Real Estate Investment Characteristics.ppt by handongqp

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									ULI—the Urban Land Institute
        Las Vegas, NV

   Real Estate Finance 101:
         October 25, 2007

        Steven W. Spillman
        Pacifica Companies
             Real Estate Investment
• Industry is highly fragmented with few barriers to entry
• Each property is a unique, individual business enterprise
• Investment is long-term, illiquid in nature and not easily traded
  due to market inefficiencies
• Investment, operation, and management requires technical and
  financial training
• Long-term, illiquid nature of real estate ownership does not
  allow for instantaneous, trading-like solutions

• Competition is constant and continuous; neither real estate nor
  capital markets are ever in equilibrium for sustained periods
• Illiquid nature of real estate does not allow owner to change
  financial structure (leverage) quickly/without cost
• Industry lacks transparency as compared to financial markets
  and other business models
• Transactions are complex and costly to execute and require
  third-party expertise
• May provide tax benefits not available in alternative investments

  Public Real Estate Equity Capital
  Markets as of September 28, 2007
                       Year-to-Date   Yield

Dow Jones Industrial      11.6%       2.0%
Standard & Poor’s         9.5%        1.8%
500 Stock Index
NASDAQ Composite         12.2%        N/A

Russell 2000              3.3%        N/A

Morgan Stanley            -3.9%       4.1%
REIT Index
        REIT Performance Year-to-Date
               Property Sector/Sub-Sector   Year-to-Date Total Return as of 0/27/07

Office-Central Business District                            -9.0%
Office-Suburban                                            -10.2%

Industrial                                                  +5.0%

Shopping Centers                                            -0.4%

Regional Malls                                              +2.1%

Free Standing                                               -0.1%

Multifamily                                                 -6.6%

Manufactured Homes                                          -3.0%

Diversified                                                 -7.6%

Hospitality                                                 -2.5%

Health Care                                                 -2.0%

Self-Storage                                               -18.0%

Morgan Stanley REIT Index                                   -3.9%

Commercial Mortgage-Backed Securities
(Increase/Decreased in Trading Spreads over10-Year Treasuries in Basis Points)

                          12/29/2006          9/28/2006   Increase/Decrease
          AAA                  +75              +123            +48
           AA                  +85              +200            +115
            A                  +93              +260            +167
          BBB                 +124              +365            +241
          BBB-                +139              +490            +351
           BB                 +290              +700            +410
            B                 +700              +950            +250
    10-Year Treasury         4.68%             4.58%           0.10%
   Source: Morgan Stanley; Bloomberg L.L.P.
        Worldwide CMBS Issuance
                         (in $ Billions)

                          12/31/2006       9/28/2007

U.S.                        $206.0          $169.9

Non-U.S.                     $93.2          $68.9

Total                       $299.2          $265.8

Source: Commercial Mortgage Alert.

           Conventional and Securitized
             Mortgage Delinquencies

• As of June 30, 2007, conventional commercial
  mortgage delinquencies were 0.03% of outstanding
  balances, a record low for the insurance industry.

• As of June 30, 2007, securitized mortgage
  delinquencies equaled 0.28% of seasoned
  mortgages (mortgages more than one year old), a
  record also

•   Source: American Council of Life Insurers; Standard & Poor’s Corp.

               Capitalization Rates by Property Sector
                         12/31/2006    6/30/2007     Year-to-Date
All Property               7.11%         6.47%           -0.64%
Multifamily                6.20%         5.70%           -0.50%
Office-CBD                 7.00%         6.00%           -1.00%
Office-Suburban            7.60%         6.60%           -1.00%
Retail-Mall                6.70%         6.60%           -0.10%
Retail-Neighborhood        6.80%         6.50%           -0.30%
Retail-Power               6.80%         6.50%           -0.30%
Industrial-Warehouse       7.10%         6.40%           -0.71%
Industrial-R & D           7.60%         7.00%           -0.60%
Industrial-Flex             N/A         7.00%            N/A
Source: Real Estate Research Corporation.                           9
Performance of National Council of Real
 Estate Investment Fiduciaries Indices
                      Trailing 12-        Trailing 12-      Trailing 12       Trailing 12
                     Months ended        Months ended      Months Income    Months Change
                        6/30/06             6/30/07                            in Value
 All Property           18.68%              17.30%              5.9%           10.9%

 Office                 19.46%              13.30%              5.0%            8.3%

 Retail                 17.22%              16.90%              6.4%           10.5%

 Industrial             18.49%              22.10%              6.0%           16.1%

 Multifamily            18.84%              13.60%              6.0%            7.6%

 Source: National Council of Real Estate Investment Fiduciaries (NCREIF).

