Chapter 3

Finance Theory and Real Estate

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Chapter 3 Learning Objectives

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

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Issues In Real Estate

Valuation Market value versus book value

Appraised value

Depends on expected amount, timing, and risk associated with the asset’s cash flows

Basic Valuation Equation PRESENT VALUE =

Where CF stands for periodic cash flows, r is the appropriate discount rate, and n is the number of cash flows

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Issues In Real Estate

NOI (or accounting profits) vs. after-tax cash flows Focus on after-tax cash flows

Added cash flows from minimizing taxes allow for greater accumulation of wealth, since cash flows can be reinvested in other corporate investments

Timing of cash flows The sooner a cash flow is received, all else equal, the great its present value (PV)

Risk of cash flows When a possibility exists that the actual cash flow may be different from the expected

and probabilities can be assigned to these possibilities.

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Risk of Real Estate Assets Commercial project Real estate limited partnership (RELP) Real estate investment trusts (REIT) Residential mortgage Mortgage-backed securities (MBS) Collateralized mortgage obligations (CMOs) Commercial mortgage-backed securities (CMBSs) Interest-Only and Principal-Only Securities (IOS and POS) Servicing Rights

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The Role of Risk in Valuation

Earn risk-free return for postponed consumption

Earn risk premium based on risk exposure

Optimal level based on degree of risk aversion

Discount rate associated with the equity portion of the real estate investment should be higher that the rate associated with the debt of the project

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Financial Leverage

Financial leverage is the concept of using debt to finance an investment project

Two primary sources of capital: debt and equity

Generally, the borrowing rate is less than the return on the asset (positive financial leverage) Negative leverage when the borrowing rate>ROI, resulting in declining return on equity

(ROE)

Financial Leverage Modigliani and Miller proposition I: in perfect markets

(no taxes, no distress costs) capital structure is irrelevant (does not create or destroy value)

When addition taxes and financial distress costs, debt financing increases the value of the asset to a point (optimal leverage)

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Options in Real Estate

Prepayment or Call Option – gives the homeowner the right to prepay the current balance on a mortgage at any time prior to maturity Prepayment penalties rare in residential real estate, but common in CRE

Put Option – in the event of default the lender can foreclose on the property and liquidate it to satisfy the obligation Put options on commercial properties – may differ in the exercise of the option

Options in Real Estate Options on House Prices – CME offers futures and

options on house price indices (S&P/Case-Shiller) for major metropolitan areas.

Explicit Option - The right to purchase property at a specified price within a specified time Often in relation to the purchase of raw (undeveloped) land

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Value of Mortgages

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Case-Shiller Home Price Index for Las Vegas, NV and Los Angeles, CA, 1997-2012

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Financial Intermediation

Intermediary stands between the supplier and user of credit

Performs economic functions by assuming: Liquidity risk (think savings account versus mortgage)

Credit evaluation on borrower and property and risk management

Interest rate risk – exposure through fixed rate mortgages (FRM) and prepayment

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Portfolio Theory When assets are combined to form a portfolio , the

expected return on the portfolio will be equal to the weighted average (based on the relative value of each asset in the portfolio) of the expected returns on the individual assets

The risk of the portfolio will depend on the correlation of the portfolio’s assets returns E.g. if the returns of two assets are perfectly negatively correlated

it is possible to construct a riskless portfolio(certain returns). Benefits of diversification through portfolio construction

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Efficient Market Theory

Efficient Market – an asset trades in a market where its value reflects all available information about that asset An investor cannot earn excess return over the normal return by employing information

that is available to everyone.

Market Efficiency Weak form efficient Semi-strong efficient Strong form efficient

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Market Efficiency Markets tend to be less efficient when:

Dominated by few large investors Involve illiquid assets Have large transaction and information costs

Research shows that RE markets are weak form efficient

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Agency Theory Agency theory deals with the relationship between

principals and agents Agency costs types:

Monitoring costs Bonding costs Structuring costs

Agency problems exist in many real estate activities and transactions

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