Book Summary Commercial Real Estate Analysis and Investments 3rd Edition PDF

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Book Summary: Commercial Real Estate Analysis and Investments 3rd Edition...

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Book Summary: Commercial Real Estate Analysis and Investments 3rd Edition Geltner, Miller, Clayton, Eichholtz (2013)

Chapter 1: Real estate space and asset markets For the real estate market a distinction can be made between two major markets: the space market and the asset market. The space market is for usage of real property. On the demand side are participants who want use for consumption or production purposes. On the supply side are real estate owners who rent the space. The rent for this space is the right to possess and use the space for a specified temporary period of time. Supply and demand of the space market are location and type specific, and the market is highly segmented: there are many geographical and usage-typical differences. This implies that rental prices differ widely as well. The real estate supply function is said to be kinked. This means that it starts out as a nearly vertical line at the current quantity of space supply in the market, meaning that the supply of office space is almost completely inelastic in the short to medium term. A rising supply function results when the development of new buildings is greater for newly added stock. The replacement cost is the level of rent that is sufficient to stimulate profitable new development, and in the long run, this tends to be the equilibrium rent. The price of a real estate asset in development depends on how much investors will pay for the income that can be expected from the building in the future. The cap rate is the annual net income relative to the value of a building. When you divide the net income by the cap rate, you get the value of the building. The supply curve tends to be cyclical, as developers anticipate on the growth in office demand for their developments. Naturally, real estate development is supply-constrained, meaning that the land supply remains fixed, and as more space is built in the market, the remaining supply of good buildable sites becomes scarcer. However, when a location loses its relative centrality, meaning that buildings will be developed in wider regions than only a central place, the supply curve can decline. In practice, the long-run supply function has tended to be nearly level beyond the kink point. The asset market is the market for the ownership of real estate assets, which consists of real property. This is also referred to as the property market. The asset market is part of the larger capital market; it is an alternative for investors’ capital against other forms of investments. The capital markets can be divided into four categories: -

Public equity Public debt Private equity

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Private debt

Public markets are known for liquidity and informational efficiency in the pricing of assets. Assets are traded on a more frequent basis, and transaction prices are known. Private markets are those in which private transactions are arranged. Here, it is more common for whole assets to be traded in a single transaction, instead of shares of ownership. These markets are normally less liquid, and transaction costs are higher, and prices are more difficult to observe. Debt assets are essentially the rights to the future cash flow to be paid out by borrowers on loans they have taken out. This is a senior or preferred claim for obtaining cash that the underlying asset generates. Equity gives the owners the residual claim on the cash flows generated by the underlying asset. This tends to be more risky. Direct ownership of real estate is mostly traded in a private market known as the property market. The demand side is made up of investors, the supply side of other investors selling or developers or owner users. With regard to the overall general valuation context of real estate, specific values of individual properties or buildings are determined by the perceptions of potential investors regarding the level and riskiness of the cash flows that each individual property can generate in the future. Return on assets (ROA), or cap rate, is similar to the current yield, which is the amount of current income the investor receives per dollar of current value of the investment. The lower the cap rate, the higher the value of the asset. This cap rate is based on three major factors: 1. Opportunity cost of capital: interest rates and other opportunities in the capital markets are determinant of how much investors are willing to pay. 2. Growth expectations: investors look forward, considering the likely amount of growth or decline in the net rent. This depends on what the balance between supply and demand will be in the space market. Additionally, each individual property may have unique attributes that affect its own growth prospects. 3. Risk: if the potential net income is seen as less risky and more certain, they will be willing to pay more. However, investors’ aversion to risk and their preferences for certain types of investments may change over time.

Chapter 2: Real estate system Evidence has shown that development of real estate is cyclical. However, even an economy in recession needs large quantities of built space to continue to function. People still need to live somewhere. But still, the demand for additional and new built space supports the development industry. The development is best viewed in its role as a converter of financial capital into physical capital as the feedback link from the assets market to the space market, adding to the supply side of the space market. As mentioned before, the space market’s demand side is determined by the need for certain quantities of physical space of various types, and the space market also determines the current operating cash flows produced by real estate assets. This interacts with the cap rates required by investors to determine the property market values in the asset market, as well as other determinants

mentioned in chapter 1. These market values represent the key signal as input into the development industry. If these current assets values are higher than current development costs, then development will proceed, thereby adding to the physical stock on the supply side of the space market. Space market participants, asset market participants and developers are naturally forward-looking; space market requires long-term planning for space needs, asset market requires current discounting of cash flows, dependent on the current situation which can be different at the time the assets is developed, and developers have to account for construction time. There can also be a negative feedback loop: supply or demand threatens to get out of balance in the space market, resulting in an effect on the operating cash flows which will trigger a pricing response in the asset markets, making development too costly. However, if the participants are sufficiently forward-looking and quick in their responses, this feedback loop can keep space supply and demand in a good balance. This has not always been the case (bubbles – positive feedback loops). An important concept in real estate is the four quadrant (4Q) model. This shows four binary relationships that together complete the linkages between the space market, the asset market, and the development industry. This is useful for examining the effect of a certain event on the long-run equilibrium between the space and asset markets. The four quadrants are: -

Q*: existing supply of space in the market. R*: amount of space in the market. P*: current asset price. C*: amount of new construction in the market per year.