            Private Real Estate
           Equity Capital Markets
• Direct equity investments and equity joint ventures
   – Available from wealthy individuals, pension funds,
     Opportunity funds, and others
   – All product types
   – All acquisition models-opportunistic, value
     creation, rehabilitation, yield, etc.
   – Utilize third-party financing (70% to 80%)
   – Term-1 to 5 years
   – Exit Strategy

Private Real Estate Equity Capital Markets
   -Range of Required Rates of Return
  • Equity investor contributes up to 90% of capital
    required; real estate partner contributes balance
  • Real estate partner’s returns subordinated to equity
    investor receipt of:
     – Current return of 4% to 8%, cash-on-cash
     – Cumulative return (look-back IRR) of 12% to
  • Real estate partner handles day-today operations;
    paid market rate fees (which increase return on

Corporate Equity and Real Estate

                     Total Real Estate-
Total Stock Market
                      $4.575 Trillion
  $45 Trillion +/-

             Real Estate Capital Flows
                     (in $ Billions)

Equity                         Debt
Private Investors    $566.5    Banks, S & Ls       $1,871.2
                               CMBS                  741.0
REITs                 415.0
                               Life Insurance        289.0
Pension Funds         166.4    Companies

Foreign Investors       52.6   REIT Unsecured        205.7
Public Untraded         44.8   Government Credit      113.9
Funds                          Agencies
Life Insurance          32.7   Pension Funds           43.4
                               Mortgage REITs          26.0
Private Financial        7.2
Institutions                   Public Untraded          0.1
Total               $1,285.2
                               Total               $4,575.5
Debt Capital Markets: Then…and Now
• Mid-May 2007                • October 2007
• Aggressive pricing          • Pricing
   – Spreads below 100           – Spreads equal to 175 to
     basis points                  225 basis points
• Aggressive underwriting     • Underwriting
   – Debt service coverage       – Debt service coverage
     ratio below 1.0 to 1          ratio of 1.15 to 1
   – Credit for future           – Credit for in-place
     income                        income
• Aggressive structuring      • Structuring
   – 10 year interest-only       – 2 year interest-only,
   – No reserves for tenant        then amortization
     improvements/leasing        – Reserves collected and
     commissions                   escrowed
               Private Real Estate
              Debt Capital Markets
            10-Year Prime Commercial Mortgages

                  12/31/2006   9/30/2007   Year-to-Date

Prime                           6.43% -      +0.97% -
Mortgages                       6.93%        +1.47%
Spread over                     1.75% -      +0.73% -
10-Year             1.02%
Treasuries                       2.25%       +1.23%

 Securities Market v. Real Estate Market
  Efficient Market v. Inefficient Market
• Characteristics of an efficient market such as the
  securities markets
   – Many buyers and sellers
   – Transparency of information
   – Very low transaction costs
• Characteristics of an inefficient market such as the real
  estate market
   – Few buyers and sellers
   – Imperfect information
   – High transaction costs
Business Planning For Development Projects

             THE PLAYERS

       Deal Structures Accommodate
            Investor Differences
1. Since investor desired returns, risks, and expectations vary (with
   the same deal), and since investors obtain different information
   about the same property
2. The ability to “componentize” real estate means:
3. Projects can be divided into components to meet different investor
   requirements, such as stripping land from buildings or creating
   different levels of debt & equity.
4. Priority levels of risk include:
                          Land owner (subordinated)
   Higher Risks           Equity (subordinated)
                          Equity (priority)
                          Second mortgage
   Lower Risks            First mortgage
                          Land owner (unsubordinated)
Required Rates of Return for Various
 Real Estate Investment Strategies
Risk Free Rate           U.S. 10-Year Treasury             4.75%
Investment Rate          Bonds (9/29/06)
Income Strategy          Triple Net Leased property     5.75% - 7.25%
                                                       (+1.0% – 2.5%)
Core Strategy            Fully leased, multi-tenant     7.00% - 7.50%
                         property                     (+2.25% - 2.75%)
High-Yield Strategy      Non-investment grade         9.75% - 12.75%%
                         CMBS, mezzanine debt         (+5.00% - 8.00%)
Value-Added Strategy     Partially leased, below      13.75% - 15.75%
                         market rents, renovation      (+9.00 – 11.00)
Opportunistic Strategy   Development, lease-up, non- 14.75% - 16.75%
                         performing loans            (+10.00% - 12.00)
   Structural Effects on NOI
        and Cash Flow
                                   Land owner (unsubordinated)
                                  First mortgage

