Post on 23-Dec-2015
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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