Thus,the

valueof theproperty isequaltothepresentvalueof NOIovertheholding periodandthepresentvalueof the terminalvalue

Example: Valuation with terminal value

Because of existingleases,theNOIofawarehouse isexpected tobe $1 million peryearoverthenextfour years Beginning in the fifth year, NOIisexpectedto increase

to$1.2 millionandgrowat3%annuallythereafter.Assuminginvestors requirea13%

return,calculate the valueof thepropertytoday assuming the warehouseissoldafterfouryears

PVof forecastNOI

PVof terminal valueTotalvalue

$2,974,471 7,359,825

topayallexpenses Inthiscase,thecaprateisknownastheARYasdiscussed earlier

Adjustmentsmustbe made when thecontract rent(passingor term rent)and the

currentmarketrent(openmarketrent)differ.Oncethe lease expires,rentwilllikelybe

adjustedtothecurrentmarketrent.IntheU.K.theproperty issaidtohavereversionary

potential when thecontract rentexpires

One wayof dealing with the problemisknownasthetermandreversionapproachwhereby thecontract (term) rentand the reversionareappraised separately usingdifferentcaprates.Thereversioncaprate isderivedfromcomparable, fullylet,

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properties.Becausethereversionoccursinthefuture, itmustbe discountedto present.

Thediscountrateappliedtothecontract rentwill likely be lowerthan the reversionrate

becausethecontract rent islessrisky(theexistingtenants are notlikelytodefaulton a

below-marketlease).

Example:Term and Reversion ValuationApproach

Asingle-tenantofficebuildingwasleasedsixyears agoat £200,000per year Thenext

rent review occursintwoyears Theestimatedrentalvalue(ERV)intwoyearsbased

on currentmarket conditionsis£300,000per year.The all risksyield (caprate)for

comparable fullyletpropertiesis 7% Becauseoflower risk,the appropriaterate to

discounttheterm rent is6%.Estimatethevalueof the officebuilding

Thepresentvalueof thereversion toERVis:

Exceptfor thedifferencesinterminology andtheuseofdifferentcapratesfortheterm

rentandreversionto currentmarketrents,thetermandreversionapproachissimilarto

thevaluationexampleusingaterminal value

A variationof thetermandreversionapproachisthe layer method With the layer

method, onesource(layer)of incomeisthecontract (term) rentthat isassumedto

continue in perpetuity Thesecond layeristheincreaseinrentthatoccurswhenthe

lease expires and therentisreviewed.A capratesimilartotheARY isappliedto

theterm rentbecause theterm rentisless risky.Ahighercaprateisappliedtothe

incrementalincomethatoccurs as aresultof therentreview

I Example: Layer method

Let’sreturn tothe example thatweusedtoillustrate thetermandreversionvaluationapproach Suppose thecontract(term)rentisdiscountedat 7%,and the incremental

rentisdiscountedat8%.Calculate the valueof the office building today using thelayer method

Answer:

The valueofterm rent (bottomlayer)intoperpetuityis:

200,000 term rent

=£2,857,143

term rentcaprate 7%

The valueof incrementalrentintoperpetuity(attimet=2) is:

(300,000-200,000)

ERV

=£1,250,000

ERVcaprate 8%

Usingourfinancialcalculator, thepresentvalueoftheincrementalrent(top layer)into

£2,857,143

1.071.674

£3,928,817

Using thetermandreversionapproach and the layermethod,different caprateswere

appliedtotheterm rentand thecurrentmarketrentafterreview.Alternatively,asinglediscountrate,knownastheequivalentyield,could have been used Theequivalent yield

isanaverage,althoughnot asimple average, of thetwo separatecaprates.

Using the discounted cash flow method requires thefollowingestimatesandassumptions, especially for properties withmanytenantsand complicated lease

structures:

• Projectincomefromexisting leases Itisnecessarytotrack thestartand end dates andthevariouscomponentsof eachlease,suchasbaserent,index adjustments, and

expensereimbursements fromtenants.

