Learning Module 1 Overview of Types of Real Estate Investment

Learning Module 1 Overview of Types of Real Estate Investment KNOWLEDGE CHECK Form of Investment An investor is interested in adding real estate to her portfolio of equity and fixed-income securities for the first time. She has no previous real estate experience but believes adding real estate will provide some diversification benefits. She is concerned about liquidity because she may need the money in a year or so. 1. Which form of investment is most likely appropriate for her? A. Shares of REITs B. Mortgage-backed securities C. Direct ownership of commercial real estate property Solution A is correct. She is probably better off investing in shares of publicly traded REITs, which provide liquidity, have professional management, and require a smaller investment than direct ownership of real estate. Using REITs, she may be able to put together a diversified real estate investment portfolio. Although REITs are more correlated with stocks than direct ownership of real estate is, direct ownership is much less liquid and a lot of properties are needed to have a diversified real estate portfolio. Also, adding shares of REITs to her current portfolio should provide more diversification benefits than adding debt in the form of mortgage-backed securities and will allow her to benefit from any appreciation of the real estate. Debt investments in real estate, such as MBS, are similar to other fixed-income investments, such as bonds, and can be highly sensitive to changes in interest rates. The difference is that their income streams are secured on real estate assets, which means that the risks are default risks linked to the performance of the real estate assets and the ability of mort- gagees to pay interest. In contrast, adding equity real estate investments to a traditional portfolio (of equity and fixed-income investments) will potential- ly have diversification benefits. KNOWLEDGE CHECK Investment Characteristics 1. An investor states that he likes investing in private real estate because he believes the market is less efficient than other liquid asset classes and, there fore, expects to earn a return premium. What are some of the sources of real estate market inefficiency? Solution It can be difficult to readily establish fair market value in real estate. Infre quent transactions, high transaction costs, and low transparency reduce market efficiency. Market players who recognize the impact of new infor- mation on underlying property value cannot readily buy real estate when it is priced below intrinsic value and sell real estate when prices move above intrinsic value. In a less efficient market, an investor with superior knowl- edge and information or a better understanding of the appropriate price to pay for properties (superior valuation skills) may earn a higher return by making more informed investment decisions, provided that they can wait until market prices adjust to intrinsic values. However, there is also mount ing evidence that real estate is becoming more efficient. Online data services provide real-time pricing transparency based on prop- erty location, type, size, and age. There is also information about commer cial tenants, rents, lease terms, and lease expiration schedules. The large number and large size of real estate private equity funds with ample capital to deploy suggest numerous professional investors are scouring markets for the best opportunities. An investor buying relatively few properties may be able to take advantage of market inefficiencies. However, larger investors with broad real estate exposure are more likely to see diversification reduce idiosyncratic opportunities for above-market returns. Private real estate investors should expect to earn a return premium for illiquidity. Earning excess returns from market inefficiency becomes in- creasingly difficult as the number of knowledgeable, well-capitalized partici pants competing for acquisitions and spurring transaction activity increases. 2. A portfolio manager believes the entire real estate sector is trading at cycli cally depressed levels because of prior overbuilding, a jump in interest rates, and a recession. The manager wants tactical exposure to real estate for what the manager expects to be a three-year recovery cycle. What would be a good real estate investment strategy for the manager? Solution The portfolio manager could purchase the shares of a large, diversified REIT or REOC. REIT shares would provide exposure to underlying real estate, and REOCs could offer exposure to a combination of rental income, property management and brokerage income, and development profits. By investing in the shares of a larger, presumably liquid company, the port folio manager should be able to exit the position if the sector recovers as expected or if the portfolio manager decides to raise cash, Geography-and sector-focused real estate companies (e.g., companies that own shopping centers in Australia) should be considered if the portfolio manager's views extend to specific markets. Investing in private funds or companies may not offer as much liquidity, and entry/exit costs could be higher. EXAMPLE 1 The COVID-19 pandemic caused tremendous shocks to the global economy. The quarantine and stay-at-home policies inflicted great pain on the lodging and brick-and-mortar retail sectors in particular and accelerated such trends as retail consolidation and the rise of internet retailing. The prevalence of work- ing from home during the pandemic may have helped the data center sector by increasing internet communication traffic and forcing companies to rely on business continuity services. At the same time, many employers realized they can get by with less office space by permitting some employees to work from home regularly, and many employees have grown accustomed to working from home and do not look to return to the office full time, at least until the pandemic ends. There is also evidence that urban residents are leaving large, expensive cities for suburban living. Rents across the residential, office, and