                                  Second mortgage
NOI (or Cash Flow)
                                  Equity (priority)

                                  Equity (subordinated)

                                  Land owner

       Tranches--Slicing a Transaction into Components

             Maturity           Coupon
Bonds                   Years            Rate    Amount of Issues

Tranche #1              1-5              8.0%      $ 25,000,000

Tranche #2              5-10             8.5%      $ 30,000,000

Tranche #3              10-19            9.0%      $ 35,000,000

Tranche #4              20-30            10.0%     $ 10,000,000

Sub-total:                                         $100,000,000

           Overview of Mezzanine
             Financing Market
• Niche market comprised of opportunity funds,
  investment banks, and commercial banks

• Capital sources aggressively entered the market
  attracted by high risk adjusted rates of return

• Capital is available for higher yielding opportunities
  as banks and non-bank financial institutions are
  attracted to the higher return associated with
  investment in this tranche in the capital structure
      Investment Characteristics of
        Mezzanine Transactions
• Advantages
   – Higher cash return than traditional real estate
     equity investments
   – Investment structure designed to insulate investors
     from declines in value and cash flow
   – Short investment horizon
   – Well matched to current market conditions
• Trade-offs
   – Limited control of asset
   – Limited liquidity

    Stages of Mezzanine Financing

• Stabilized-existing property with current cash flow
  coverage for return on mezzanine investment
• Value added-existing property with moderate to
  substantial lease-up and/or re-leasing risk; generally
  requires cosmetic rehabilitation
• Development-to-be-built property with substantial
  development, construction, and lease-up risk
• Stabilized mortgage pool-purchase of non-rated
  tranche of commercial mortgage-backed securities

       Risks of Mezzanine Investing

•   Change in property values
•   Amount and timing of cash flow
•   Financial risk
•   Quality of underwriting
•   Management control
•   Exit strategy and timing
•   Quality of asset management
•   Real estate risks-development, construction,
    operation, etc.

Mezzanine and “Market-Rate Equity”
     Capital Marketing Sheet
• Mezzanine
  – Target Investment Range: $5 - $15 million
  – Investment Period: 3 years
  – Target Exposure: 95% of project cost
  – Project return: 12% to 16% IRR
      • IRR is typically a combination of preferred,
        look-back, and exit fees/profit participation
  – Non-recourse, secured by partnership interest (or
    second mortgage, if available)

          Example of Mezzanine
          Equity/Debt Transaction
• Senior debt--75%
• Mezzanine investment--15%
• Sponsor equity investment--10%
• Financing structure utilized by developers who want
  to minimize investment in transaction
• Sponsor equity usually includes full deferral of fees
• Profit participation by Mezzanine lender is significant
  part of return
• Pricing: 10% current return plus 50% of net profits
  from property operation and 50% of sale proceeds
  after repayment of loan and sponsor equity
                Joint Ventures

• Sale and financing transactions are “commodity-like”
  whereas joint ventures are individually negotiated
  and tailored transactions
• A joint venture may be formed to:
   – Acquire a specific property, a portfolio of
     properties, or an operating company
   – Recapitalize an existing partnership
   – Develop a property

        Structuring Joint Ventures

• Each joint venture is idiosyncratic; there are no pre-
  set terms and conditions
• Terms to be negotiated include:
   – Contributions
   – Preferred returns and “Claw-backs”
   – “Promotes”
   – Governance, guarantees (if any), fees and
     transaction costs and expenses
   – Winding-up

    Joint Venture-REIT/Pension Fund

• Purpose-to acquire existing shopping centers
• Capitalization-30% equity; 70% debt
• Equity Capital-25% REIT; 75% pension fund
• Term-minimum 3 years; maximum 5 years
• Call Option-prior to 3rd year, REIT may acquire
  properties for cash sufficient to provide pension fund
  with 15% IRR
• Fees to REIT-acquisition, leasing, property
  management, asset management, and disposition

            Joint Venture-Developer/
                  Pension Fund
• Purpose-to develop multifamily apartment complex
• Capitalization-25% equity, 75% construction loan
• Equity Capital-12% developer, 88% pension fund
• Term-24 months (construction>lease-up>stabilization)
• Fees to Developer-development and property management
• Sale Proceeds-pension fund receives return of invested
  capital plus 9% preferred return, then developer receives
  return of invested capital plus 9%; additional proceeds 70%
  to pension fund, 30% to developer

