Real Estate Investment and Finance

DAVID HARTZELL is Steven D. Bell and Leonard W. Wood Distinguished Professor of Finance and Real Estate and Director, Wood Center for Real Estate Studies, University of North Carolina. He is a Fellow of the Private Equity Research Consortium, Kenan Institute and serves on the Board of Directors of Highwoods Properties, a publicly traded Real Estate Investment Trust (REIT), and has served on the Investment Advisory Committee of the $100 billion North Carolina Retirement System. ANDREW BAUM is Professor of Practice, Saïd Business School, University of Oxford and Professor Emeritus, University of Reading. He is Director of the Oxford Future of Real Estate Initiative, Chairman of Newcore Capital Management, and has held senior executive and non-executive positions with Grosvenor, The Crown Estate, CBRE Global Investors and others.

Acknowledgements xxi

About the Authors xxiii

Preface xxv

Part One Real Estate as an Investment: An Introduction

Chapter 1 Real Estate – The Global Asset 3

1.1 The Global Property Investment Universe 3

1.2 Market Players 6

1.2.1 Investors 6

1.2.2 Fund Managers 9

1.2.3 Advisors 9

1.3 Property – Its Character as an Asset Class 11

1.3.1 Property Depreciates 12

1.3.2 Lease Contracts Control Cash Flows 13

1.3.3 The Supply Side is Inelastic 13

1.3.4 Valuations Influence Performance 14

1.3.5 Property is Not Liquid 15

1.3.6 Large Lot Sizes Produce Specific Risk 16

1.3.7 Leverage is Commonly Used in Real Estate Investment 18

1.3.8 Property Appears to be an Inflation Hedge 19

1.3.9 Property is a Medium-Risk Asset 21

1.3.10 Real Estate Cycles Control Returns 22

1.3.11 Property Appears to be a Diversifying Asset 24

Specific Risk 27

Leverage 27

Illiquidity 28

Taxes, Currency, and Fees 28

1.4 Conclusion 28

Chapter 2 Global Property Markets and Real Estate Cycles, 1950–2020 33

2.1 Introduction and Background 33

2.1.1 The Property Cycle 33

2.2 A Performance History 34

2.2.1 Before 1970: Real Estate Becomes a Medium-Return Asset 34

2.2.2 The 1970s: Inflation, Boom, and Bust 36

The USA 36

The UK 37

2.2.3 The 1980s: New Investors Flood the Real Estate Capital Market 38

The USA 38

The UK 42

2.2.4 The 1990s: The Rise of REITs 43

The USA 43

The UK: Deep Recession, Low Inflation, and Globalization 45

2.2.5 2002–7: A Rising Tide Lifts All Boats 47

The USA 47

The UK 59

2.2.6 The Global Real Estate Credit Crisis Hits 60

The USA 60

The UK 67

2.2.7 The Markets Recover Post-crisis 70

2.3 The Global Market 72

2.3.1 The European Market Develops 72

2.3.2 Asia Emerges 75

2.4 Real Estate Cycles: Conclusion 80

Lesson 1: Too Much Lending to Property is Dangerous 80

Lesson 2: Yields are Mean-Reverting – Unless Real Risk-Free Rates Change 81

Lesson 3: Look at Yields on Index-Linked 81

Chapter 3 Market Fundamentals and Rent 83

3.1 Introduction: The Global Property Cycle and Rent 83

3.2 The Economics of Rent 84

3.2.1 Rent and Operational Profits 84

3.2.2 Theories of Rent 86

Ricardo 86

von Thünen 87

Fisher 89

3.2.3 Rent as the Price of Space 90

3.2.4 Supply 91

3.2.5 Demand 93

The Cyclical Demand for Space 93

The Structural Demand for Space 94

Variations in Locational Demand by Use 95

3.2.6 The Relationship Between Rental Value and Rental Income 97

3.2.7 The Impact of Currency Movements on Rent 99

3.2.8 Property Rents and Inflation 99

3.3 Forecasting Rents 101

3.3.1 Forecasting National Rents 101

Model Types 101

Price 102

Demand 102

Supply 102

Building the Model 104

An Historical Model 104

A Forecasting Model 105

3.3.2 Forecasting at the Local Level 105