• Leaserenewalassumptions.May require estimating the probability of renewal

• Operatingexpenseassumptions Operatingexpensescanbe classifiedasfixed, variable,

orahybrid of thetwo.Variable expensesvarywith occupancy, while fixed expenses

donot.Fixedexpensescanchange because of inflation

• Capital expenditureassumptions.Expenditures for capital improvements, suchasroofreplacement,renovation,andtenantfinish-out, arelumpy; thatis,they donotoccur

evenlyover time.Consequently,someappraisers average thecapital expenditures anddeductaportion eachyearinsteadof deducting theentireamountwhen paid

• Vacancyassumptions.Itis necessarytoestimatehow long before currentlyvacant

space isleased

• Estimated resale price.Aholdingperiod that extends beyond the existing leases

should be chosen This will makeit easiertoestimatethe resale price because all

leases will reflectcurrentmarketrents.

• Appropriate discountrate.The discountrateisnotdirectlyobservable,butsome

analystsusebuyersurveysas aguide The discountrateshould behigherthan the

mortgage ratebecauseofmorerisk and should reflect the riskinessof theinvestment

relativetoother alternatives

Example:Allocationofoperatingexpenses

Total operating expenses foramulti-tenant office buildingare30%fixed and 70%

variable If the100,000squarefoot buildingwasfully occupied, operatingexpenses

would total$6 per squarefoot The buildingiscurrently90%occupied If the total

operatingexpensesareallocatedtothe occupiedspace,calculate the operatingexpense

peroccupied square foot

Answer:

If the buildingisfully occupied, total operating expenses would be$600,000(100,000

SF x$6 per SF).Fixed and variable operatingexpenseswould be:

Fixed

Variable

Total

Thus,variable operating expensesare$4.20 persquarefoot($420,000 /100,000SF)

if the buildingisfully occupied.Sincethe buildingis 90%occupied, total operating

So,operatingexpenses peroccupiedsquarefootare$6.20 (558,000total operating

first-year NOI Implicitinthe caprateormultiplierareexpectedincreases ingrowth

Under the discounted cash flow(DCF) method,thefuture cashflows,including the

capital expenditures and terminalvalue,areprojectedoverthe holding period and

discountedto present atthe discountrate.Futuregrowthof NOIisexplicitinthe DCF

method

I Becauseof the inputs required, the DCF methodismorecomplex than the direct

capitalizationmethod,asitfocusesonNOIovertheentireholdingperiod andnot

just NOIinthefirstyear.DCFdoesnotrelyoncomparabletransactionsaslongasan

appropriate discountrateischosen Choosing the appropriate discountrateand terminal

caprate arecrucialassmall differencesintherates cansignificantly affect value

Followingare some common errorsmade using the DCF method:

• The discountratedoesnotadequatelycapturerisk

• Incomegrowth exceeds expense growth

• The terminalcaprateand the going-incaprate are notconsistent

• The terminalcaprateisappliedtoNOIthatisatypical

• Thecyclicality of realestatemarketsisignored

LOS 38.i:Calculatethe valueofapropertyusing thecostand sales comparison

approach involves estimating the market value of theland,estimating thereplacement

costof the building, and adjusting for depreciation and obsolescence Thecostapproach

isoften usedfor unusual propertiesorproperties wherecomparabletransactions are

limited

Professor’sNote: Depreciationforappraisalpurposesis notthe same asdepreciation usedforfinancialreportingor taxreportingpurposes.Financialdepreciation andtaxdepreciation involve the allocationoforiginalcost over time.Forappraisalpurposes,depreciationrepresentsanactual declinein value

Thestepsinvolvedinapplying thecostapproachareasfollows:

Step1: Estimatethe market valueof the land The value of the landisestimatedseparately, often using the sales comparison approach

Step2: Estimatethe building’s replacementcost.Replacementcostisbasedon current

constructioncostsand standards and should includeanybuilder/developer’sprofit

Professor’sNote:Replacementcostreferstothecostofabuilding havingthe

sameutility but constructed with modern building materials Reproductioncostreferstothecostofreproducinganexactreplicaofthe buildingusingthesamebuildingmaterials,architectural design, andqualityofconstruction

