Real Estate 101

1
Real Estate 101

• Introduction to Basic Real Estate Terms and
  Concepts

2
Summary of Topics

• What is real estate value?
• Property Types
• Real Estate Terminology
• Basic Legal Topics
• Basic Finance, Investment Terms and Concepts

3
Summary of Topics (Contd)

• Development Outline
• Major Players/Sources of Capital
• Size of Domestic Real Estate Markets
• Career Opportunities

4
What is Real Estate Value?

• Present Value of Cash Flows
• Capital Structure Decisions
• Definition of Market Value
• Market Value vs. Price vs. Cost

5
Property Types

• Office
• Industrial
• Retail
• Multifamily

• Hospitality
• Institutional
• Mixed use
• Single Family

6
Real Estate Terminology - Leasing

• In-Place vs. Market Rents
• Expense structures
• Triple Net (NNN)
• Expense Stops
• Full Service
• Vacancy
• Absorption
• Sublease Space
• Phantom Space

7
Leasing Terminology (Contd)

• Tenant Improvements (TI allowance)
• Leasing Commissions
• Both in-house and external brokerage fees
• Concessions
• Free rent, excess TI over the building standard
  allowance moving expenses, etc.
  
• Calculation of effective rent straight line,
  PV equivalent of the rental stream over the term
  of the lease
  

8
Per Unit Terminology

• Real estate is measured, costed, and leased on a
  per unit basis
  
• Construction cost per square foot
• Land price per square foot of building area
• Leases are quoted per unit as well
• Unit definition depends on the property type
• Retail, office, industrial per square root
• Multifamily per apartment
• Hospitality per key (ie, per room)

9
Office Terminology

• Gross, rentable and usable area
• Floor to ceiling heights
• Floor Area Ratio FAR
• Skin external curtain wall/façade materials
• Property types
• Low, mid and high rise CBD vs. suburban
• Build to suit
• Office leases quoted annually, all structures
  depending upon market convention
  
• Parking ratio zoned as spaces per 1,000 sq.ft. of
  space

10
Industrial Terminology

• Gross, rentable and useable area
• Clear Height
• Dock doors
• Types
• Warehouse/distribution, flex/RD, hybrid
• Industrial leases quoted both monthly and
  annually, NNN
  

11
Terminology - Retail

• Types of Shopping Centers
• Strip, neighborhood, grocery-anchored, power
  centers, regional and super regional malls
  
• Common Area Maintenance Charges
• 1, 3, and 5 mile trade areas
• Anchor Tenants
• Anchors are the draw for the center
• In-line Tenants
• In line tenants subsidize the anchors
• Leases quoted annually, hybrid with CAM
  charges
  

12
Terminology - Multifamily

• Type
• Garden, midrise, highrise
• Condominium, coop
• Base rent plus additional tenant charges
• Repositioning
• Unit Turnover

13
Hospitality Operating Business Using Real Estate

• ADR
• REVPAR
• Departmental Profitability
• Gross Operating Profit
• Flagged vs. Independent
• Type
• Limited service, full service, luxury, resort
• Other subsets exist as well

14
Basic Legal Concepts

• Ownership Control over bundle of rights
• Transfers of Ownership
• Types of Legal Interests
• Possessory vs. Non-Possessory
• Fee Simple
• Leasehold
• Easements

15
Basic Legal Concepts (Contd)

• Title
• Purchase and Sale Agreements
• Escrow
• Go Firm
• Closing
• Types of deeds, importance of recording
• Mortgages
• Promissory Notes

16
Legal (Contd)

• Deeds of Trust
• 1st Lien Secured vs. Unsecured
• Guarantees
• Defaults Monetary vs. Technical
• Foreclosures
• Deed in Lieu
• Deficiency Judgment

17
Finance and Investment TermsThe Operating
Statement

• Revenue
• Actual vs Gross Potential
• Vacancy Allowance
• Gross Effective Income
• Operating Expenses
• Replacement Reserves

• Net Operating Income
• Debt Service
• Capital Expenditures
• TI, Commissions, and other Capex
• Before Tax Net Cash Flow to Equity

18
Finance and Investment Terms Debt Financing

• Loan to Value (LTV)
• DCR
• Spread
• Interest Rate
• Amortization vs. Maturity
• Discount Points
• Prepayment Points
• Types of Debt
• Private vs. Public Debt Markets CMBS
• Private vs. Public Equity Markets - REITs

19
Finance and Investment Terms Return Analysis
Three Critical Components

• Initial Investment Amount
• Cash Flow pro forma over the holding period
• Exit or Terminal Value

20
Finance and Investment Terms Return Analysis
(Contd)

• Leveraged vs. Unleveraged Returns
• Yields
• going-in yield
• free and clear yield
• cash on cash yield
• in place vs. stabilized yield
• Capitalization Rates
• WACC
• Real rate risk, inflation, and recapture
  premiums
  
• Discount Rates

21
Finance and Investment TermsIRR

• Use DCF analysis to calculate internal rate of
  return
  
• Return to investment over a holding period
• Also, use DCF to conduct sensitivity analysis
• Test level of risk in your pro forma assumptions
• Partitioning the IRR
• How much of your return comes from cash flow
  versus residual value?
  