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The northeast quadrant represents the price/quantity diagram. The vertical line from Q* to the D0 line tells the current equilibrium rent. This equilibrium rent is R*, given Q* amount of space. The northwest quadrant depicts the asset market valuation process, relating the equilibrium property prices, on the horizontal axis, to the level of current rent on the vertical axis. Where the

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downward sloping line meets both P* and R*, that is the property price (per SF) implied by the current rent. The line in that quadrant represents the cap rate. The steeper the line, the higher the cap rate. The southwest quadrant show a construction function line, which is outward sloping, stating that higher property prices leads to more and faster development. As this line does not start at the center of the diagram, you can see that there is a threshold of property price where construction will become profitable and thus take place. A vertical line dropped down from P*, through the function line and then to the vertical axis gives the amount of new construction in the market per year (C*) given current asset price P*. The southeast quadrant links the rate of construction to the total stock of built space. The function line is the average rate of space construction per year to the total stock of space that can be maintained. The concept behind this is that, in the long run, in the absence of new construction, older space will be removed from stock as it wars out and older buildings are abandoned, demolished or converted. Therefore you have a certain amount of new construction per year which is necessary to maintain a given stock of space. The greater the total stock, the greater the annual construction. The lines given state a certain level of annual construction (C*), given a certain amount of total supply of built space (Q*).

The 4Q diagram can help to understand boom and bust in real estate markets. If we look at the lines D0 and D1 we can show this. Consider the effect of an increase in demand for space usage, holding the asset market constant. The line moves from D0 to D1. In the short term, there is no time for new space to be built. However, rents can rise to an R1 level, and this already means a move of the square as a whole. The new long run equilibrium is R**, which is below R1 because of a fall-back in rents as this is anticipated by decision makers, so the significance of the boom is reduced. This new R** means higher prices, namely P** (between P* and P1). This leads to a situation where more buildings are being profitable for construction, so they will be developed. This ultimately leads to a move of Q* to the right to Q**. This was an example of an increase in demand, but the 4Q model could also, for example, show the effects of a relative shift in preferences among investors so that they are willing to pay higher p/e multiples for real estate assets. P/E going up means price going up. This can run through the 4Q model as well and explain the effects. When ultimately the effect of a real estate development boom brings the stock of space up to a new Q** level, you can speak of the physical capital result of the flow of financial capital into real estate asset market caused by the shift in investor preferences. The lesson learned from this system is that how in principle cycles can be dampened by the ability of the asset market and development industry to react quickly with foresight to relevant new information and perhaps by the application of supply inelasticity in the development industry (‘discipline’) and by conservative use of debt in the asset market.

Chapter 6: Real Estate Market Analysis Real estate market analysis seeks to quantify and forecast the supply and demand side of specific space usage markets. The purpose of the market analysis, like micro level decisions on individual

building sites or more general characterizations of the market (forecasting supply and demand), strongly dictates the type of analysis approach to be taken. The latter general market analysis focuses on certain variables or indicators, that quantitavely characterize supply and demand. This could be quantity of new construction started/completed, absorption of new space, vacancy rate or rent level. The variation in vacancy and rents appears strongly cyclical, some markets tend to be more cyclical than others. When a market is less cyclical, rents are less sensitive to vacancy and would reflect greater price elasticity of supply ( a small increase in rents evokes a large and fast response in new development thereby preventing rents from rising further). The five examples of variables mentioned before can be combined or added to other data to provide indicators. For example, monthly supply is a function of vacancy, construction and net absorption, and is an indicator of how long it will take (in months) for all of the vacant space in the market to be absorbed. The first step in any space market analysis is to know or define the subject market. National aggregations are of interest for studying the entire industry, while defining the market more specifically and functionally might be relevant for specific business decisions. It can thus be location-specific, category-specific and finally quality-specific. The next step is the type of analysis approach required. The two broadly different types are simple trend extrapolation and structural analysis. The former looks directly at the market supply and demand variables of interest and extrapolates into the future based on historical trends. The latter attempts to model the structure of the market by identifying and quantifying the underlying determinants of the variables of interest, like amount of office space or level of real per capita disposable income. The structural analysis consists of several steps: -

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Inventory the existing supply of space and identify the fundamental sources of the demand (demand drives, like population) for space usage in the relevant market. Relate the underlying demand sources to the amount of real estate space usage data. There should for example be approximately a one-to-one correspondence between the number of households and the number of housing units demanded. Develop forecasts of future demand for and supply of space in the relevant market. The sources of demand should be projected based on the extrapolation of past trends or judgment about the evolution of the local economic base of demand.

