A BIG WELCOME TO ALL OF YOU : A BIG WELCOME TO ALL OF YOU Jay Sa-Aadu
Chester A. Phillips Professor of Finance and Real Estate
Slide2 : Introduction to Real Estate
Investment Analysis Session #1
Three Popular Myths About Real Estate Investments : Three Popular Myths About Real Estate Investments The Three Myths
#1 Real estate lasts for ever
#2 Supply of real estate is limited
#3 So real estate prices always go up
The HTG Truth: “Real Estate is Highly Perishable” --- this is your first assignment
“Land is the only thing in the world worth working for ...because it’s the only thing that lasts” : “Land is the only thing in the world worth working for ...because it’s the only thing that lasts” Gerald O’Hara in
Gone with the Wind
by Margaret Mitchell
Slide5 : “Buy land. They ain’t making any more of the stuff.”
Will Rogers
What is Real Estate? : What is Real Estate? Physical Assets
Surface, Subsurface, Air Rights
Property Rights
Freeholds: fee simple, defeasible fee, etc
Leaseholds: tenancy for years, periodic tenancy
Financial contracts
Mortgages, MBS, CMBS, REITs
Game Theory and Real Estate Investment : Game Theory and Real Estate Investment Real Estate business is “War” (competition)
Outsmarting the competition
Capturing market share
Locking up tenants
Real Estate Investment is “Peace” (cooperation)
Developer needs the lender
Developer needs tenant
Developer needs suppliers
Lender, tenant also need developer
Game Theory and Real Estate Investment: A New Mindset : Game Theory and Real Estate Investment: A New Mindset Real estate investment requires “cooperation” when it comes to creating the asset
It is “competition” when it comes dividing the benefits or cash flows generated by the project
So real estate business is simultaneously war and peace
Game Theory and Real Investment: The Business Strategy : Game Theory and Real Investment: The Business Strategy Five Basic Elements of Real Estate Investment Game
P Players
A Added Value
R Rules
T Tactics
S Scope Competition
+
Cooperation
=? Think “Complement”
Slide10 : The Setting for Real Estate Investment Game services tax user fees capital capital gain Political System Social System Enterprise System Public
Sector Consumption
Sector Production
Sector Real
Estate services tax rentals, purchases Finance
Sector Interest Construction Cost Regulation Mortgage Payments R
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T
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N M
A
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Real Estate Investments: A cooperative + competitive game : Real Estate Investments: A cooperative + competitive game Every real estate project requires adopting to the context of a specific surrounding environment and time, involving different interest groups and limited resources
The process requires the coordination of many expertise
Financing, construction, engineering, legal, marketing, regulation, services, and management
The creation and management of space-time unit is termed real estate development
every space-time has monetary equivalent
Space Rent Cash flow Value
The Key Players in the Game : The Key Players in the Game The process is a dynamic interaction between four key groups
Space Consumption Sector: demand
individual consumers, collective consumers, future users
Space Production Sector: supply
developer, lawyers, engineers, architect, material etc
Financing Sector: financial markets
construction lenders, permanent lenders, equity partners
Public Sector: regulatory environment
regulation, zoning, building codes, tangible and intangible services
Critical Common Objective of Players: Financial Solvency : Critical Common Objective of Players: Financial Solvency All participants are Cash Cycle Enterprises
Real estate development requires attainment of equilibrium
Equilibrium means financial solvency for all participants
Financial solvency is the critical common objective that forces cooperation and equilibrium, not necessarily profit maximization
CASH FLOW (NOT PROFIT) IS KING
Are we saying that profit or wealth maximization is not important?
Thinking “Complement” in Real Estate Investment : Thinking “Complement” in Real Estate Investment What is a complement?
Any other product or service that makes another more attractive
Financing is complement to real estate investment
Can you name other complements to real estate? There are many more!!