Replacementcostisusuallymorerelevantforappraisalpurposesbecausereproductioncostmay be uneconomical

Step3: Deduct depreciation including physicaldeterioration,functionalobsolescence,

locationalobsolescence,and economic obsolescence.Physical deteriorationis

relatedtothebuilding’sageandoccursas aresultof normalwearandtear over

time.Physical deteriorationcanbecurableorincurable.Anitem iscurable ifthe

benefitoffixingtheproblemis atleastasmuchasthecost tocure Forexample,

replacingtheroof will likelyincreasethe value ofthebuilding byatleastas

muchasthecostof the roof Thecostof fixing curableitems issubtracted from

replacementcost.

Anitem isincurable iftheproblemis noteconomicallyfeasibletoremedy.For

example,thecostoffixingastructural problem might exceed the benefit ofthe

repair.Sinceanincurable defect wouldnotbefixed,depreciationcanbe estimated

basedonthe effective age of thepropertyrelativeto itstotaleconomiclife For

example,thephysical depreciationofa propertywithaneffectiveage of 30 years

anda50-yeartotaleconomiclifeis60%(30 yeareffectiveage /50year economic

life).To avoid double counting, the age/liferatio ismultiplied by and deducted from

replacementcost minusthecostoffixing curableitems.

Professor’sNote:Theeffectiveage and the actual agecandifferas aresultof

above-normalorbelow-normalwear andtear.Incurableitemsincreasethe

effectiveageoftheproperty.

Functional obsolescenceisthe lossinvalue resultingfromdefectsindesign that

impairsabuilding’s utility.Forexample,abuilding might haveabad floor plan.As

aresultof functionalobsolescence,NOI isusuallylower thanitotherwisewould be

becauseoflowerrent orhigheroperatingexpenses.Functionalobsolescencecanbe

estimated by capitalizing the declineinNOI

Locational obsolescenceoccurswhenthelocationis nolonger optimal.Forexample,

fiveyearsafteraluxuryapartmentcomplexiscompleted,aprison isbuilt down the

streetmakingthe locationoftheapartmentcomplexless desirable Asaresult, lower

rentalrateswilldecreasethevalueof thecomplex.Caremustbe taken indeducting

the loss invalue becausepartof the lossislikely already reflectedin the marketvalue

of the land

Economicobsolescenceoccurswhennewconstruction isnotfeasible undercurrent

economicconditions.Thiscan occurwhen rentalrates are notsufficientto support

theproperty.Consequently,thereplacementcostof thesubjectpropertyexceeds the

valueofa newbuilding ifit wasdeveloped

I Example: Thecostapproach

HeavenlyTowersisa 200,000squarefoot high-riseapartmentbuilding locatedinthedowntownarea.

The building hasaneffectiveageof10 years,whileitstotaleconomiclifeisestimated

at40years.The building hasastructural problem thatisnotfeasibletorepair Thebuilding also needsa newroofat a costof€1,000,000.Thenewroof willincreasethevalueof the building by€1,300,000.

The bedroomsineachapartmentaretoosmall and the floor plansareawkward Asaresultof the poor design,rentsare €400,000ayearlower than competing properties

When Heavenly Towerswasoriginallybuilt, itwaslocatedacrossthestreetfromapark.Five years ago,thecityconverted the parkto asewagetreatmentplant Thenegative impacton rentsisestimatedat€600,000ayear

Dueto recentconstructionof competing properties,vacancyrateshave increased

significantlyresultinginalossofanestimated valueof€1,200,000.

