CFA Level II Alternative Investments

Real Estate Investments

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Graphs, charts, tables, examples, and figures are copyright 2012, CFA Institute. Reproduced
and republished with permission from CFA Institute. All rights reserved.

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Contents
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.

Introduction
Real Estate Investment: Basic Forms
Real Estate: Characteristics and Classifications
Private Market Real Estate Equity Investments
Overview of the Valuation of Commercial Real Estate
The Income Approach to Valuation
The Cost and Sales Comparison Approaches to Valuation
Reconciliation
Due Diligence
Valuation in a International Context
Indices
Private Market Real Estate Debt

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2. Real Estate Investment: Basic Forms

Debt

Equity

Private

Publicly
Traded

Example 1

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3. Real Estate: Characteristics and Classifications

Characteristics

Heterogeneity and fixed locations

High unit value
Management intensive
High transaction costs
Depreciation
Need for debt capital
Illiquidity
Price determination

Example 2
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3. Real Estate: Characteristics and Classifications

Many types of real estate
properties
Residential: single family; multifamily
Non-residential: Commercial
property other than multi-family
properties, farmland and timber

Commercial real estate properties are

categorized by end use

Office
Industrial and warehouse
Retail
Hospitality
Multi-family
Farmland
Timberland

Example 3
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4. Private Market Real Estate Equity Investments

Current Income
Price appreciation

Motivation

Inflation hedge
Diversification
Tax benefits
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4.1 Risk Factors

Business conditions
Long lead time for new developments
Cost and availability of capital
Unexpected inflation
Demographics
Lack of liquidity
Environmental
Availability of information
Management (asset management and property management)
Leverage (loan-to-value ratio)
Example 5
Other risk factors
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4.2 Real Estate Risk and Return Relative to Stocks and Bonds
Example 6

4.3 Commercial Real Estate

Office
Example 7
Industrial and Warehouse
Retail
Example 8
Multi-Family
Example 9
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5. Overview of the Valuation of Commercial Real Estate

5.1 Appraisals
Transaction data is limited; hence need to rely on estimates of value
How much to buy/sell for
Performance measurement
Definitions of value
Market value
Investment value (particular investor)
Value in use
Mortgage lending value

Example 10
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5.2 Introduction to Valuation Approaches

Three Approaches
Income Approach
Cost Approach
Sales Comparison Approach
Triangulate
Example 11

Highest and Best Use

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6. The Income Approach to Valuation

6.1 General Approach and Net Operating Income
NOI is roughly analogous to EBITDA in the FRA context
Rental income at full occupancy
+ other income
= Potential gross income
- Vacancy and collection loss
= Effective gross income
- Operating expenses

Example 12

= Net operating income

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6.2 The Direct Capitalization Method

Discount rate
Growth rate
Cap rate
Cap rate from comparable
Value from cap rate
ARY = NOI / recent sales price of comparable
Stabilized NOI
Gross Income Multiplier
Example 14
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6.3 The Discounted Cash Flow (DCF) Method

Assuming constant growth of NOI
Terminal Capitalization Rate
Depends on expected future interest rates and growth rates
Example 16
NOI = 100,000 for 5 years
Year 6 NOI = 120,000 and grows at 2%
Property value also increases at 2%
Reversion: value obtained by selling property in the future
Example 17

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Example 18
UK-based example
400,000 for 2 years
ERV = 450,000
All Risks Yield = 5%

Example 19
The Layer Method
Discount increment rent at 6%

Equivalent Yield

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6.4 Advanced DCF: Lease-by-Lease Analysis

Project income from existing leases
Make assumptions about
lease renewals
operating expenses (Example 20)
capital expenditures
absorption of any vacant space
Estimate resale value (reversion)
Estimate discount rate

Example 21
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6.5 Advantages and Disadvantages of the Income Approach

Advantage: captures cash flows investors care about
Disadvantage: forecasts are prone to error

6.6 Common Errors

Discount rate does not reflect risk
Income growth is greater than expense growth
Terminal cap rate is not logical compared with implied going-in cap rate
Terminal cap rate is applied to an income that is not typical
Cyclical nature of real estate markets is not recognized

Example 22
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7. The Cost and Sales Comparison Approaches to Valuation

7.1 Cost Approach
Used for unusual properties or properties for specialized use (comparable data not
available)
Land + replacement cost
Adjust for depreciation
Physical deterioration (curable and incurable)
Functional obsolescence
Locational obsolescence
Economic Obsolescence

Exhibit 9
Example 23
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7.2 The Sales Comparison Approach

Subject property and comparables

use comparables price as starting point and then make
adjustments

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7.3 Advantages and Disadvantages of the Cost and Sales Comparison

Approaches
Cost approach is more reliable for new properties and less reliable for old properties
Cost approach is most reliable for new properties with relatively modern design in a stable
market
Sales comparison approach relies on reasonable number of comparable sales
Problematic if comparable data is limited
Assumes prices paid are representative of market values

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8. Reconciliation
Reconcile difference between three approach before arriving at final conclusion
Example 25

9. Due Diligence
Verify facts and conditions which might affect value of
property:
Review leases of major tenants
Study past operating expenses
Environmental inspection
Physical/engineering inspection

Intent to purchase but subject to due diligence

Example 26
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10. Valuation in an International Context

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11. Indices
Many real estate indices but we (investors) should be aware of how the
indices are created and inherent limitations
Seemingly low correlations between real estate and other asset classes
might be explained by limitations of how the index is created

11.1 Appraisal Based Indices

Indices often rely on appraisals because transaction data is not available
Example 27

11.2 Transaction-Based Indices

Two ways of creating:
Repeat Sales Index
Hedonic Index
Example 28

11.3 Advantages and Disadvantages

Appraisal lag smoothing effect volatility
Transaction-based indices can be noisy
Example 29

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12. Private Market Real Estate Debt

Investors using debt financing will expect relatively higher returns
Loan to value ratio
Debt service coverage ratio
Example 30

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Equity Dividend Rate

(cash-on-cash return)
Example 31

Example 32: Leveraged IRR

Example 33: Unleveraged IRR

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Summary

Basic forms
Characteristics
Classifications
Motivation
Risk Factors
Valuation
Due Diligence
Indices
Debt
Leveraged IRR

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Conclusion
Read the summary
Review learning objectives
Examples
Practice problems
Practice questions from other sources
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