Real Estate 101

Introduction to Basic Real Estate Terms and Concepts

Summary of Topics

What is real estate “value”? Property Types Real Estate Terminology Basic Legal Topics Basic Finance, Investment Terms and

Concepts

Summary of Topics (Cont’d)

Development Outline Major Players/Sources of Capital Size of Domestic Real Estate Markets Career Opportunities

What is Real Estate Value?

Present Value of Cash Flows Capital Structure Decisions Definition of Market Value Market Value vs. Price vs. Cost

Property Types

Office Industrial Retail Multifamily

Hospitality Institutional Mixed use Single Family

Real Estate Terminology - Leasing

In-Place vs. Market Rents Expense structures

– Triple Net (NNN)– Expense Stops

– Full Service Vacancy Absorption Sublease Space “Phantom Space”

Leasing Terminology (Cont’d)

Tenant Improvements (“TI allowance”) Leasing Commissions

– Both in-house and external brokerage fees Concessions

– Free rent, excess TI over the “building standard allowance” moving expenses, etc.

– Calculation of “effective rent” – straight line, PV equivalent of the rental stream over the term of the lease

“Per Unit” Terminology

Real estate is measured, costed, and leased on a “per unit” basis

– Construction cost per square foot– Land price per square foot of building area– Leases are quoted per unit as well

Unit definition depends on the property type– Retail, office, industrial – per square root– Multifamily – per apartment – Hospitality – per “key” (ie, per room)

Office Terminology

Gross, rentable and usable area Floor to ceiling heights Floor Area Ratio – “FAR” “Skin” – external curtain wall/façade materials Property types:

– Low, mid and high rise; CBD vs. suburban– Build to suit

Office leases – quoted annually, all structures depending upon market convention

Parking ratio zoned as spaces per 1,000 sq.ft. of space

Industrial Terminology

Gross, rentable and useable area “Clear Height” Dock doors Types:

– Warehouse/distribution, flex/R&D, hybrid

Industrial leases quoted both monthly and annually, NNN

Terminology - Retail

Types of Shopping Centers– Strip, neighborhood, grocery-anchored, power centers,

regional and super regional malls Common Area Maintenance Charges 1, 3, and 5 mile “trade areas” Anchor Tenants

– Anchors are the “draw” for the center In-line Tenants

– In line tenants subsidize the anchors Leases quoted annually, hybrid with “CAM” charges

Terminology - Multifamily

Type:– Garden, midrise, highrise– Condominium, coop

Base rent plus additional tenant charges Repositioning Unit Turnover

Hospitality – Operating Business Using Real Estate

ADR REVPAR Departmental Profitability Gross Operating Profit Flagged vs. Independent Type

– Limited service, full service, luxury, resort– Other subsets exist as well

Basic Legal Concepts

Ownership = Control over “bundle of rights” Transfers of Ownership Types of Legal Interests

– Possessory vs. Non-Possessory– Fee Simple– Leasehold– Easements

Basic Legal Concepts (Cont’d)

Title Purchase and Sale Agreements

– Escrow– “Go Firm”– Closing– Types of deeds, importance of recording

Mortgages Promissory Notes

Legal (Cont’d)

Deeds of Trust 1st Lien – Secured vs. Unsecured Guarantees Defaults – Monetary vs. Technical Foreclosures “Deed in Lieu” Deficiency Judgment

Finance and Investment Terms:The Operating Statement

Revenue Actual vs Gross

Potential Vacancy Allowance Gross Effective Income Operating Expenses Replacement Reserves

Net Operating Income Debt Service Capital Expenditures TI, Commissions, and

other Capex Before Tax Net Cash

Flow to Equity

Finance and Investment Terms – Debt Financing

Loan to Value (LTV) DCR Spread Interest Rate Amortization vs. Maturity Discount Points Prepayment Points Types of Debt Private vs. Public Debt Markets – CMBS Private vs. Public Equity Markets - REITs

Finance and Investment Terms: Return Analysis – Three Critical Components

Initial Investment Amount Cash Flow “pro forma” over the holding period Exit or Terminal Value

Finance and Investment Terms: Return Analysis (Cont’d)

Leveraged vs. Unleveraged Returns Yields

– “going-in” yield– “free and clear “ yield– “cash on cash” yield – in place vs. stabilized yield

Capitalization Rates– WACC– Real rate + risk, inflation, and recapture premiums

Discount Rates

Finance and Investment Terms:IRR

Use DCF analysis to calculate internal rate of return– Return to investment over a holding period

Also, use DCF to conduct sensitivity analysis – Test level of risk in your pro forma assumptions

Partitioning the IRR– How much of your return comes from cash flow versus

“residual” value?– Helps assess the risk in achieving the IRR – or, is your IRR

requirement a good match with the level of risk in the property?

