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2019 Curriculum CFA Program Level II Alternative Investments

Private Real Estate Investments

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Introduction

Real estate investments comprise a significant part of the portfolios of many investors, so understanding how to analyze real estate investments and evaluate the role of real estate investments in a portfolio is important. Real estate investments can take a variety of forms, from private equity investment in (ownership of) real estate properties (real estate properties, hereafter, may simply be referred to as real estate) to publicly traded debt investment, such as mortgage-backed securities. While this reading discusses the basic forms of real estate investments and provides an overview of the real estate market, its focus is private equity investment in commercial (or income-producing) real estate.

Private equity investment in real estate is sometimes referred to as direct ownership, in contrast to indirect ownership of real estate through publicly traded equity securities, such as real estate investment trusts (REITs). Similarly, lending in the private market, such as mortgage lending by banks or insurance companies, is sometimes referred to as direct lending. Mortgages are loans with real estate serving as collateral for the loan. Publicly traded debt investment, such as mortgage-backed securities (MBSs), are sometimes referred to as indirect lending. Each form of real estate investment has characteristics that an investor should be aware of when considering and making a real estate investment. Also, real estate has characteristics that differentiate it from other asset classes.

Private real estate investments—equity and debt—are often included in the portfolios of investors with long-term investment horizons and with the ability to tolerate relatively lower liquidity. Examples of such investors are endowments, pension funds, and life insurance companies. Other real estate investors may have short investment horizons, such as a real estate developer who plans to sell a real estate property to a long-term investor once the development of the property is complete. Publicly traded, pooled-investment forms of real estate investments, such as REITs, may be suitable for investors with short investment horizons and higher liquidity needs.

Valuation of commercial real estate properties constitutes a significant portion of this reading. Regardless of the form of real estate investment, the value of the underlying real estate is critical to its value. The concepts and valuation techniques described in this reading are generally applicable to global real estate markets. Valuation of the underlying real estate is of importance to private real estate equity and debt investors because the value of each type of investment is inextricably tied to the value of the underlying real estate. Also, because real estate properties do not transact frequently and are unique, we rely on estimates of value or appraisals rather than transaction prices to assess changes in value over time. However, transaction prices of similar properties can be useful in estimating value. In creating real estate indexes that serve as benchmarks for performance evaluation, appraised values—rather than transaction prices—are often used. In recent years, several indexes based on actual transactions have been developed. Both types of indexes are discussed in this reading.

The reading is organized as follows: Section 2 describes basic forms of real estate investment, covering equity and debt investments and public and private investments. Section 3 discusses characteristics of real estate and classifications of real estate properties. Section 4 focuses on private equity investment in real estate. It discusses benefits of and risks associated with investing in real estate. The main types of commercial real estate markets and characteristics of each are covered. Section 5 introduces the appraisal (valuation) process and the main approaches used by appraisers to estimate value. Section 6 discusses the income approach, and Section 7 discusses the cost and sales comparison approaches. Section 8 discusses reconciling the results from these three approaches. Section 9 discusses the due diligence process typically followed when acquiring real estate investments. Section 10 presents a brief international perspective. Section 11 considers real estate market indexes. Section 12 discusses some aspects of private market real estate debt. A summary and practice problems complete the reading.

Learning Outcomes

The candidate should be able to:

  1. classify and describe basic forms of real estate investments;
  2. describe the characteristics, the classification, and basic segments of real estate;
  3. explain the role in a portfolio, economic value determinants, investment characteristics, and principal risks of private real estate;
  4. describe commercial property types, including their distinctive investment characteristics;
  5. compare the income, cost, and sales comparison approaches to valuing real estate properties;
  6. estimate and interpret the inputs (for example, net operating income, capitalization rate, and discount rate) to the direct capitalization and discounted cash flow valuation methods;
  7. calculate the value of a property using the direct capitalization and discounted cash flow valuation methods;
  8. compare the direct capitalization and discounted cash flow valuation methods;
  9. calculate the value of a property using the cost and sales comparison approaches;
  10. describe due diligence in private equity real estate investment;
  11. discuss private equity real estate investment indexes, including their construction and potential biases;
  12. explain the role in a portfolio, the major economic value determinants, investment characteristics, principal risks, and due diligence of private real estate debt investment;
  13. calculate and interpret financial ratios used to analyze and evaluate private real estate investments.