The implications of the analysis could be that projected tightening of the market should lead to higher rents and lower vacancy rates, and project surplus of supply will lead to rising vacancy rates and falling rents.

Chapter 11: Nuts and Bolts for Real Estate Valuation In real estate valuation, cash flow forecasting is of importance, and laying out the cash flow projection is called proforma. A long horizon, for example, is necessary for a solid evaluation. Two

categories should furthermore be represented in a complete proforma: operating cash flows and reversion cash flows. The former is cash flows that result from normal operation, and the latter occurs only at the time of, and due to, the sale of all or a portion of the property asset. The operating cash flow can be labeled potential gross income (PGI), or rent roll. This is determined by multiplying the amount of rentable space by the rent per unit of space (SF). Projecting this means understanding existing leases and forecasting the rental market. A rent comps analysis (comparables) is comparing the recent leases signed for the building and comparing that with similar buildings, in order to check the realism of the assumption about current market rent. A way to gain some insight about the rental growth projection is to examine the past rental history and that of other similar buildings. In the valuation analysis, you also have to include a vacancy allowance, which accounts for the expected effect of vacancy in the net cash flow of the property. This is typically a percentage of the PGI, or by forecasting explicitly the likely vacancy period that will be associated with each rental unit. Subsequently, you have to compare the projected average vacancy percentage to available information about typical vacancy in the market. Realistic vacancy allowance tends to increase over time as buildings age. It is more likely that existing tenants will not renew and/or longer period between tenants. Subtracting vacancy allowance amount from PGI provides the effective gross income (EGI). Operating expenses are a number of regularly occurring, specific expense line items associated with the ongoing operation of the property. Depreciation expenses are not included among the operating expenses, as it is not a cash outflow per se, and depreciation will also already be reflected in the cash flows, for example by lower real rents and higher vacancy allowances, higher capital improvement expenditures, or lower resale value. Fixed costs are unaffected by the level of occupancy in the building, variable costs are. Net leases are in which tenants pay all or most of the operating expenses. Expense stops is in which tenants pay all operating expenses above an agreed-on base level. Net operating income (NOI) results from the subtraction of the operating expenses from all the sources of revenue. Capital improvement expenditures are not included in this. These are major expenditures providing long-term improvements to the physical quality of the property, required to maintain or add to the value of the property. There can also be capital expenditures associated with the signing of specific long-term leases, such as tenant improvement expenditures (physical improvements at time of lease signing) and leasing commissions paid to leasing brokers. Capital expenditures occur at irregular intervals of time. Eventually, you get the property-before-tax cash flow (PBTCF). This is the realistic picture of the free-and-clear cash flow available to the owners of the property, before debt service and income taxes. Reversion cash flows also need to be included in the proforma. This is simply the expected resale price of the property at the projected future point in time, net of selling expenses. The best and most widely used method of forecasting resale price is to apply direct capitalization to the end of the proforma projection period. In that case, they take the NOI of 1 year after the proforma period, and divide it by the reversion cap rate (or going-out cap rate), and this should provide a realistic projection. This helps protect investors against market bubbles and the Greater Fool fallacy, as it:

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Places the reversion fairly far into the future, and the relative magnitude of reversion value component in overall present value is sharply reduced. Uses project direct capitalization based on NOI, so that it is based on the fundamental ability of the property to earn operating cash flow in the rental market, rather than extrapolation of the purchase price.

The going-in cap rate is the cap rate at the time of purchase, and is not really realistic, as buildings become riskier or less able to grow the rents they can charge as they age. For a DCF procedure, you need a denominator, namely the discount rate. This is the multiperiod, dollar-weighted average of total return expected by the investor, in the form of a going-in IRR. It is therefore an ex-ante return measure. The discount rate is meant to be the opportunity cost of capital, which is the return investors could typically expect to earn on average in other investments of similar risk to the subject investment. The calculation is mainly a risk-free rate plus market premium (excess return over risk-free return times beta of investment). Another method is the constant-growth perpetuity model. This says that the expected total return (discount rate) is yield (cap rate) plus yield growth rate. Overall, these approaches (cap rate approach vs. risk premium approach) differ in the sense that the risk premium approach can more easily reflect an underlying normative or equilibrium theory perspective (what OCC should be) and the cap rate approach is more directly based on or observable from the current empirical evidence in the marketplace, so the cap rates at which properties are trading.

Chapter 12: Micro-Level Valuation In the last chapter, they treated the market value of real estate more or less like stock markets; low transaction costs and highly liquid. However, real state is not always like stock market investing, but more like corporate capital budgeting, b...