Conceptual and Modelling Problems 106

Data Issues 106

3.4 Conclusion 107

Chapter 4 Asset Pricing, Portfolio Theory, and Real Estate 109

4.1 Risk, Return, and Portfolio Theory 109

4.1.1 Introduction 109

4.1.2 Risk and Return 110

4.1.3 Portfolio Theory 111

The Efficient Frontier 111

4.1.4 Risk and Competitors 112

4.1.5 Risk and Liabilities 113

4.1.6 Property Portfolio Management in Practice 113

The Investment Strategy 114

4.2 A Property Appraisal Model 115

4.2.1 Introduction: The Excess Return 115

4.2.2 The Cap Rate or Initial Yield – A Simple Price Indicator 116

UK Terminology 116

US Terminology 117

How are Cap Rates Estimated in Practice? 118

Cap Rates are the Inverse of Price/Earnings Ratios 118

What Drives the Cap Rate? 119

4.2.3 The Fisher Equation 121

4.2.4 A Simple Cash Flow Model 121

4.2.5 Gordon’s Growth Model (Constant Income Growth) 122

4.2.6 A Property Valuation Model Including Depreciation 122

4.3 The Model Components 123

4.3.1 The Risk-Free Rate 123

4.3.2 The Risk Premium 124

What is Risk? 124

The Capital Asset Pricing Model 125

4.3.3 Inflation 127

4.3.4 Real Rental Growth 128

4.3.5 Depreciation 128

4.3.6 ‘Correct’ Yields 129

4.3.7 An Analysis in Real Terms 129

4.4 The Required Return for Property Assets 130

4.4.1 The Sector Premium 130

4.4.2 The City Premium 131

4.4.3 The Property Premium 131

4.4.4 Example 131

Tenant 131

Tenure 132

Leases 132

Building 132

Location 132

4.5 Forecasting Real Estate Returns 135

4.5.1 The Origin and Uses of Property Forecasts 135

4.5.2 Forecasting Cap Rates 136

4.5.3 Forecasting Property Cash Flows 138

4.5.4 The Portfolio Model 138

4.5.5 Example 139

4.5.6 Fair Value Analysis 141

4.6 Conclusion: A Simple Way to Think About Real Estate Returns 141

Part Two Making Investment Decisions at the Property Level

Chapter 5 Basic Valuation and Investment Analysis 145

5.1 Introduction 145

5.1.1 Cash Flow 146

5.1.2 Risk and the Discount Rate 147

5.1.3 Determining Price 147

5.1.4 Determining Return 148

5.2 Estimating Future Cash Flows 148

5.2.1 Introduction 148

5.2.2 Holding Period 149

5.2.3 Lease Rent 149

5.2.4 Resale Price 149

Estimated Rental Value at Resale 150

Going-Out Capitalisation Rate 150

5.2.5 Depreciation 150

5.2.6 Expenses 152

Fees 152

Taxes 152

Debt Finance (Interest) 153

5.3 The Discount Rate 153

5.4 Conclusion 156

Chapter 6 Leasing 159

6.1 Introduction 159

6.2 Legal Characteristics of Leases 160

6.3 The Leasing Process 161

6.4 Important Economic Elements of a Lease 161

6.4.1 The Term of the Lease 162

6.4.2 Base Rent and Rent Escalation Provisions 162

6.4.3 Options 163

Renewal Options 163

Expansion, Contraction, and Termination Options 163

6.4.4 Measurement of Space 164

6.4.5 Expense Treatment 165

Gross Lease 165

Triple Net Lease 168

6.4.6 Concessions: Tenant Improvement Allowance and Rental Abatement 170

Tenant Improvement Allowance or Tenant Upfit/Fitout 170

Rental Abatement (Rent-Free Periods) 171

6.4.7 Brokerage Commissions 172

6.4.8 Other Key Elements of a Lease 174

6.4.9 Leasing Differences Across Property Types 175

6.5 Lease Economics and Effective Rent 177

6.5.1 Comparing Leases with Different Expense Treatment 177

The Landlord’s Perspective 177

The Tenant’s Perspective 178

6.5.2 Comparing Leases with Different Concession Allowances 179

Landlord’s Perspective 180

Tenant’s Perspective 181

6.6 Conclusions 183

Appendix: Modeling Lease Flexibility In The Uk 183

Example 185

Assumptions 185

Result 185

Explanation 186

Chapter 7 Techniques for Valuing Commercial Real Estate and Determining Feasibility: The Unleveraged Case 187