• Helps assess the risk in achieving the IRR or,
  is your IRR requirement a good match with the
  level of risk in the property?

22
Finance and Investment TermsAssumptions

• General Economic Conditions
• Rental Rate Growth
• Occupancy
• Exit Cap Rates
• Loan Underwriting Parameters
• LTV and DCR ratio tests
• Year of Exit

23
Finance and Investment TermsDeal Structure

• Use of Tax Efficient Forms of Ownership
• Partnerships
• LLCs
• Syndications
• REITS and UPREITS
• Preferred Returns
• Promotes

24
Finance and Investment TermsAnalysis of Tax
Benefits

• Interest Expense Deductibility
• Depreciation
• Loss Carryforwards
• Must demonstrate substantial economic effect to
  use tax deductions

25
Development Issues

• Supply and demand constraints
• Urban economic analysis
• Understanding when the market is ripe for new
  development
  
• Understanding what the tenants want - and will
  pay for - is critical
  
• Lag times for bringing property to completion
• Zoning and Entitlements
• Financing Issues and capital market constraints
• Renovation and Repositioning

26
Major Equity Players and Capital Sources

• Pension Funds
• Direct Investments
• Core Funds
• Opportunity Funds
• Separate Account Allocations
• Advisors
• Equity REITS
• Life Companies
• Foreign Investors
• Individuals, Syndications and Partnerships

27
Major Player/Capital Sources Equity
28
Major Player/Capital SourcesDebt
29
Growth of MBS Market
30
Creation of MBS Fannie Mae MBS Creation
31
Mortgage Pass Through from Pooled Investment
Characteristics

• Cash Flows
• Interest
• Principal
• Unscheduled principal (PREPAYMENT)
• Risks
• Basic FI (bond) risk time value, reinvestment
• Mitigate default and payment timing risk through
  pool insurance issued by Ginnie, Fannie, and
  Freddie
  
• Prepayment easier to predict prepayment across
  a pool
  
• (think insurance life, auto, flood, health, etc.
  law of large numbers)
  
• Additionally, pooled creature now divisible
  into MBS securities

32
Mortgage Pass Through Securities Benefits
created

• Default and payment timing risk (receiving both
  PI timely) mitigated by pool insurance supplied
  by Ginnie, Fannie, Freddie
  
• Prepayment risk still exists (total prepayment
  risk unchanged) but becomes easier to predict
  across the entire pool
  
• Adds liquidity to the investment through creation
  of small pieces
  
• This is different from adding liquidity to
  primary mortgage market that weve been talking
  about

33
Ginnie Mae (GNMA)

• Oldest started making MBS in 1970
• Ginnie pools contain only government insured
  mortgages (primarily FHA and VA)
  
• Ginnie pass-through securities are fully
  modified
  
• Fully modified means security holder will receive
  full and timely payment of PI regardless of
  payment pattern on underlying mortgage
  
• 2002 single family conforming limit up to
  300,700 from 203,000
  
• Increased to match Fannie and Freddie

34
Fannie Mae (FNMA) General

• Quasi-private
• Not a government department or entity
• Guarantee does not carry full faith and credit
  of U.S. Government
  
• Freddie has ability to request emergency
  funding from the U.S. Treasury
  
• Like Ginnie, Fannie guarantees timely payment of
  PI fro all securities it issues
  
• Unlike Ginnie, Fannie securitizes conventional
  mortgages (mortgages that do not have government
  insurance) and seasoned (older) FHA/VA mortgages
  
• On the web at fanniemae.com

35
Freddie Mac (FHLMC) General

• Very similar to Fannie
• Created to securitize conventional mortgages and
  seasoned non-conventionals
  
• Wide variety of pool types
• Bi-weekly mortgages
• High LTV mortgages
• On the web at freddiemac.com

36
Fannie Freddie loan limits Definition of
Conforming Loans
37
Private MBS issues NOT Ginnie, Fannie or
Freddie

• Private MBS issues account for about 11 of total
  market
  
• Private MBS market primarily for non-conforming
  loans, i.e., loans that Fannie, Freddie or Ginnie
  cannot accept
  
• Jumbos (greater than 300,700 (2002))
• No-docs or limited doc

38
MBS Pass-Through Wrap-up

• Concept MBS pass-through is an ownership share
  of an underlying mortgage pool where each
  security receives a pro-rata share of both the
  PI paid by the underlying mortgages
• Are there any questions on this?
• Particulars modeling the cash flow is
  essentially modeling N mortgages with the
  prepayment option explicitly included in the cash
  flows
• Are there any questions on the MBS cash flow
  spreadsheet everyone now has?