Thecost toreplace Heavenly Towersisestimatedat€400per squarefoot plus builderprofit of€5,000,000.The market valueof the landisestimatedat €20,000,000.An

appropriatecaprateis8%.Using thecostapproach,estimatethe valueof HeavenlyTowers

Incurable functional obsolescence-poor design

[400,000lowerrent/ 8% cap rate]

Locational obsolescence- sewageplant

[600,000lowerrent/ 8% cap rate]

Economicobsolescence-competing propertiesMarket valueof land

Estimated value using thecostapproach

85,000,000

(1.000.0001

€84,000,000(21,000,000)

Becauseof the difficultyinmeasuringdepreciation andobsolescence,thecostapproach

ismostuseful when the subjectpropertyisrelativelynew

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Thecostapproachis sometimesconsidered theupperlimit of valuesinceaninvestor

wouldneverpaymorethan thecost tobuildacomparable building.However,investors

mustconsider thatconstruction is timeconsuming and theremaynotbeenough

demandfor another building of thesametype.Thatsaid,market values that exceed the

implied value of thecostapproacharequestionable

Sales ComparisonApproach

The premise of the sales comparison approachisthatabuyer would payno morefora

propertythan othersarepaying for similar propertiesinthecurrentmarket Ideally, the

comparable properties would be identicaltothesubjectbut,ofcourse,thisisimpossible

sinceall propertiesaredifferent Consequently, the sales prices of similar (comparable)

propertiesareadjusted for differences with the subjectproperty.The differencesmay

relateto size,age, location,propertycondition,and market conditionsatthetime

of sale The values of comparabletransactions areadjustedupward(downward)for

undesirable(desirable)differences with the subjectproperty.Wedo thistovalue the

comparableasifitwassimilartothe subjectproperty.

Example: Salescomparisonapproach

Anappraiser has been askedtoestimatethe valueofawarehouse and has collected the

following information:

ComparableTransactions

UnitofComparison SubjectProperty 1 2 3

Size, in square feet

Poor

Prime Prime

Sale date, months ago

Salesprice

$9,000,000 $4,500,000 $8,000,000The appraiser’s adjustmentsarebasedonthe following:

• Each adjustmentisbasedonthe unadjusted sales price of the comparable

• Propertiesdepreciateat2% perannum.Sincecomparable#1isfouryearsolder

than the subject,anupward adjustment of$720,000ismade[$9,000,000 x2%x

4 years]

• Condition adjustment Good:+5%,average:none;poor: -5%.Becausecomparable

#1is inbetter condition than the subject,adownward adjustment of$450,000

ismade[$9,000,000 x5%].Similarly,anupward adjustmentismade for

comparable #3tothetuneof$400,000 [$8,000,000x5%]

• Locationadjustment.Prime-none,secondary- 10% Becauseboth comparable#1

and the subjectareinaprimelocation,noadjustmentismade

• Overthepast24months,sales prices have been appreciating0.5% permonth

Becausecomparable#1wassoldsixmonthsago,anupward adjustment of

$270,000 ismade[$9,000,000 x 0.5% x 6months]

+400,000 +450,000

+405,000 +480,000 5,265,000 $8,880,000

The sales comparisonapproachis mostuseful whenthereare anumberof properties

similartothesubject that havebeenrecentlysold,asisusually thecasewith single¬

family homes When the marketis weak,there tendtobefewertransactions.Even in

anactivemarket,there maybe limitedtransactionsof specializedproperty types,such

asregionalmallsand hospitals.The sales comparisonapproachassumespurchasersareacting rationally;the pricespaidarerepresentative ofthecurrentmarket.However,there

aretimeswhen purchasers become overly exuberant and market bubblesoccur.

An appraiser mayprovidemore, orless,weightto anapproach becauseof theproperty

type ormarket conditions.Forexample,anappraisermight applyahigher weighttothe

value obtained with the sales comparison approach when the marketis activewith plenty

of comparableproperties.Alternatively, ifthesubjectproperty isold and estimating

depreciationisdifficult,anappraisermight applyalower weighttothecostmethod

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LOS 38.j: Describe duediligenceinprivate equity realestateinvestment.

CFA®Program Curriculum,Volume5,page 54

Realestate investors,both debt and equity, usuallyperform due diligencetoconfirm the

facts and conditions that might affect the value of thetransaction.Duediligencemay

include thefollowing:

• Lease reviewand rental history

• Confirm the operatingexpensesby examining bills

• Reviewcash flowstatements.