7.1 Introduction 187

7.2 Background on the Investment Opportunity 188

7.2.1 Project Details 188

7.2.2 Where Do You Find Information About Income and Expenses? 189

7.3 Developing a Pro Forma Income Statement 190

7.3.1 Calculating Total Revenues 191

7.3.2 Estimating Vacancy Loss 191

7.3.3 Estimating Operating Expenses 192

7.3.4 Calculating Net Operating Income 193

7.4 Valuation Using Net Operating Income: Single-Year Cash Flow 193

7.4.1 An Aside on Capitalization Rates 194

Estimating the Market Cap Rate 194

Cap Rates are the Inverse of Price/Earnings Ratios 195

Using Cap Rates to Value the Apartment Project 195

Calculating the Implied Cap Rate for the Apartment Investment Opportunity 196

7.5 Investment Analysis Using Operating Income: Multiple-Year Cash Flows 197

7.5.1 Operating Cash Flows from Leasing 197

7.5.2 Cash Flows from Disposition 198

7.6 Applying Discounted Cash Flow to Analyze Investment Feasibility 200

7.6.1 Determining Feasibility 200

7.6.2 Equity Multiple 200

7.6.3 Partitioning the Internal Rate of Return 201

7.6.4 Calculating the Maximum Price to Pay 202

7.7 Sensitivity Analysis 202

7.8 Conclusion 203

Chapter 8 Mortgages: An Introduction 205

8.1 Introduction 205

8.2 What is a Mortgage? 206

8.2.1 Promissory Note 206

8.2.2 Mortgage Instrument 206

8.3 The Risks and Returns of Mortgage Investment 207

8.4 The Financial Components of a Mortgage 208

8.4.1 The Bond Component 208

8.4.2 The Call Option Component 208

8.4.3 The Put Option Component 209

8.5 The Mortgage Menu 210

8.5.1 Fixed or Floating-Rate Loans 210

8.5.2 Fully or Partially Amortizing Loans 211

8.6 An Introduction to Mortgage Math 212

8.6.1 Calculating the Monthly Payment 212

8.6.2 The Mortgage Loan Constant 213

8.6.3 The Amortization Schedule 213

8.6.4 Converting from the Contract Rate to the Compounded Rate 217

8.6.5 Determining the Cost of Borrowing 217

Borrowing Cost without Up-front Fees 217

Borrowing Costs when the Lender Charges Fees 219

Borrowing Costs when the Loan is Prepaid Prior to Maturity 220

8.7 Calculating Prepayment Penalties 220

8.7.1 Lockout Periods 221

8.7.2 Step-down Prepayment Penalties 221

8.7.3 Yield Maintenance Penalties and Yield Calculations 222

8.7.4 Treasury Flat Prepayment Penalty 225

8.7.5 Defeasance 228

8.8 Conclusion 228

Chapter 9 Commercial Mortgage Underwriting and Leveraged Feasibility Analysis 229