retail sectors declined more than 10% in many gateway cities. Such events as the COVID-19 pandemic make it difficult to predict by how much and how fast demand for space will change during the next 2 to 10 years. KNOWLEDGE CHECK Commercial Real Estate Risk 1. An investor wants to add real estate to her portfolio to benefit from its di- versifying characteristics. She decides to buy a commercial property, financ- ing at most 30% of the asset with debt in order to avoid incurring financial risk due to interest rate changes. This strategy is most likely to: A. limit the risk due to leverage. B. mitigate the risk due to inflation. C. eliminate the risk due to interest rate changes. Solution A is correct. If less money is borrowed, there is less risk of cash flow and equity value volatility due to the use of financial leverage. C is not correct because the risk related to changes in interest rates remains. The investor may be able to accept slightly more leverage and mitigate the interest rate risk associated with debt by locking in the current interest rate with a long-term, fixed-rate amortizing loan. If interest rates rise, however, the value of real estate will likely be affected even if the investor did not bor- row any money. Higher interest rates mean investors require a higher rate of return on all assets. In addition, the resale price of the property will likely depend on the cost of debt to the next buyer, who may be more likely to rely on higher leverage to finance the purchase. B is not correct because there is still risk of inflation, although real estate tends to have a low amount of inflation risk. But borrowing less money doesn't necessarily mean the property is less affected by inflation. Further- more, inflation benefits fixed-rate borrowers who are able to repay debt in the future with cash that is worth less than cash borrowed today. KNOWLEDGE CHECK Economic Value Drivers 1. Which of the following statistics is likely to be most relevant for all of the following: office, industrial, and hotel properties? A. Business confidence B. Household formation C. Industrial production Solution A is correct. Companies are more likely to expand their business and engage in business travel when business confidence is rising. Household forma- tions have an indirect effect on these sectors and are most relevant to the multi-family sector. Changes in industrial production are less directly tied to the office and hotel markets. 2. In addition to the market and property-specific analysis of occupancy, rental rate, lease expiry, and financing statistics, analysts of office properties are most likely to pay particular attention to trends in: A. retail sales growth. B. household formation. C. job creation. Solution C is correct. Job creation is most significant for office REITs. Household for- mations are more significant for multi-family and retail REITs than for office REITs, whereas retail sales growth is more significant for shopping center/ retail and industrial REITs than for office REITs. 3. Which of the following property sectors would be expected to experience the greatest cash flow volatility? A. Industrial B. Hotel C. Shopping center Solution B is correct. Hotel room demand fluctuates with economic activity and business and consumer confidence; there are no long-term leases on hotel rooms to protect hotel REITs' revenue streams from changes in demand. Industrial and shopping center REITs benefit from long-term leases on their properties and from the relatively mild dislocations between supply and demand caused by the construction of new space in these subsectors. KNOWLEDGE CHECK Motivations for Investing in Real Estate 1. Why would an investor want to include real estate equity investments in a portfolio that already has a diversified mixture of stocks and bonds? Solution Real estate equity offers diversification benefits because it is less than perfectly correlated with stocks and bonds-for direct ownership (private equity investment) in particular. In other words, there are times when stocks and bonds may perform poorly while private equity real estate investments perform well, and vice versa. Thus, adding real estate equity investments may improve the risk-adjusted return of the portfolio. KNOWLEDGE CHECK Investment Risk 1. Which is a riskier investment: core private real estate or investment-grade bonds? Explain why. Solution Historically, core private equity real estate with modest leverage is riski- er than investment-grade bonds. Although real estate leases offer income streams somewhat like those of bonds, the income expected when leases renew can be uncertain and will depend on market conditions at that time- unlike the more certain face value of a bond at maturity. KNOWLEDGE CHECK Commercial Real Estate Segments 1. Commercial real estate properties are most likely to include: A. residential, industrial, hospitality, retail, and office. B. multi-family, industrial, warehouse, retail, and office. C. multi-family, industrial, hospitality, retail, and timberland. Solution B is correct. Commercial real estate properties include multi-family, industrial, warehouse, retail, and office, as well as hospitality and other. Residential properties include single-family, owner-occupied homes and income-producing (commercial) residential properties. Timberland is a unique category of real estate. KNOWLEDGE CHECK Net and Gross Leases 1. What is the net rent equivalent for an office building where the gross rent is $20 per square foot and operating expenses are currently $8 per square foot? Solution On a gross lease, the owner pays the operating expense, whereas on a net lease, the tenant pays. So, we might expect the rent on a net lease to be $12 per square foot (or $20 psf-$8 psf). With the gross lease, the owner bears the risk of rising operating expenses, whereas the same is true of the tenant with net leases. If expenses decline, the benefit under a gross lease accrues to the owner through improved operating margins because the tenant still would pay $20. With the net lease, the tenant would benefit from a decline in operating