• Obtainanenvironmentalreport toidentify the possibility ofcontamination

• Performaphysical/engineering inspectiontoidentify structuralissuesand check the

condition of thebuildingsystems.

• Inspect the title and other legal documents for deficiencies

• Havethepropertysurveyedtoconfirm the boundaries and identifyeasements.

• Verify compliance with zoninglaws, buildingcodes,and environmentalregulations

• Verifypaymentoftaxes, insurance,specialassessments,and otherexpenditures

Duediligencecanbe costly, butitlowers the riskof unexpected legal and physical

problems

LOS 38.k:Discussprivate equity realestateinvestment indices,includingtheir

constructionandpotentialbiases

CFA®ProgramCurriculum,Volume5,page57

Anumberof realestateindicesareusedtotrack theperformance of realestateincluding

appraisal-based indices and transaction-based indices Investors should beawareof how

the indicesareconstructedaswellastheir limitations

Appraisal-BasedIndices

Becauserealestatetransactionscoveringaspecificpropertyoccurinfrequently, indices

have been developed basedonappraised values Appraisal-based indices combine

valuations of individual properties thatcanbe usedtomeasuremarketmovements.A

popular indexinthe United Statesisthe NCREIF Property Index(NPI).Members of

NCREIF,mainlyinvestmentmanagers andpensionfund sponsors, submit appraisal data

quarterly, and NCREIF calculates thereturn asfollows:

NOI—capital expenditures+ (endmarket value—beg marketvalue)return=

beginning market valueThe indexisthenvalue-weightedbasedonthereturnsof theseparateproperties The

returnisknownas aholding-periodreturnandisequivalentto asingle-period IRR

Earlier,wefound that the caprateisequaltoNOIdivided by the beginning market

valueof theproperty.Thisisthecurrentyieldor incomereturnof thepropertyand

isone componentof the index equation The remainingcomponentsof the equation

I produce the capitalreturn.To haveapositive capitalreturn,the market valuemust

increasebymorethan the capital expenditures

The index allowsinvestorstocompareperformance with otherassetclasses,and thequarterlyreturnscanbe usedtomeasurerisk(standarddeviation).The indexcanalsobe

usedbyinvestorstobenchmarkreturns.

Appraisal-based indices tendtolag actualtransactionsbecause actualtransactionsoccurbefore appraisalsareperformed.Thus,achangeinpricemaynotbe reflectedin

appraised values until thenext quarter orlonger ifa propertyisnotappraisedevery

quarter.Also,appraisallagtendstosmooth theindex;thatis,reduceitsvolatility, muchlikeamovingaverage reduces volatility Finally,appraisal lag resultsinlower correlationwith otherassetclasses Appraisal lagcanbe adjusted by unsmoothing the indexorbyusingatransaction-based index

developedtoallocate the changeinvaluetoeachquarter.

Ahedonic index requires onlyonesale.Aregressionisdevelopedtocontrolfordifferencesinpropertycharacteristics suchas size,age, location,andsoforth

LOS 38.m:Calculate and interpret financialratiosused toanalyzeand evaluateprivate realestateinvestments

CFA®ProgramCurriculum, Volume5,page62Lendersoftenusethe debtservice coverage ratio (DSCR)and the loan-to-value(LTV)ratiotodetermine themaximumloanamount on aspecificproperty.Themaximum

loanamountisbasedonthemeasurethatresultsinthe lowest debt

The DSCRiscalculatedasfollows:

first-year NOIDSCR=

A realestatelenderagreedtomakea10%interest-onlyloanon a propertythatwas

recently appraisedat €1,200,000 aslongasthe debtservice coverage ratio isatleast

1.5 and the loan-to-valueratiodoesnotexceed80%.Calculate themaximumloan

amountassuming theproperty’sNOIis €135,000.

Answer:

Using the LTVratio,thepropertywillsupport aloanamountof €960,000 [1,200,000

value x 80%LTVratio].