9.1 Introduction 229

9.2 Mortgage Underwriting and the Underwriting Process 229

9.2.1 Ratios and Rules of Thumb 230

Loan-to-Value Ratio 230

Debt Coverage Ratio 230

Debt Yield 232

9.2.2 Determining the Maximum Loan Amount 232

Operating Expense Ratio 236

Breakeven Ratio 236

Debt Yield 237

9.3 Investment Feasibility with Leverage: Before-Tax Analysis 238

9.3.1 The Two-Part Nature of Cash Flows: Operating Income and Disposition Income 238

9.3.2 Financing Impact on Investor Income Statements: Adding Debt Service Cash Flows 238

Income from Disposition 239

9.3.3 Determining Investment Feasibility: The Leveraged Before-Tax Case 240

Static or Single-Year Measures of Investment Performance 240

Determining Investment Feasibility Using Multiple Year Cash Flows 242

Equity Multiple 242

Partitioning the IRR and NPV 242

Determining the Maximum Price to Pay with Leverage 243

9.4 Sensitivity Analysis 244

9.5 Conclusion 245

Chapter 10 Real Estate Development 247

10.1 Introduction 247

10.2 The Development Process 248

10.3 Preliminary Analysis of “The Station” Development 250

10.3.1 “Back-of-the-Envelope” Analysis 250

Estimating Construction Costs 251

Estimating Market Value 251

10.3.2 Adding Construction Financing 253

10.3.3 Sensitivity Analysis 254

10.4 Formal Analysis of Development of “The Station” 257

10.5 Budget for “The Station” Office Project 258

10.6 Financing Development 259

10.6.1 Stage One: Pre-construction 260

10.6.2 Stage Two: Construction 260

Construction Loan Calculations 260

10.6.3 Stage Three: Lease-Up 263

10.6.4 Stage Four: Operations 264

Lender Yield Calculation for the Construction Loan 264

10.7 Developer Profit and Return 265

10.8 Comparison to “Back-of-the-Envelope” Analysis 266

10.9 A London Office Development Through the Cycle 267

10.10 Conclusion 274

Part Three Real Estate Investment Structures

Chapter 11 Unlisted Real Estate Funds 277

11.1 Introduction to Unlisted Real Estate Funds 277

11.1.1 The US Market 278

11.1.2 The Global Market 278

11.2 The Growth of the Unlisted Real Estate Fund Market 280

11.2.1 The Global Unlisted Property Market Universe 281

11.2.2 How Much Global Real Estate is in Unlisted Funds? 283

11.3 Unlisted Fund Structures 284

11.3.1 Open-Ended Funds 285

11.3.2 Closed-Ended Funds 286

11.3.3 Funds of Funds 287

11.4 Characteristics of Unlisted Real Estate Funds 288

11.4.1 Style 288

11.4.2 Investment Restrictions 289

11.4.3 Property Sector and Geographic Focus 290

11.5 Liquidity and Valuation Issues 291

11.5.1 Liquidity 291

11.5.2 Valuation 294

11.6 The Case for and Against Unlisted Real Estate Funds 294

11.6.1 The Case for Unlisted Real Estate Funds 294

Unlisted Real Estate Funds can Diversify Real Estate-Specific Risk 294

Unlisted Funds are Priced by Reference to NAV 294

Unlisted Funds Provide Access to Specialist Managers 295

11.6.2 The Case Against Unlisted Real Estate Funds 295

The Drawdown Profile 295

Gearing and the J-curve Effect 296

Fees and Performance Persistence 297

Do Trading Prices Track NAV? 297

11.7 Conclusion 300

Chapter 12 Real Estate Private Equity: Fund Structure and Cash Flow Distribution 301

