Final Exam Review

1. Final Exam Review Thursday, May 4 1:00pm – 3:00pm

2. Valuation Approaches • Cost Approach • Income Approach • V = I/R, I=stabilized NOI, R=cap rate • Relationship between cap rate and discount rates. • Incorporates real estate specific risk • Market Approach • Hedonics • Overall: Weaker methods of valuations; know the approaches, pros/cons of each, when you would use them.

3. Cash Flow Valuation • Operations: • Gross potential income- Vacancy/bad debt= Effective gross income- Operating expenses= Net Operating Income- Debt Service- Capital Improvements = Before Tax Cash Flow

4. Net Operating Income- Interest- Depreciation (Residential=27.5 yrs/Commercial = 39)= Taxable IncomeBefore Tax Cash Flow- Tax Bill= After-Tax Cash Flow

5. At Sale: • Gross Sale Price- Sale expenses= Net Sales Price- Mortgage Balance= Before Tax Cash at Sale- Tax Bill at Sale= After Tax Cash Flow at Sale

6. Net Sales Price- Book Value ((Cost+Cap Improve) – Accumulated Depreciation)= Capital Gain* Capital Gain Tax Rate= Tax Bill at Sale • Overall: Know how to do cash flows. Period. Remember how to incorporate capital improvements into the cash flows as well.

7. Mortgage Mechanics • Write down basic TVM equations on your cheat sheet. • To receive partial credit, you must prove that you understand the basics – • i.e. use the correct equation and indicate that you know what to solve for. • Loan Amortization: know how to find the remaining balance on a mortgage at any point. • Loan Amortization: know how to divide the mortgage payment into principal and interest • Overall: Know how to manipulate the equations, solve for effective interest rates, IRRs, etc.

8. Cash Flow Pro formas • Where does value in deal come from? When? Timing matters for NPV. • Are assumptions realistic? • Expense growth? Increase at an increasing rate. • Are you budgeting enough capital reserves? • Are you taking market conditions into account? • Make less money when leases rollover in market downturns. • Watch out for unrealistic sale price assumptions. • What does it mean to have differences in going-in and terminal cap rates? • Overall: Be able to think about what’s going on.

9. Leases • Designed to align incentives of landlord and tenant. • Primary goal: get tenants to internalize externalities (foot traffic) • Use strategic, tactical, and price control features. • Strategic: picking tenants and establishing control to maximize return • Tactical: locating tenants and incentives to maximize positive effects on each other • Price: Maximize return to the mall owner without deterring tenants. • Overall: Understand incentives and think about how to maximize return

10. Corporate Real Estate • Financial Criteria: • Low cost of capital is important for decision to own • Most companies should lease based on financial grounds • Should do short-term rents if you’re not sure you’ll be staying. • Most firms/managers underestimate the value of flexibility resulting from short-term and overestimate the cost savings from long-term leases.

11. Corporate Real Estate • Non-financial or hard-to-value criteria: • Need control over space • Put a big investment in and think landlord will take advantage of you • Corporate image. • Overall: Be able to weigh costs/benefits of different potential ownership or leasing strategies

12. Wraparound Mortgages • Existing first mortgage has low interest rate • Borrower wants to refinance or buyer wants to assume mortgage (but current market interest rates are significantly above existing first mortgage’s contract rate). • Lender offers a below market loan and assumes first mortgage • Borrower gets to refinance at a below-market rate • Lender makes money of the spread between wrap and first • Borrower gets to frontload interest • Complexity and subordination issues can be costly • Overall: Know how to put these together and when you might want to use one.

13. Participating and Convertible Mortgages • Two types of participating mortgages: • Income participation: lender receives a portion of upside income • Equity participation: lender receives some portion of upside of building value. • Structure deal carefully to avoid giving borrower incentives to change building operations to lower lender’s return • Cost/benefit analysis • Borrowers get low base interest rate, share operating or sale risk, but doesn’t get all of upside, loss of liquidity, loses some operational control • Lenders get baseline income flow and some upside action with limited liability but have more risk.

14. Convertible mortgage: • Low rate mortgage with an option for the lender to become an equity owner at some future date. • Similar cost/benefit analysis to participation mortgages, but borrower retains more control pre-conversion, structure is more illiquid, complex, and expensive. Lender gets to join in a joint venture after the risky start-up period. • Overall: These structures allow borrowers and lenders to trade off interest rates, the amount of risk, and the timing of cash flows and risk.

15. Deals Structured Around the Land • Ground leases – lease use of land for some period; have right to improve it and collect net rents. • Leasehold estate is valuable • Subordination issues; high costs of complexity • Subtract ground rent after debt service when analyzing cash flows • Sale/leaseback – sell real estate and lease back space • Overall: Be able to weigh costs/benefits of each of these options.

16. REITs • Three types of REITs • Key REIT restrictions: • 75% of assets must be invested in real estate assets, cash, or government securities • 95% of GAAP taxable income must be distributed to shareholders • 75% of gross income must be from real estate • Five or fewer investors cannot own 50% or more of the REIT’s shares • UPREIT structure • Control, capital gains tax avoidance vs. complexity and potential management/shareholder conflicts

17. General REIT market information • Funds from operations (FFO) – akin to recurring earnings • NET Income from GAAP– Profit from Asset Sales+ Real Estate D&A= FFO per NAREIT

18. Expensing/depreciating strategy can affect FFO; tradeoff with payout ratio • Cash available for distribution – recurring cash that can be paid as dividends “What will cash flow be over the following year?” • FFO per NAREIT+/- Straight-lining of rents– Recurring, non-value-enhancing CAPEX+/- Other adjustments=CAD or Adjusted FFO • Optimal REIT size • Overall: Understand meaning of and how to apply FFO and CAD.