Complements help explain why some real estate business fail and others thrive
Thinking complement is about finding ways to make the real estate investment more valuable (making the pie bigger)
Slide15 : Property
Rights Cash Flow Lease Contract Promissory Note Financial
Contract/Lien Debt
Service Taxation,
other
Constraints Leasehold Right
of use Restrictions on user (Tenant) Landlord-Tenant
contract Landlord-Tenant Laws Regulatory Constraints Income and Wealth
Taxation Mortgage Laws Complementators Competitors Exhibit 2: The Real Estate Investment Value Net
Real Estate as the Nexus of Profit Centers : Real Estate as the Nexus of Profit Centers True profit centers are in cash revenues created by developers’ expertise in the process of creating the real estate
Some classic Illustrations
DISNEY LAND (California)
How Disney created a potentially BIG PIE but ended up with a small piece of it
DISNEY WORLD (Florida)
How Disney created a BIG PIE and ended up with all of it
Slide17 : One portion of Fee Interest
Subsurface, Subsurface, & Part
Airspace Alcoa Plaza Associates (APA)
Single Fee Simple Ownership
Single Physical Interest
(Subsurface, Surface and Airspace)
APA split fee interest into three portions 6-Story Office Building
developed by APA APA sold one portion of Fee Interest to Equitable for $12 APA obtains 99-year
ground lease from Equitable
APA construct Office Building with
a $3.5M 27-year leasehold mortgage
provided by Equitable APA sold ½ airspace fee interest
above office building to
a Housing Corporation for $19 M APA sold ½ air space fee interest
above office building to second
Housing Corporation for $19M Financing:
$15M Equitable 1st mortgage
$4M APA 2nd mortgage
Financing:
$15M Equitable 1ST mortgage
$4M APA 2nd mortgage Exhibit 3:Nine Legal and Physical Interests in same Parcel of Real Estate
Financial Engineering: United Nations Plaza Building Project (1968)
Major Concepts & Discussion Points in Connection with the Case : Major Concepts & Discussion Points in Connection with the Case 1. Major concepts
Ground Lease
Sale-Lease-Back
Leasehold Mortgage
1st Mortgage, 2nd Mortgage
2. Major parties in the transaction
3. Objectives of the parties
4. How the parties realized their objectives
Commercial Real Estate System : Commercial Real Estate System The real estate system consists of three major branches: (1) the space market, (2) the asset market, and (3) the development industry. See Exhibit 4
The development industry converts financial capital into physical capital (built space)
Additions to the existing stock is primarily induced by economic growth
But, replacement demand is present even in recession
Because built space is extremely long lived and only demand supports new built space, development is most cyclical of all the branches of real estate system
Slide20 : Supply
(Landlords) Demand
(Tenants) Rents &
Occupancy Space Market Cash flow Property
Market Value Supply
(“Sell”Side) Demand
(“Buy” Side) Market
Required
Cap rate Asset Market Is development
Profitable? Development cost
Including land If yes Add new
stock Local &
National economy Forecast
Future demand Global
Capital
Markets Development
Industry
Exhibit 4: The Real Estate System Causal flow Information gathering and use
The Real Estate System : The Real Estate System Space and asset market
The two markets reflect the underlying economic base (fundamentals) and the general capital markets
Their interaction produce current real estate market value
Market value acts as signals telling the developers whether or not to build new stock
Development industry
This sector compares development cost (including construction cost, land cost and builder’s profit) with market value
If market value equals or exceeds development costs then build
Negative feedback loops
Negative feedbacks are dampening mechanism that serve to self-regulate the system, though not always successful
All three branches are inherently forwarding looking,
Four-Quadrant Model : Four-Quadrant Model To understand the dynamic linkages between the space market and the asset market we rely on the four-quadrant model
The model depicts four binary relationships between the two markets: (a) rent determination (supply and demand), (2) valuation (or asset pricing); (3) physical addition of new space; and (4) stock adjustment – see exhibit 5
Equilibrium price and quantities is where the sides of the rectangle cross the four axes (Q*, R*, P*, and C*)
Slide23 : Q* R* C* P* Stock (SF) Price $ Space Market:
Rent Determination Space Market:
Stock adjustment Asset Market:
Valuation Asset Market:
New Construction Rent $ Construction (SF) Exhibit 5: The Four Quadrant D D CAP RATE
Space Market Fundamental Matter Now and Forever : Space Market Fundamental Matter Now and Forever Performance of the economy, in particular the key economic drivers
Sustained landlord pricing power
Property market equilibrium – supply and demand