Lender’s Underwriting Decision,
          Method I
• Adequacy of value of property as collateral for
   – Test # 1- Loan-to-Value (LTV) Ratio
   – LTV is an absolute standard; “no loans in
     excess of 75% of market value”
   – Example: Market value = $1,250,000 x 75%
     LTV ratio = $937,500 loan
   – At 75% LTV ratio, maximum loan is

      Valuing Uneven Cash Flows

• Typically, real estate ownership produces cash flows
  that are “uneven” or “lumpy”
• How do you value “uneven” cash flows?
   – By discounting them individually to present value
     using a discounted cash flow (DCF)
• When do you use normally use a DCF model?
   – When the cash flows are not easily represented by
     a single year’s stabilized cash flow

      Measures of Equity and Debt
        Investment Performance
Equity Investment           Debt Investment
  Measures                    Measures
• Price per square foot     • Debt Service Constant
• Capitalization rate       • Loan-to-Value Ratio
• Equity dividend rate
                            • Loan-to-Cost Ratio
• Estimated future sale
  price                     • Debt Service Coverage
• Net present value           Ratio
• Internal rate of return

            CMBS: Basic Concept

• Adapt securitization technology from residential
    mortgages and asset-backed securities (ABS)
•   Use real estate credit risk analysis
     – Underwriter
     – Rating agency
     – Investor
•   Result: Commercial Mortgage-Backed Securities

       How CMBS Have Been Used

• Disposition of loans acquired by the Government in
    the process of liquidating failed savings institutions
•   Restructuring of lender balance sheets
     – Dispose of real estate assets
     – Transform mortgages to bonds
     – Liquidity
•   Beginning in 1995, conduits have become primary
    source of funds

              Summary of Typical
             CMBS Characteristics
• Multiple tranches
     – Fixed- and/or floating-rate
     – Interest only (IO)
•   Prioritized payments: Senior gets paid before
    mezzanine; mezzanine before subordinate (the
•   A loan servicer collects payments from individual
    borrowers and forwards to
•   A trustee who remits principal and interest to bond
•   A special servicer handles defaults and loan
    workouts                                              38
        Different Ownership Structures
• Individual
• Simple & easy to form with limited ability to raise funds
• Co-Ownership
    – Joint Tenancy: Held by two or more people having equal
      ownership rights and the right of survivorship. (If one owner ides,
      then the undivided estate passes to the survivors.)
    – Tenancy In Common: Exists when two or more entities own
      separate and possibly unequal positions. There is no right of
      survivorship. Simple & inexpensive to form with limited ability to
      raise funds, but generally superior to individual ownership.
    – Tenancy by the Entirely: Limited to spouses, and the property is
      not subject to claims of one spouse’s creditors.                39

--General Partnership: An association of two or more co-owners
to run a business or project. Moderately easy to form with limited
ability to raise funds, but typically superior to individual ownership.

--Limited Partnership: Has at least one general partner that
assumes liability and limited partners that have no personal liability
to creditors. Passive tax losses & income are passed through.
Limited partner has less flexibility to control or influence the project
without tax & liability consequences. Moderately difficult &
expensive to form and superior to general partnership in the ability
to raise funds.

--LLP (Limited Liability Partnership): a relatively new creation
that operates much like a limited partnership, but allows the
members of the LLP to take an active role in the business of the
partnership, without exposing them to personal liability for others'
acts except to the extent of their investment in the LLP.       40
     Ordinary Chapter C Corporation

• A separate legal entity in the eyes of the IRS, taxed
  at the corporate instead of individual tax rates.
• The C Corporation status will have a double taxation
  effect, one tax at the corporation level and one at
  the individual level upon distribution of dividends.
   – The participating owner/shareholder will be
     subject to payroll requirements. Any distribution
     from the corporation to the individual, after the
     payroll deduction, is treated as dividends.
     Income, expenses, gains, and losses that affect
     taxable income are reported to the IRS. Employer
     salaries are deductible corporate expenses
     subject to withholding requirements.              41
Ordinary Chapter C Corporation
 A collapsible corporation is typically created to
  avoid federal taxes and results in income being
  ineligible for capital gain treatment.

 A non-collapsible corporation is the typical business
  corporation. Complex & expensive to form with good
  ability to raise funds, if closely held. If publicly held,
  raising funds depends on the investment.

                       S Corporation
--An S corporation is a domestic corporation with no more than
75 eligible shareholders (shareholders can not be nonresident

There is only one class of stock (but can have voting and
non-voting stock).

--Personal liability is limited in the same way as a Subchapter C

--It avoids double taxation.

--No more than 25 percent of the gross corporate income may be
derived from passive income.

--An S Corporation can own 80 percent or more of the stock of a
C corporation.