Using theDSCR,thepropertywillsupport adebtservicepaymentof€90,000

[135,000 NOI / 1.5] Thecorresponding loanamountwould be€900,000[90,000

payment/ 10%interest rate].

In thiscase,themaximumloanamount isthe€900,000,whichisthe lowerof thetwo

amounts.

At€900,000, theLTVis75% [900,000 loanamount/1,200,000value]andthe

DSCR is1.5[135,000 NOI /90,000payment]

When debtisusedtofinance realestate,equityinvestorsoften calculate theequity

dividendrate,also knownasthecash-on-cashreturn,whichmeasuresthecashreturn on

theamountof cashinvested

first year cash flowequitydividendrate=

equity

Theequity dividendrateonlycovers oneperiod Itisnotthesame asthe IRR that

measures thereturn overtheentireholding period

Example: Equity dividendmaximumloanamount

Returningtothepreviousexample,calculate the equity dividendrate (cash-on-cash

return)assuming theproperty ispurchasedfor theappraised value

Answer:

The€1,200,000 property wasfinanced with€900,000debt and€300,000equity

First-year cash flowis€45,000(135,000NOI- 90,000debtservicepayment).Thus,

the equitydividendrate is15%(45,000first year cash flow /300,000equity)

Inordertocalculate the IRR with leverage,weneedtoconsider the cash flowsover

theentireholding period including the changeinvalueofthe originalinvestment

Sincethepropertywasfinanced withdebt, the cashflowsthatarereceivedattheend

oftheholding period(i.e.,netsales proceeds)arereduced by the outstandingmortgage

balance

I Example: Leveraged IRR

Returningtothe last example, calculate theIRRif thepropertyissoldatthe endofsixyearsfor€1,500,000.

Answer:

Overthe holding period, annual cash flows of€45,000 arereceivedand,atthe end

ofsix years,the sale proceeds of€1,500,000 arereducedby the outstandingmortgagebalanceof€900,000.Recall that the loanwasinterestonlyand, hence,theentire

originalmortgage amountof€900,000 wasoutstandingatthe endof the holdingperiod Usingourfinancialcalculator,the leveraged IRRis24.1%asfollows:

Noticethe leveraged IRR of 24.1%ishigherthan theunleveragedIRR of14.2% As

aresult,the equityinvestorbenefitsby financing thepropertywith debt becauseofpositive leverage.Remember, however,that leverage will also magnify negativereturns.

KEY CONCEPTS

LOS 38.a

Therearefour basic forms of realestate investment;private equity(directownership),

publicly traded equity(indirectownership), private debt(directmortgagelending), and

publicly traded debt (mortgage-backedsecurities)

LOS38.b

Realestateinvestmentsareheterogeneous, have highunit values,have hightransaction

costs,depreciateovertime,areinfluenced by thecostand availability of debt capital,are

illiquid, andaredifficulttovalue

Realestateiscommonly classifiedasresidential and non-residential.Income-producing

properties (including income-producing residentialproperties)areconsidered

commercial realestate.

LOS38.c

Reasonstoinvest inrealestateincludecurrent income,capital appreciation, inflation

hedge,diversification,andtaxbenefits

Risks include changing businessconditions,long leadtimestodevelopproperty,

costand availability of capital, unexpectedinflation,demographicfactors,illiquidity,

environmentalissues, property managementexpertise, and the effects of leverage

Realestateisless than perfectly correlated with thereturnsof stocks andbonds; thus,

addingrealestate to aportfoliocanreduce risk relativetothe expectedreturn.

LOS38.d

Commercialproperty types,and the demand for eachisdriven by:

• Office— Jobgrowth

• Industrial—The overalleconomy

• Retail—Consumerspending

• Multi-family—Population growth

LOS38.e

Costapproach.Valueisderived byaddingthe value of the landtothe replacementcostof

anewbuildingless adjustments for estimated depreciation and obsolescence

Salescomparisonapproach The sale prices of similar (comparable) propertiesareadjusted

for differences with the subjectproperty.