Supply cannot be turned off quickly in response declining demand
Physically real estate is a long lived asset
Over capacity makes real estate a perishable asset
Markets with strong local economy and supply constraints will experience strong rental growth
Real estate investment is not just about buying low and selling high
It is also about actively managing the asset
Real Estate Space Market : Real Estate Space Market Like all markets real estate usage market (space market) has a demand side and a supply side
The two sides of the market are linked by the price of the right to use space Rent
Both the demand side and supply side of the market are “location and type specific”
Because markets are highly segmented, a market for say warehouse in the U.S. does not really exist as a single space market
Rental prices differ by location for physically similar space, or for different space in similar location
Exhibit 6: Commercial real estate rental market equilibrium : Exhibit 6: Commercial real estate rental market equilibrium Pe Ph Pl C D A B S = f(P) Quantity of space sq.ft.) Qe AB = excess demand
excess demand drives up prices CD = Excess supply
excess supply causes prices to be
bid down Rent/unit Pe = equilibrium price
Qe = equilibrium quantity Normal vacancy Vacancy rate increases Vacancy rate decreases Qb Qa D = f(P)
Exhibit 7: Short and long run Equilibrium Adjustments : Exhibit 7: Short and long run Equilibrium Adjustments New demand curve Old demand curve Existing supply (fixed) Quantity of space Rent/unit P0 P1 New long run supply curve Net results = positive absorption, lower vacancy and higher NOI P* Qo Q* Monopoly Rent = P1
How Cycles Occur in Space Markets : How Cycles Occur in Space Markets In Exhibit 8 developers anticipating growth in demand increased supply from 5 million to 6 million SF
As a result the supply curve shifts from S1 to S2
If demand increases from D1 to D2, expansion is justified and rent level remains at long-run equilibrium level of $16/SF
However, supply tend to overshot demand
Demand essentially stuck at D1 which cause rent to plummet to say $13/SF (below replacement rent level)
Indeed, in some markets demand may actually decline to say D0
Slide29 : D2 D1 D0 Replacement rent = LRMC =$16 S1 S2 3.5 4.0 4.5 5.0 5.5 6.0 6.5
Quantity of Space (mil. SF) $5 $10 $13 $16* $20 $25 Real Rent Exhibit 8: Supply overshooting Demand over Time
Housing Investment, Wealth Accumulation and Commercial Real Estate Investment : Housing Investment, Wealth Accumulation and Commercial Real Estate Investment Session #1, Part 2
“There is No Place Like Home”
Now the interesting stuff : Now the interesting stuff Why should commercial real estate investor bother about what happens in the housing market?
Do phenomena in housing sector have any relevance to commercial real estate sector?
What are the strategic linkages (forward and backward) between the housing sector, commercial real estate sector, and the rest of the economy?
Real Estate and Wealth Accumulation : Real Estate and Wealth Accumulation Real estate is probably the biggest business in the world
15% of advanced economies GDP is accounted by the construction, buying, selling and renting of properties and imputed benefits to owner-occupiers
In most economies two thirds or 67% of tangible capital stock is made up of real estate
The Importance of Housing Wealth : The Importance of Housing Wealth Over the past 50 years housing expenditures have directly accounted for more than 1/5 of the US GDP
Indirectly, housing wealth also influences the economy through consumer spending
When housing wealth increases consumers spend more
Housing is both a consumption good (shelter) and an investment (wealth accumulation)
In the aftermath of the stock market collapse in 2000 and the subsequent recession of 2001, housing wealth, realized capital gains and home equity borrowing propped up the U.S. economy
World Wide, Real Estate is Biggest Asset Class : World Wide, Real Estate is Biggest Asset Class
Slide35 : Worldwide, More People Own Home than Equities
Slide36 : The average home owner has more wealth tied in the home than in
equities
Slide37 : Home owners are extracting equity from at an accelerating rate
Slide38 : Source: Federal Reserve Board, Flow of Funds,
in “Housing’s Impact on Wealth Accumulation, Wealth Distribution and Consumer Spending” $1 trillion Where is the money?
Slide39 : $323B
4th Q Where did the wealth go? Home Equity Realized at the time of sale is at all time high
Slide40 : Reported Uses of Money Cashed out in Refinancing in Two Recent Time Periods
are Similar
Real Estate Returns : Real Estate Returns Over the past 10 years total return from residential real estate have exceeded 10%, beating the return on stocks and bonds
In fact when leverage is taken into account the return on initial investment is even more impressive
In addition investment in housing get favorable tax treatment