--An S Corporation is also now allowed to own a "qualified
subchapter S subsidiary;" the parent S corporation must own 100
percent of the stock of the subsidiary.
              S Corporation (cont.)

--Qualified retirement plans or Section 501(c)(3) charitable
organizations may now be shareholders in S Corporations.

--An S corporation can generally provide employee benefits
and deferred compensation plans.

--Not all domestic general business corporations are eligible
for S corporation status. Exclusions include: a financial
institution that is a bank; an insurance company taxed under
Subchapter L; a Domestic International Sales Corporation
(DISC); or certain affiliated groups of corporations.

--Complex & expensive to form with limited ability to raise
funds—unsuited for income property
      Limited Liability Corporation (LLC)
• Similar to Chapter S
• A Limited Liability Company is a hybrid of a corporation and a
general partnership that is treated like a corporation for liability
purposes, and like a partnership for tax purposes.
• An LLC, like a corporation, has not only the benefit of "limited
liability," i.e., the owners, called members, are not personally liable
for the LLC’s debts, but also an LLC has the benefit of being treated
as a partnership for income tax purposes.
     •Unlike a Subchapter S corporation, an LLC is not limited to 75
     shareholders, who may be a shareholder, and is not limited by
     the types of business it may transact.
     •An LLC is not subject to the risks of double taxation inherent
     with corporations.
     •Moderately easy to form with limited ability to raise funds.
  Real Estate Investment Trusts (REITs)
A REIT is similar to a tax conduit vehicle in corporate or trust form that
combines the capital of many investors in order to acquire and hold real
estate or provide financing for all forms or real estate.

REITs started in Massachusetts in 1880s, when trusts were not taxed if
income was passed through to the beneficiaries. As a result of a Supreme
Court ruling, all passive income vehicles that were organized and managed
centrally like a corporation were taxed like a corporation (double taxation)
starting in 1935. Stock and bond investment companies, including mutual
funds were exempted.

After World War II, there was a huge need for real estate capital, which
sparked a movement that resulted in the current form of REITs being
established by Congress in 1960. That legislation provided small investors
with the chance to participate in the benefits of owning larger-scale
commercial real estate or mortgage lending and to receive an enhanced
return, due to the fact that the income is not taxed at the REIT entity level.
                   REITS (Cont.)
REITs have had a troubled past. In the 1970s, Wall Street
banks and insurance companies formed REITs that made high-
risk construction and development loans and operated with a
large amount of leverage. The ensuing crash gave REITs a bad

Most public REITs are now equity REITs, which own existing
real estate portfolios with low leverage. Equity REITs are
typically fully integrated with acquisition, development and
property management expertise. Also, management typically
owns 5 percent to 40 percent of a REIT, which helps keep the
interests of investors and management aligned.

REITs are complex & expensive to form with a good ability to
raise funds.

                 REIT Classifications

Equity REITs invest in and own property; revenues come
principally from their properties rents.

Mortgage REITs deal in the investment and ownership of property
mortgages; they loan money for mortgages to owners and
operators of real estate or invest in (purchase) existing mortgages
or mortgage-backed securities. Most of their revenue is from
interest earned on mortgage loans.

Hybrid REITs invest in both mortgages and properties, combining
the investment strategies of Equity REITs and Mortgage REITs.
Health-care REITs make participating mortgages, enter into master
leases, and develop & acquire medical buildings.
     Advantages of Becoming a REIT
•Greater availability and lower cost of capital
•Broad base of investors including institutions and small
•Allows small investors to participate in a diversified
portfolio, like mutual funds
•Professional management and creative market tools
•Single taxation
•Limited liability
•Properties can be de-leveraged without having to sell
and, in some cases, without triggering immediate tax
Arbitrage opportunity (positive-spread investing)
    Disadvantages of Becoming a REIT
•Initial and ongoing expenses
•Management time demands
•Pressure to maintain growth
•Loss of control
•Potential for conflicts of interest due to close association of the
trust with real estate organization and individuals who are sponsors
•Rising interest rates
•An owner's contribution of property to a REIT can trigger taxable
•Traditional safe harbors for capitalization transactions under IRS
Section 351 may not be available, where, shortly following the
contribution, the underwriter distributes a large portion of the
shares to diverse investors
•Transfer of property to a REIT where the debt on the property
exceeds its basis will trigger taxes to the extent of the excess

ULI—the Urban Land Institute

  Other Concurrent Sessions

   Real Estate Finance 201:
    Friday (10/26) @ 9:45 a.m.

   Real Estate Finance 301
    Friday (10/26) @ 11:15 a.m.


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