Summary

Real estate property is an asset class that plays a significant role in many investment portfolios. Because of the unique characteristics of real estate property, it tends to behave differently from other asset classes, such as stocks, bonds, and commodities, and thus has different risks and diversification benefits. Private real estate investments are especially unique because the investments are not publicly traded and require different analytic techniques from publicly traded assets. Because of the lack of transactions, the appraisal process is required to value real estate property. Many of the indexes and benchmarks used for private real estate also rely on appraisals, and because of this characteristic, they behave differently from indexes for publicly traded assets, such as the S&P 500.

The factors that affect the performance of private real estate investments tend to be similar across countries, and the methods for valuing real estate property tend to be similar. Cross-border investment is facilitated by the development of standardized ways of analyzing real estate and by responses to the demand for transparency and sufficient data to do the necessary due diligence. As the availability of real estate data improves along with the technology to analyze the data, real estate markets are likely to become more efficient.

Key points of the reading include the following:

  • Real estate investments make up a significant portion of the portfolios of many investors.
  • Real estate investments can occur in four basic forms: private equity (direct ownership), publicly traded equity (indirect ownership claim), private debt (direct mortgage lending), and publicly traded debt (securitized mortgages).
  • Each of the basic forms of real estate investment has its own risks, expected returns, regulations, legal structures, and market structures.
  • There are many motivations for investing in real estate income property. The key ones are current income, price appreciation, inflation hedge, diversification, and tax benefits.
  • Equity investors generally expect a higher rate of return than lenders (debt investors) because they take on more risk. The returns to equity real estate investors have two components: an income stream and a capital appreciation. Adding equity real estate investments to a traditional portfolio will potentially have diversification benefits because of the less-than-perfect correlation of equity real estate returns with returns to stocks and bonds. If the income stream can be adjusted for inflation and real estate prices increase with inflation, then equity real estate investments may provide an inflation hedge.
  • Debt investors in real estate expect to receive their return from promised cash flows and typically do not participate in any appreciation in value of the underlying real estate. Thus, debt investments in real estate are similar to other fixed-income investments, such as bonds.
  • Regardless of the form of real estate investment, the value of the underlying real estate property can affect the performance of the investment. Location is a critical factor in determining the value of a real estate property.
  • Real estate property has some unique characteristics compared with other investment asset classes. These characteristics include heterogeneity and fixed location, high unit value, management intensiveness, high transaction costs, depreciation, sensitivity to the credit market, illiquidity, and difficulty of value and price determination.
  • There are many different types of real estate properties in which to invest. The main commercial (income-producing) real estate property types are office, industrial and warehouse, retail, and multi-family. There are other types of commercial properties, which are typically classified by their specific use.
  • There are risk factors common to commercial property, but each property type is likely to have a different susceptibility to these factors. The key risk factors that can affect commercial real estate include business conditions, lead time for new development, cost and availability of capital, unexpected inflation, demographics, lack of liquidity, environmental issues, availability of information, management expertise, and leverage.
  • Location, lease structures, and economic factors, such as employment growth, economic growth, consumer spending, and population growth, affect the value of each property type.
  • An understanding of the lease structure is important when analyzing a real estate investment.
  • Appraisals estimate the value of real estate income property. Definitions of value include market value, investment value, value in use, and mortgage lending value.
  • Generally, three different approaches are used by appraisers to estimate value: income, cost, and sales comparison.
  • The income approach includes direct capitalization and discounted cash flow methods. Both methods focus on net operating income as an input to the value of a property.
  • The cost approach estimates the value of a property based on adjusted replacement cost. This approach is typically used for unusual properties for which market comparables are difficult to obtain.
  • The sales comparison approach estimates the value of a property based on what comparable properties are selling for in the current market.
  • Due diligence investigates factors that might affect the value of a property. These factors include leases and lease history; operating expenses; environmental issues; structural integrity; lien, ownership, and property tax history; and compliance with relevant laws and regulations.
  • Appraisal-based and transaction-based indexes are used to track the performance of private real estate. Appraisal-based indexes tend to lag transaction-based indexes and appear to have lower volatility and lower correlation with other asset classes than transaction-based indexes.
  • When debt financing is used to purchase a property, additional ratios and returns calculated and interpreted by debt and/or equity investors include the loan-to-value ratio, the debt service coverage ratio, the equity dividend rate (cash-on-cash return), and leveraged and unleveraged internal rates of return.

2.5 CE

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