Finance and Investment Terms:Assumptions

General Economic Conditions Rental Rate Growth Occupancy Exit Cap Rates Loan Underwriting Parameters

– LTV and DCR ratio tests

Year of Exit

Finance and Investment Terms:Deal Structure

Use of Tax Efficient Forms of Ownership– Partnerships– LLC’s– Syndications– REITS and UPREITS

Preferred Returns Promotes

Finance and Investment Terms:Analysis of Tax Benefits

“Interest Expense Deductibility Depreciation Loss Carryforwards Must demonstrate “substantial economic

effect” to use tax deductions

Development Issues

Supply and demand constraints– Urban economic analysis– Understanding when the market is ripe for new development– Understanding what the tenants want - and will pay for - is

critical– Lag times for bringing property to completion

Zoning and Entitlements Financing Issues and capital market constraints Renovation and Repositioning

Major Equity Players and Capital Sources

Pension Funds– Direct Investments– “Core” Funds– Opportunity Funds– Separate Account Allocations– Advisors

Equity REITS Life Companies Foreign Investors Individuals, Syndications and Partnerships

Major Player/Capital Sources: Equity:

PensionFunds

REITS

ForeignInvestors

LifeCompanies

Banks/S&L's

Major Player/Capital Sources:Debt

Banks

CMBS

Life Co.

Federally Guar.Pools

Other

Growth of MBS Market

MBS Market Market Value of Traded MBS

1980 - 2002

1980, $11,000,000,000

1990, $914,000,000,000

2000, $3,500,000,000,000

2002, $4,300,000,000,000

$0

$500,000,000,000

$1,000,000,000,000

$1,500,000,000,000

$2,000,000,000,000

$2,500,000,000,000

$3,000,000,000,000

$3,500,000,000,000

$4,000,000,000,000

$4,500,000,000,000

$5,000,000,000,000

year

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Value ofPublicly Traded U.S. Treasuries = $3.5 trillion

Value of outstanding residential mortgages = $6.5 trillion

Creation of MBS – Fannie Mae MBS Creation

Mortgage Pass Through from Pooled – Investment Characteristics

Cash Flows

1. Interest

2. Principal

3. Unscheduled principal (PREPAYMENT)

Risks

– Basic FI (bond) risk – time value, reinvestment

Mitigate default and payment timing risk through pool insurance issued by Ginnie, Fannie, and Freddie

– Prepayment – easier to predict prepayment across a pool

(think insurance: life, auto, flood, health, etc. – law of large numbers)

Additionally, pooled “creature” now divisible into MBS securities

Mortgage Pass Through Securities – Benefits created

Default and payment timing risk (receiving both P&I timely) mitigated by pool insurance supplied by Ginnie, Fannie, Freddie

Prepayment risk still exists (total prepayment risk unchanged) but becomes easier to predict across the entire pool

Adds liquidity to the investment through creation of “small pieces”

– This is different from adding liquidity to primary mortgage market that we’ve been talking about

Ginnie Mae (GNMA)

Oldest; started making MBS in 1970 Ginnie pools contain only government insured

mortgages (primarily FHA and VA) Ginnie pass-through securities are fully modified

– Fully modified means security holder will receive full and timely payment of P&I regardless of payment pattern on underlying mortgage

2002 single family conforming limit up to $300,700 from $203,000

– Increased to match Fannie and Freddie

Fannie Mae (FNMA) : General

Quasi-private– Not a government department or entity– Guarantee does not carry “full faith and credit of U.S.

Government”– Freddie has ability to request “emergency funding” from the

U.S. Treasury Like Ginnie, Fannie guarantees timely payment of

P&I fro all securities it issues Unlike Ginnie, Fannie securitizes conventional

mortgages (mortgages that do not have government insurance) and seasoned (older) FHA/VA mortgages

On the web at fanniemae.com

Freddie Mac (FHLMC) : General

Very similar to Fannie Created to securitize conventional mortgages

and seasoned non-conventionals Wide variety of pool types

– Bi-weekly mortgages– High LTV mortgages

On the web at freddiemac.com

Fannie & Freddie loan limits – Definition of Conforming Loans

2002 Fannie Mae/Freddie Mac Conforming Loan Limits

Effective January 1, 2002 Previous (2001) limit

One-family loan $300,700 $275,000

Two-family loan $384,900 $351,950

Three-family loan $465,200 $425,400

Four-family loan $578,150 $528,700

note: one to four family loan mortgages in Alaska, Hawaii, and the U.S. Virgin Islands are 50% higher than the limits for the rest of the country.

Private MBS issues – NOT Ginnie, Fannie or Freddie

Private MBS issues account for about 11% of total market

Private MBS market primarily for non-conforming loans, i.e., loans that Fannie, Freddie or Ginnie cannot accept– Jumbos (greater than $300,700 (2002))– No-docs or limited doc

MBS Pass-Through Wrap-up

Concept – MBS pass-through is an ownership share of an underlying mortgage pool where each security receives a pro-rata share of both the P&I paid by the underlying mortgages

– Are there any questions on this?

Particulars – modeling the cash flow is essentially modeling N mortgages with the prepayment option explicitly included in the cash flows

– Are there any questions on the MBS cash flow spreadsheet everyone now has?