Incomeapproach.Valueisequaltothepresentvalue of thesubject’sfuture cash flows

overthe holding period

I LOS38.f

NOIisequaltopotentialgrossincome (rentalincomefully leased plusotherincome)

less vacancyandcollection losses and operating expenses

Thecaprate,discountrate,andgrowthrate arelinked

cap rate=discountrate (r)-growthrate(g)

Ifthe caprate is unknown, it canbederivedfromrecentcomparabletransactions as

follows:

NOI1caprate=

comparablesales price

The discountrateisthe requiredrateofreturnof theinvestor

discountrate=caprate +growthrate

LOS 38.gDirectcapitalization method:

NOIl

value= V0 =

caprate

Discountedcash flowmethod:

Step1: Forecastthe terminal valueattheendof theholding period(usedirectcapitalization method ifNOIgrowthis constant)

Step2: DiscounttheNOIoverthe holding period and the terminal valueto present.

LOS 38.hUnderthe direct capitalizationmethod,acaprateisappliedtofirst-yearNOI.Implicit

in thecaprate is anexpectedincrease ingrowth

Under theDCF method,thefuture cashflows,including the capital expenditures and

terminal value,areprojectedovertheholding periodanddiscountedto present atthe

discountrate.Futuregrowthof NOIisexplicittothe DCFmethod Choosingtheappropriatediscountrateand terminalcaprate arecrucialassmalldifferencesinthe

rates cansignificantly affect value

LOS 38.i

Steps involved with applying thecostapproach

Step1: Estimate the marketvalueoftheland

Step2: Estimate thebuilding’s replacementcost.

Step3: Deduct physical deterioration (estimateincurable using effective age/economicliferatio),functionalobsolescence,locationalobsolescence,andeconomicobsolescence

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With the sales comparison approach, the sales prices of similar (comparable) properties

areadjusted for differences with thesubjectproperty.The differencesmayrelateto

size,age, location,propertycondition,and market conditionsatthetimeof sale Once

the adjustmentsare made,the adjusted sales price per square foot of the comparable

transactionsareaveraged andappliedtothe subjectproperty

LOS 38.j

Investorsperform due diligencetoconfirm thefacts and conditions that might affect

the value of thetransaction.Duediligencecanbe costly butitlowers risk of unexpected

legal and physical problems Due diligence involves reviewingleases,confirming

expenses, performing inspections, surveying thepropertyexamininglegaldocuments,

and verifying compliance

LOS38.k

Appraisal-based indices tendtolag transaction-based indices andappeartohave lower

volatility and lower correlation with otherassetclasses

LOS38.1

Investors usedebt financing (leverage)toincreasereturns.Aslongastheinvestment

returnisgreaterthan theinterestpaidtolenders,thereispositiveleverageandreturns

aremagnified Leverage resultsinhigher risk

LOS 38.m

Lendersoftenusethe debtservicecoverageratioand the loan-to-valueratioto

determine themaximumloanamountonaspecificpropertyInvestorsuseratiossuchas

the equity dividendrate(cash-on-cash return),leveragedIRR,and unleveraged IRRto

evaluateperformance

I CONCEPT CHECKERS

Whichform ofinvestment ismostappropriateforafirst-time realestateinvestor

thatisconcerned about liquidity and diversification?

A Directownership ofasuburban office building

B Sharesofarealestateinvestmenttrust.

C Anundivided participationinterestinacommercialmortgage.

Whichof the following realestatepropertiesismostlikely classifiedascommercial realestate?

A Aresidentialapartmentbuilding

B Timberland andfarmland

C Anowner-occupied, single-family home

Arealestateinvestor isconcerned about risinginterestratesand decidestopay

cashfora propertyinstead offinancingthetransactionwith debt Whatisthemostlikely effect of this strategy?

A Inflation riskiseliminated

B Riskof changinginterestratesiseliminated

C Riskisreduced becauseof lowerleverage

Whichof the following best describes the primaryeconomicdriverof demand formulti-family realestate?

A Growthinsavingsrates.