12.1 Introduction: The Four Quadrants and Private Equity 301

12.2 Private Equity Fund Background 303

12.3 The Lifecycle of a Private Equity Fund 304

12.3.1 Initial Fundraising 304

12.3.2 Acquisition Stage 305

12.3.3 Asset Management 306

12.3.4 Portfolio Management 306

12.3.5 End of Fund Life 307

12.4 Fund Economics 307

12.4.1 Management Fees 307

12.4.2 Limited Partner Distributions 307

Return of Initial Capital 308

Preferred Return 308

Carried Interest 308

Promoted Interest 309

12.5 Waterfall Structures 310

12.5.1 Introduction 310

12.5.2 Pro-rata Investment and Distribution 311

12.5.3 All Equity Provided by Limited Partner, 80%/20% Carried Interest 311

12.5.4 Adding a Preferred Return 312

12.5.5 Return of Capital, Simple Interest Preferred Return, Carried Interest 314

Adding Management Fees 316

12.5.6 Return of Capital, Compounded Interest Preferred Return, Carried Interest 317

12.6 Private Equity Structures in the Credit Crisis 319

12.7 Conclusion 321

Chapter 13 Listed Equity Real Estate 323

13.1 Introduction 323

13.2 REITs and REOCS 324

13.3 Listed Funds and Mutual Funds 324

13.4 Exchange-Traded Funds 325

13.5 The US REIT Experience 325

13.5.1 Introduction 325

13.5.2 Distributions 326

13.5.3 Measuring REIT Net Income 327

Defining Net Income 327

Funds from Operations 329

13.5.4 Performance 332

Summary 335

13.6 The Global Market 335

13.6.1 The Global Property Company Universe 335

13.6.2 The Global REIT Universe 335

13.6.3 The UK REIT 338

13.7 REIT Pricing 339

13.7.1 Using Earnings to Value REITs 339

13.7.2 Market Capitalization and Net Asset Value 340

13.7.3 Premium or Discount to NAV? 340

Instant Exposure 341

Liquidity/Divisibility 342

Asset Values are Higher than the Reported NAV 342

Projected Asset Values are Expected to Exceed the Reported NAV 342

Management Skills 342

Tax 343

Debt 343

13.8 Conclusion 343

Chapter 14 Real Estate Debt Markets 345

14.1 Introduction 345

14.2 A Brief History Lesson 347

14.2.1 Banking in the 1960s and 1970s 347

14.2.2 The Volcker Era of High and Volatile Interest Rates 349

14.3 Wall Street Act I: The Early Residential

Mortgage-Backed Securities Market 349

14.3.1 The Securitization Process Explained 350

14.3.2 Lender Profitability from Securitization 353

14.4 Wall Street Act II: Senior-Subordinated Securities, the Advent of Structured Finance 354

14.4.1 The Coast Federal Savings and Loan Deal 354

14.4.2 Risk and Return Characteristics of the Senior-Subordinated Structures 358

14.5 Wall Street Act III: The Evolution of Structured Finance 359

14.5.1 An Updated Look at the Senior-Subordinated Security 359

14.5.2 Who Profits from these Transactions? 362

14.6 Collateralized Debt Obligations 363

14.7 Mezzanine Debt 365

14.7.1 Mezzanine: The Background 365

14.7.2 Mezzanine Structures 366

14.7.3 A UK Example 368

14.8 Whole Loans and Synthetic Mezzanine 368

14.9 Income Strips 369

14.10 Cash-out Refinancing 371

14.11 All Good Things Must Come to an End 373

14.11.1 The Cash-out Refinancing Example Extended 374

14.12 Post-crisis Recovery 381

14.12.1 A Final Update to the Cash-out Refinancing Example 382

14.13 Conclusion 383

Part Four Creating a Property Investment Portfolio

Chapter 15 Building the Portfolio 387

15.1 The Top-Down Portfolio Construction Process 387

15.1.1 Introduction 387

15.1.2 Risk and Return Objectives 390

The Relative Return Target 392

The Absolute Return Target 393

15.1.3 Benchmarks 394

15.2 Strengths, Weaknesses, Constraints: Portfolio Analysis 394

15.2.1 Current Portfolio Structure 394

15.2.2 Strengths, Weaknesses, Constraints 395

15.2.3 Structure and Stock Selection 395

15.3 Portfolio Construction 397

15.3.1 Top-Down or Bottom-Up? 397

15.3.2 Mixing Listed and Unlisted Real Estate 398

15.3.3 Can Real Estate Investors Build Efficient Portfolios? 400

15.3.4 Possible Approaches 403

Case 1: Large US Endowment Fund 403

Case 2: UK Family Office 406

15.4 Conclusion 409

Chapter 16 International Real Estate Investment: Issues 411

16.1 Introduction: The Growth of Cross-Border Real Estate Capital 411

