1. Chapter 3 Finance Theory and Real Estate

2. Chapter 3 Learning Objectives Understand how basic finance principles can be applied to real estate Understand how basic finance principles can be applied to real estate Understand how finance principles can be applied to a wide variety of real estate topics Understand how finance principles can be applied to a wide variety of real estate topics 3-1

3. Issues In Real Estate THE ROLE OF RISK IN VALUATION THE ROLE OF RISK IN VALUATION Earn risk-free return for postponed consumption Earn risk-free return for postponed consumption Earn risk premium based on risk exposure Earn risk premium based on risk exposure Optimal level based on degree of risk aversion Optimal level based on degree of risk aversion 3-2

4. Issues In Real Estate VALUATION VALUATION Market value versus book value Market value versus book value Appraised value Appraised value Amount and riskiness of cash flows Amount and riskiness of cash flows FINANCIAL LEVERAGE FINANCIAL LEVERAGE The use of debt in financing The use of debt in financing Optimal mix of debt and equity Optimal mix of debt and equity 3-3

5. Financial Intermediation Intermediary stands between the supplier and user of credit Intermediary stands between the supplier and user of credit Performs economic functions by assuming: Performs economic functions by assuming: Liquidity risk (think savings account versus mortgage) Liquidity risk (think savings account versus mortgage) Credit evaluation on borrower and property Credit evaluation on borrower and property Interest rate risk Interest rate risk

6. Issues In Real Estate MARKET EFFICIENCY MARKET EFFICIENCY Weak form efficient Weak form efficient Semi-strong efficient Semi-strong efficient Strong form efficient Strong form efficient AGENCY THEORY AGENCY THEORY Monitoring Costs Monitoring Costs Bonding Costs Bonding Costs Structuring Costs Structuring Costs 3-4

7. Issues In Real Estate OPTIONS IN REAL ESTATE OPTIONS IN REAL ESTATE Call Option - Right To Prepay Call Option - Right To Prepay Put Option - Putting The Property In Place Of The Debt Put Option - Putting The Property In Place Of The Debt Explicit Option - The Right To Purchase Property At A Specified Price Within A Specified Time Explicit Option - The Right To Purchase Property At A Specified Price Within A Specified Time 3-5