39
Problems with MBS Pass-Throughs

• Unknown maturity
• Difficult to hedge, difficult to include in a
  traditional FI portfolio
  
• Negative Convexity
• Convexity (as you know) is the curvature in the
  price/yield relationship for a FI instrument
  
• Convexity means that a drop in rates leads to a
  more than linear increase in price, and an
  increase in rates leads to a less than linear
  decrease in price convexity is a good thing
• Negative convexity is not a good thing for a FI
  instrument
  
• Rate declines lead to PP and reinvestment
  problems, market knows this and value suffers on
  rate declines
  
• Rate increases dont lead to PP, but they then
  hurt the FI component (fixed future cash flows)
  
• Both problems stem mainly from prepayment

40
Source of MBS problems

• Primarily Prepayment
• Related issue is the fact that every pass-through
  share gets both principal and interest
  
• Early prepayment
• good thing in terms of getting money back sooner
  (good in terms of principal),
  
• bad in that interest flow stops (bad in terms of
  interest)
  
• Late prepayment
• bad because you wait longer for money to return
  (bad in terms of principal)
  
• good in that interest flow continues longer (good
  in terms of interest)

41
Financial Innovation in the MBS MarketLecture Map

• IOs and POs (basic strips)
• Break apart the payment stream into interest and
  principal increase predictability of price
  reaction to rate changes
  
• CMOs
• Increase maturity certainty (tranche creation)
• Parcel out or concentrate prepayment risk and
  interest rate risk
  
• Freddie Mac Multiclass Certificates, Series 2468

42
OAS Calculating PV for a Path
43
What is a REIT?

• Owns, and in most cases operates,
  income-producing property (Equity REITs)
  
• Office
• Apartment
• Retail (shopping centers)
• Hotels
• Warehouses (storage)
• Some REITs also finance real estate (Mortgage
  REITs)
  
• REIT shares trade on major exchanges
• Debt (bonds) are also publicly traded

44
Where did REITs come from?

• Created in 1960 (act of Congress) as a way to
  make property investment available to individual
  investors
  
• Offer expert management and familiar corporate
  governance structures (BOD)
  
• REIT trivia original REIT act was an amendment
  to an Act regarding excise taxes on cigars
  
• REITs make equity interest in commercial
  property
  
• Divisible into shares that can be purchased by
  small investors
  
• LIQUID the shares trade on major exchanges

45
How Many REITs are there?

• About 300, 2/3 of which are publicly traded
• 149 on NYSE
• 27 on American
• 12 on NASDAQ
• Total REIT assets 300 billion

46
Types of REITs

• Equity REITs
• Own and operate income-producing real estate
• Perform leasing, development, and construction
  activities
  
• 151 publicly traded equity REITs
• Mortgage REITs
• Hold mortgages on real property
• Make mortgages (lend money), usually on existing
  property
  
• Buy mortgages
• 22 publicly traded mortgage REITs
• Hybrid REITs
• Both own properties and make loans
• 9 publicly traded Hybrid REITs

47
Types of REITs more detail(source NAREIT)
48
REIT Structures UPREITs and Traditional REITs

• UPREIT (Umbrella Partnership REIT)
• First UPREIT was Taubman Realty IPO in 1992
• UPREIT structure created to shield owners
  contributing real estate assets to the REIT from
  capital gains taxes on contributed property
  
• Transfer is then partnership shares for
  partnership shares, and this is not a taxable
  event for the owners
  
• UPREIT owns a controlling interest in a limited
  partnership that owns the real estate, as opposed
  to a traditional REIT structure in which the REIT
  owns the real estate
• The Umbrella Partnership shares known as
  operating partnership units, or OP units are
  convertible into REIT shares and enjoy voting
  rights and dividends just like REIT shares
• Convertibility allowed after one year, and
  triggers taxes

49
REITs and Taxes

• REITs do not have to pay federal taxes at the
  corporate level
  
• More specifically, REITs are allowed to deduct
  dividends paid to shareholders from taxable
  income, and thus have the ability to shield 100
  of taxable income through distributions to
  shareholders
• No other firm in the economy can deduct
  dividends
  
• REIT shareholders still have to pay taxes on
  dividends and capital gains
  
• Most states honor the REIT status and dont
  require REITs to pay state taxes

50
Career Opportunities

• Construction
• Development
• Property Management
• Leasing Brokerage/Tenant Rep
• Asset Management
• Consulting
• City Planning/Economic Community Dev.

51
Career Opportunities (Contd)

• Investment Management (institutional and family
  office)
  
• Equity Funds
• Commercial Banking
• Mortgage Brokerage and Placement
• Institutional Brokerage
• Investment Banking