Veritas Financial Group Introduction to the Financial Universe Week 6 – Real Estate

Today’s Agenda – Real Estate What is Real Estate? How can you invest in real estate? How do you finance real estate? What drives real estate prices? What is a “housing bubble”? How did real estate contribute to the financial crisis?

What is Real Estate? Real Estate is an ownership interest in land and/or buildings positioned on land Sometimes land + building do not go together Long-term operating leases are real estate

What is Real Estate? Three broad categories of real estate Residential: houses, apartments, and condos Next subdivision: single-family vs. multi-family Outside investment more common in multi-family Commercial: shopping centers, offices, etc. Industrial: warehouses, factories

How can you invest in real estate? Direct Investment Simplest and easiest to understand Buy an interest in a particular piece of property Requires large amounts of capital, especially if you are looking to build a diversified portfolio High transaction costs and low liquidity

Rent versus Buy Home Price$1,000,000 % Down20% Amount Downpayment$200,000 Home Loan Amount$800,000 Loan to Value/ "LTV"80% Interest Rate5% Term Loan30 Expected House Appreciation2% Monthly Rent$5,000 Annual Rent$60,000 Rent Inflation2%

How can you invest in real estate? Real Estate Development is a form of Direct Investment Build something new (residential or commercial development) Improve an existing property Can either sell off entire property or individual units

How can you invest in real estate? Indirect Investment REITs – Real Estate Investment Trusts Comingled vehicle for buying real estate Mutual funds are for stocks what REITs are for real estate Pool your money with other investors to purchase a particular type of real estate in a particular market Examples: Commercial real estate in Seattle, residential real estate in New England, etc.

Real Estate Pros and Cons Pros Real estate is a ‘store of value’ Projects can have significant upside Long term outlook Cons Relatively Illiquid High capital requirements can make it difficult to diversify risk sources Negative cash flow at the beginning Exposed to broader macro trends

How can you finance real estate? Cash – simple, but uncommon Standard financing – down payment (20%) and bank financing for the rest Adjustable Rate Mortgages (ARMs) “Interest Only” – no principal payments; essentially renting but you’ve taken title Second Mortgages – used for down payment Loan-to-Value a key factor in determining the interest rate on these loans

What drives real estate prices? Cash flow from real estate In theory, this is a simple DCF calculation Value of a building is determined by cash flow and discount rate General market pricing techniques Analogous to a multiples analysis for stock Pricing per square foot is most common Other measures include price per parking space, square foot of selling space, etc.

What drives real estate prices? Old-fashioned supply and demand Market forces drive real estate prices just like they do stock prices and prices for other goods. When markets are “hot” prices rise dramatically because investors get excited about a market Bubbles are primarily driven by investors and not buyers who intend to use the space themselves Government incentives Governments often provide tax incentives to locate businesses or homes in certain geographic areas. This will raise prices.

What is a housing bubble? Unsustainable rise in housing prices caused by a stream of outside investment into a particular market Why are bubbles dangerous? Home equity loans – “Make your home work for you” High loan-to-value ratios – “Zero Down!” No doc mortgages Both categories of products put houses at a high risk if going “under water” if there is a decline in prices (which there almost always will be) What happens when you are under water? The bank is in trouble because if you default, they cannot recover the loan balance from the property

Mortgage Securitization

How did real estate contribute to the financial crisis? Textbook real estate bubble People believed that housing prices would go up forever

How did real estate contribute to the financial crisis? Loan standards deteriorated Constant refinancing and home equity loans

How did real estate contribute to the financial crisis? US economy began to slow. A few people couldn’t pay their loans (subprime) Everyone got nervous about the economy. Economy continued to slow. More people couldn’t pay. Defaults rose to previously unbelievable levels.

How did real estate contribute to the financial crisis? Banks, who had a lot of housing exposure, suffered from greater than expected losses and restricted lending

The “Great Recession”