B Jobgrowth, especiallyinthe finance andinsuranceindustries

2%

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Whichof the followingmostaccurately describes therelationship betweena

discountrateandacapitalizationrate?

A Thecapitalizationrateisthe appropriate discountrateless NOIgrowth

B The appropriate discountrateisthe capitalizationrateless NOI growth

C The capitalizationrateisthepresentvalueof the appropriate discountrate.

You just enteredintoa contract topurchasearecently renovatedapartment

building, andyou areconcerned thatsomeof thecontractorshavenotbeen

paid.Inperformingyourdue diligence, which of the following procedures

should be performedtoalleviateyour concern?

A Have thepropertysurveyed

B Have anenvironmentalstudy performed

C Search the public records for outstanding liens

Whichof thefollowingstatementsabout realestateindicesismost accurate?

A Transaction-based indices tendtolag appraisal-based indices

B Appraisal-based indices tendtolag transaction-based indices

C Transaction-based indicesappeartohave lower correlation with otherasset

classesascomparedtoappraisal-based indices

Whichof the followingstatementsabout financial leverageismost accurate?

A Debt financingincreasesthe appraised value ofa propertybecauseinterest

expense istaxdeductible

B Increasing financialleverage reduces risktothe equityowner

C Fora propertyfinanced withdebt,achangeinNOIwill resultinamore

than proportionate changeincash flow

Alender will makea 10%,interest-only loanona property aslongasthe debt

servicecoverageratio isatleast 1.6 and the loan-to-valueratiodoesnotexceed

80%.Themaximumloanamount,assuming thepropertyjustappraised for

$1,500,000and NOIis $200,000, isclosestto:

I ANSWERS - CONCEPT CHECKERS

Of the three investment choices,REITsare the mostliquid becausethesharesare

actively traded.Also, REITsprovide quick andeasydiversificationacross many properties Neither the direct investment nor the mortgage participation isliquid,and

significantcapitalwould berequiredto diversify the investments.

1 B

Residential real estate (i.e., an apartmentbuilding)purchasedwith the intent toproduce

income is usually considered commercial real estate property Timberland and farmland

are unique categories of real estate.

2 A

Anall-cashtransactioneliminatesfinancialleverage and lowersrisk Inflation risk is

typicallylower with a real estate investment, but the risk is nottotallyeliminated.If

interest rates rise,non-leveragedproperty values are stillimpacted.Investors require

higherreturns when rates rise Resale prices also depend on the cost and availability of

debtcapital

3 C

4 C Demand formulti-familypropertiesdependson populationgrowth,especiallyin the age

demographicthattypicallyrents apartments.

Thesalescomparisonapproachislikelythe bestvaluationapproach becauseof the number ofcomparabletransactions The costapproachis not as appropriate because

of the difficulty in estimatingdepreciationand obsolescence of an older property The incomeapproachis not appropriate because anowner-occupiedproperty does not

generate income.

5 B

The cap rate of thecomparabletransaction is 8% (200,000 NOI / 2,500,000 sales

price).ThevalueofRoyalOaks is $1,625,000 (130,000 NOI / 8% cap rate).

6 B

The terminal value at the end of five years is $8,750,000 [700,000 year 6 payment / (10% discount rate - 2%growthrate)] The terminal value is discounted to present and added to the present value of the NOIduringtheholdingperiod.You can combine both

steps using thefollowing keystrokes:

7 A

N=5; I/Y=10;PMT =600,000; FV=8,750,000;CPT-*ÿ PV=$7,707,534

Thecapitalizationrate is the discount rate (required rate of return on equity, r) less the

constantgrowthrate in net operating income, g (i.e., cap rate=r—g)

8 A

Replacement cost

Physical deterioration

Economic obsolescence Land value

Thepublicrecordsshouldbesearchedforoutstandingliensfiledby contractorsinvolved

in the renovation An existing lien canresultinlegal problemsfor thepurchaserand the lender A survey will not identifyoutstandingliens A survey confirms the property

boundaries and identifies any easements.