Problems with MBS Pass-Throughs

Unknown maturity Difficult to hedge, difficult to include in a traditional FI portfolio

Negative Convexity– Convexity (as you know) is the curvature in the price/yield relationship

for a FI instrument Convexity means that a drop in rates leads to a more than linear increase

in price, and an increase in rates leads to a less than linear decrease in price : convexity is a good thing

Negative convexity is not a good thing for a FI instrument– Rate declines lead to PP and reinvestment problems, market knows this and

value suffers on rate declines– Rate increases don’t lead to PP, but they then hurt the FI component (fixed

future cash flows) Both problems stem mainly from prepayment

Source of MBS problems

Primarily Prepayment Related issue is the fact that every pass-through share gets both

principal and interest

– Early prepayment good thing in terms of getting money back sooner (good in terms of

principal), bad in that interest flow stops (bad in terms of interest)

– Late prepayment bad because you wait longer for money to return (bad in terms of

principal) good in that interest flow continues longer (good in terms of interest)

Financial Innovation in the MBS MarketLecture Map

IOs and POs (basic strips)– Break apart the payment stream into interest and

principal – increase predictability of price reaction to rate changes

CMOs– Increase maturity certainty (tranche creation)– Parcel out or concentrate prepayment risk and

interest rate risk Freddie Mac Multiclass Certificates, Series 2468

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What is a REIT?

Owns, and in most cases operates, income-producing property (Equity REITs)

– Office – Apartment – Retail (shopping centers)– Hotels– Warehouses (storage)

Some REITs also finance real estate (Mortgage REITs)

REIT shares trade on major exchanges– Debt (bonds) are also publicly traded

Where did REITs come from?

Created in 1960 (act of Congress) as a way to make property investment available to individual investors

– Offer expert management and familiar corporate governance structures (BOD) REIT trivia – original REIT act was an amendment to an Act

regarding excise taxes on cigars

REITs make equity interest in commercial property:1. Divisible into shares that can be purchased by small investors2. LIQUID – the shares trade on major exchanges

How Many REITs are there?

About 300, ≈ 2/3 of which are publicly traded– 149 on NYSE– 27 on American– 12 on NASDAQ

Total REIT assets ≈ $300 billion

Types of REITs

Equity REITs – Own and operate income-producing real estate– Perform leasing, development, and construction activities

151 publicly traded equity REITs Mortgage REITs

– Hold mortgages on real property Make mortgages (lend money), usually on existing property Buy mortgages 22 publicly traded mortgage REITs

Hybrid REITs– Both own properties and make loans

9 publicly traded Hybrid REITs

Types of REITs – more detail(source: NAREIT)

Number Millions of Percent ofof REITs Summary by Property Sector and Subsector dollars Total

34 Industrial/Office 48,044.9 2920 Office 28,869.5 187 Industrial 10,154.9 67 Mixed 9,020.4 6

41 Retail 38,877.9 2426 Shopping Centers 18,361.9 119 Regional Malls 17,658.7 116 Free Standing 2,857.3 2

24 Residential 29,797.7 1819 Apartments 27,478.8 175 Manufactured Homes 2,318.9 1

20 Diversified 12,917.7 816 Lodging/Resorts 7,900.4 53 Self Storage 5,209.0 3

13 Health Care 8,518.5 57 Specialty 5,592.3 3

19 Mortgage 6,335.9 412 Home Financing 4,336.7 37 Commercial Financing 1,999.1 1

177 Industry Totals 163,194.3 100

Note:1 Equity market capitalization does not include operating partnership units or preferred stock.

Equity Market Capitalization1

REIT Structures – UPREITs and Traditional REITs

UPREIT (Umbrella Partnership REIT)– First UPREIT was Taubman Realty IPO in 1992– UPREIT structure created to shield owners contributing real

estate assets to the REIT from capital gains taxes on contributed property

Transfer is then partnership shares for partnership shares, and this is not a taxable event for the owners

– UPREIT owns a controlling interest in a limited partnership that owns the real estate, as opposed to a traditional REIT structure in which the REIT owns the real estate

– The Umbrella Partnership “shares” – known as operating partnership units, or OP units – are convertible into REIT shares and enjoy voting rights and dividends just like REIT shares

Convertibility allowed after one year, and triggers taxes

REITs and Taxes

REITs do not have to pay federal taxes at the corporate level

– More specifically, REITs are allowed to deduct dividends paid to shareholders from taxable income, and thus have the ability to shield 100% of taxable income through distributions to shareholders

No other firm in the economy can deduct dividends

– REIT shareholders still have to pay taxes on dividends and capital gains

– Most states honor the REIT status and don’t require REITs to pay state taxes

Career Opportunities

Construction Development Property Management Leasing Brokerage/Tenant Rep Asset Management Consulting City Planning/Economic Community Dev.

Career Opportunities (Cont’d)

Investment Management (institutional and family office)

Equity Funds Commercial Banking Mortgage Brokerage and Placement Institutional Brokerage Investment Banking