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

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.

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

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

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

–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.

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.

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.

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

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.

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

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.

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.

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.

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.

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

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

–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.