Finance Theory and Real Estate | George Real Estate Group

Finance Theory and Real Estate

George Real Estate Group

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 =

∑ (1 + ) −1

𝐹

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𝑁

𝐶

𝑖

𝑖

𝑟

𝐼

Where CF stands for periodic cash flows, r is the appropriate discount rate, and n is the number of cash flows

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)

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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

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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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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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Thank You

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