Chapter 3 Finance Theory and Real Estate © OnCourse Learning

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 2 © OnCourse Learning

Issues In Real Estate 3 © OnCourse Learning

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. 4 © OnCourse Learning

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 5 © OnCourse Learning

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 6 © OnCourse Learning

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) 7 © OnCourse Learning

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) 8 © OnCourse Learning

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 9 © OnCourse Learning

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 10 © OnCourse Learning

Value of Mortgages 11 © OnCourse Learning

Case-Shiller Home Price Index for Las Vegas, NV and Los Angeles, CA, © OnCourse Learning

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 13 © OnCourse Learning

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 14 © OnCourse Learning

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 15 © OnCourse Learning

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 16 © OnCourse Learning

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 17 © OnCourse Learning