expenses by paying a lower amount to the landlord, thereby reducing the tenant's total cost of occupancy. KNOWLEDGE CHECK Retail Rents 1. A retail lease specifies that the minimum rent is $40 per square foot plus 5% of sales revenue over $800 per square foot. What will the rent be if the tenant's sales are $1,000 per square foot? Solution The rent per square foot will be $40+5% x ($1,000-$800), or $40 + $10 = $50. We get the same answer by multiplying 5% x $1,000 (= $50) because $800 is the "natural breakpoint," meaning that 5% of $800 results in the minimum rent of $40. A lease may not have the breakpoint set at this nat- ural level; in which case, it is important that the lease clearly define how to calculate the rent. KNOWLEDGE CHECK Economic Value Determinants 1. The primary economic driver of the demand for office space is most likely: A. job growth. B. population growth. C. growth in savings rates. Solution A is correct. Job growth is the main economic driver of office demand, especially for jobs in industries that are heavy users of office space, such as finance and insurance. As the number of jobs increases, companies need to provide office space for the new employees. Population growth may indi- rectly affect the demand for office space because it affects demand and job growth. Growth in savings rates affects consumer spending and the demand for retail space. 2. The demand for which of the following types of real estate is likely most affected by population demographics? A. Office B. Multi-family C. Industrial and warehouse Solution B is correct. Population demographics are a primary determinant of the demand for multi-family space. KNOWLEDGE CHECK Due Diligence 1. What is the primary purpose of due diligence? Solution Due diligence is done to identify legal, environmental, physical, and other unanticipated problems that have not been disclosed by the seller that could be costly to remediate or that could negatively affect value. If identified, an issue or issues could result in negotiating a lower price or allow the investor to walk away from the transaction. EXAMPLE 2 IFC Sustainable Investments in Hotels The International Finance Corporation (IFC), a member of the World Bank Group, is the largest global development institution focused exclusively on leveraging the power of the private sector to tackle the world's most pressing development challenges. Working with private enterprises in more than 100 countries, IFC uses its capital, expertise, and influence to help eliminate extreme poverty and promote shared prosperity. Tourism is a major contributor to employment, foreign exchange earnings, and tax revenues for developing countries. Hotels and tourism generate economic activity for small and medium-sized enterprises (SMEs), which supply goods and services during both construction and operations. The IFC has made many investments in hotels in countries around the world. Here, we highlight some ESG impacts of three such investments: . Ghana-Movenpick Ambassador Hotel; Mali-Azalai Grand Hotel; Maldives-Villingili Hotel (part of Shangri-La group). Social and Environmental Impacts of These Investments Mali-Azalai Grand Hotel The hotel has implemented several corporate responsibility initia- tives, for example, participating in the United against Malaria (UAM) campaign. The hotel has implemented international standards in such areas as sewage treatment, waste disposal, power and water conservation, and employee safety. Ghana-Movenpick Ambassador Hotel The hotel has been awarded a Green Globe certificate, an industry certification program for sustainable tourism . Engages with local artists to produce original artwork for the hotel and established an art academy. The hotel decorates with over 800 pieces of Ghanaian art, including wood carvings, textile weavings, and paintings. Maldives-Villingili Hotel (part of Shangri-La group) Globally known for its commitment to bio-diversity and environmen- tal sustainability through its Eco Centre, which sponsors the Reef Care project and other activities. Maintains an excellent record of managing environmental, health, and safety measures. Source: https://www.ifc.org/wps/wcm/connect/industry_ext_content/ifc_external_corporate_site/ trp/news/restored_tourism_casestudy_hotels_2016 KNOWLEDGE CHECK Appraisal-Based Indexes 1. Why are appraisals often used to create real estate performance indexes? Solution Because properties do not transact very frequently, it is more difficult to create transaction-based indexes as is done for publicly traded securities. Appraisal-based indexes can be constructed even when there are no transac- tions by relying on quarterly or annual appraisals of the property. Of course, when no transactions occur, it is also difficult for appraisers to estimate value. KNOWLEDGE CHECK Transaction-Based Indexes 1. Describe two main ways of creating transaction-based indexes. Solution The two main ways are (1) a repeat sales index and (2) a hedonic index. A repeat sales index requires repeat sales of the same property; because it is the same property, controls for differences in property characteristics, such as its size and location, are not required. A hedonic index requires only one sale of a property and thus can usually include more properties than a repeat sales index; however, it must control for "hedonic" characteristics of the property, such as its size and location. KNOWLEDGE CHECK Comparing Appraisal-Based and Transaction-Based Indexes 1. What are the main differences between the performance of appraisal-based and transaction-based indexes? Solution An appraisal-based index will tend to have less volatility and lag a transaction-based index, resulting in a lower correlation with other asset classes being reported. KNOWLEDGE CHECK Comparing Appraisal-Based and Transaction-Based Indexes 1. What are the main differences between the performance of appraisal-based and transaction-based indexes? Solution An appraisal-based index will tend to have less volatility and lag a transaction-based index, resulting in a lower correlation with other asset classes being reported.