16.2 The Global Real Estate Market 413

16.2.1 The Global Universe 413

16.2.2 Core, Developing, Emerging 413

16.2.3 Transparency 414

16.2.4 The Limits to Globalisation 414

16.3 The Case for International Real Estate Investment 415

16.3.1 The Case for International Real Estate Investment: Diversification 415

16.3.2 The Case for International Real Estate Investment: Enhanced Return 417

16.3.3 Other Drivers of International Property Investment 418

16.4 The Problems 419

16.4.1 Introduction 419

16.4.2 Index Replication and Tracking Error 419

16.4.3 Leverage 420

16.4.4 Global Cycles, Converging Markets 420

16.4.5 Execution Challenges 421

16.4.6 Loss of Focus and Specialisation 421

16.5 Formal Barriers 421

16.5.1 Legal Barriers 421

16.5.2 Capital Controls 422

16.5.3 Tax 422

16.6 Informal Barriers 425

16.6.1 Introduction 425

16.6.2 Currency Risk 425

16.6.3 Legal and Title Risk 426

16.6.4 Liquidity Risk 427

16.6.5 Geographical Barriers 427

16.6.6 Political Risk 428

16.6.7 Cultural Barriers 428

16.6.8 Information Asymmetry 429

16.7 A Pricing Approach for International Property 429

16.7.1 Example 429

16.7.2 Theories of Interest Rates and Exchange Rates 431

The Law of One Price 431

Absolute Purchasing Power Parity 431

Relative Purchasing Power Parity 432

The Monetary Model of Exchange Rates 432

The Fisher Equation 432

Interest Rate Parity 432

Putting Relative Purchasing Power Parity and Interest Rate Parity Together with the Fisher Equation 432

16.7.3 Putting Theory into Practice 433

16.7.4 Using Local Excess Returns 438

16.8 Managing Currency Exposure and Currency Risk 441

16.8.1 Diversifying 442

16.8.2 Using a ‘Currency Overlay’ 442

16.8.3 Using Local Debt 443

16.8.4 Hedging Equity 444

16.8.5 Leverage, Tax, and Fees 446

16.9 Building a Portfolio 447

16.10 Conclusion 450

Chapter 17 Performance Measurement and Attribution 451

17.1 Performance Measurement: An Introduction 451

17.2 Return Measures 452

17.2.1 Introduction 452

Income Return 453

Capital Return 453

Total Return 453

Time-Weighted Return 454

Internal Rate of Return 454

17.2.2 Example: IRR, TWRR, or Total Return? 454

IRR or TWRR? 456

IRR or Total Return? 456

17.2.3 Required and Delivered Returns 456

The Required Return 456

The Delivered Return 458

17.2.4 Capital Expenditure 459

Timing of Expenditure 460

17.2.5 Risk-Adjusted Measures of Performance 460

17.3 Attribution Analysis: Sources of Return 462

17.3.1 Changes in Initial Yields 462

17.3.2 The Combined Impact 464

17.4 Attribution Analysis: The Property Level 465

17.5 Attribution Analysis: The Portfolio Level 467

17.5.1 Introduction 467

17.5.2 The Choice of Segmentation 468

17.5.3 Style 469

17.5.4 Themes 470

17.5.5 City or Metropolitan Statistical Area Selection 471

17.5.6 Two or Three Terms? 471

17.5.7 The Formulae 472

17.5.8 Results from Different Attribution Methods 473

Case 1 474

Case 2 474

17.6 Attribution and Portfolio Management: Alpha and Beta 474

17.6.1 Alpha and Beta Attribution: An Introduction 474

17.6.2 Sources of Alpha and Beta 476

17.7 Performance Measurement and Return Attribution for Property Funds 477

17.7.1 Introduction 477

17.7.2 The Asymmetry of Performance Fees 478

17.7.3 An Attribution System for Funds 480

17.7.4 Alpha and Beta in Property Funds: A Case Study 482

17.7.5 Unlisted Fund Performance: Empirical Evidence 485

The Data 485

Relative Returns 486

Alpha and Beta 486

Timing: IRR and TWRR 488

IRRs and Vintage Year 488

17.8 Conclusion 489

Chapter 18 Conclusions 491

18.1 Why Property? 491

18.2 Lessons Learned 493

18.2.1 Liquid Structures 493

18.2.2 Unlisted Funds 494

18.2.3 International Investing 495

18.2.4 Best-Practice Real Estate Investing 495

18.2.5 Pricing 496

18.3 The Future 496

18.3.1 The PropTech Explosion 496

18.3.2 Smart Buildings and ESG 499

18.3.3 Occupier Markets: Space as a Service 499

18.3.4 Fractionalization and Liquidity 500

Liquidity and Faster Transactions 500

Tokenization and Fractionalization 502

18.3.5 Derivatives 502

18.4 Conclusion 504

References 509

Glossary 515

Index 527