CREIFISUUTEST

PS03

Real Estate Finance & Investment

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PS03  Real Estate Finance & Investment

About this Subject

About this Subject About this Subject In this subject various forms of structuring finance are presented for both the listed and unlisted real estate market. This is followed by investment strategies and performance benchmarking. Accounting and financial analysis is also addressed. The aim of this subject is not to provide students with an in depth working knowledge of the complexities of real estate finance and accounting, which is an extremely specialised area of finance and investment banking.

However, like all other certificate subjects, the aim is to provide an appreciation of the necessary fundamentals of these topics. As can be expected, specialist advice should be obtained where necessary.

Workshop Attendance at this subject‟s 2-day workshop is a compulsory component of the Certificate course. Please refer to the CREIF Policy on Workshop Attendance which is available on APREA Institute‟s Learning Management System.

The workshop will be delivered by industry practitioners who will demonstrate the practicalities of applying what is contained within the course notes to dayto-day market practices. By undertaking the workshop preparation activities within the subject notes students will enter the workshop being prepared for the intensive learning environment.

Further details of workshop venue and dates are available on APREA Institute‟s Learning Management System.

Assessment Research Task Included with this subject is a compulsory Assessment Research Task. Students will be advised shortly, via APREA Institute‟s Learning Management System, of the Research Task topic and other details as well as submission date. The Assessment Research Task will be marked and the result will go towards the student‟s overall assessment mark for the course.

Students are advised to read the CREIF Policy on CREIF Assessment which is available on APREA Institute‟s Learning Management System.

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PS03  Real Estate Finance & Investment

About this Subject

APREA Institute’s Plagiarism Policy Assessment Research Tasks must be the student‟s own work. The Institute encourages collaboration i.e. constructive educational and intellectual practice that aims to facilitate optimal learning outcomes through interaction between students, however it does not approve of collusion i.e. working with others without permission to produce or copy work which is then presented as work completed independently by the student. Collusion is a form of plagiarism.

Students should not knowingly allow their work to be copied.

A student plagiarises if he or she gives the impression that the ideas, words or work of another person are the ideas, words or work of the student.

Plagiarism includes:  copying any material from books, journals study notes or tapes, the web, the work of other students, or any other source without indicating this by quotation marks or by indentation, italics or spacing and without acknowledging that source by footnote or citation  rephrasing ideas from books, journals, study notes or tapes, the web, the work of other students, or any other source without acknowledging the source of those ideas by footnotes or citations  unauthorised collaboration with other students that goes beyond the discussion of general strategies or other general advice  copies or paraphrases all or part of another student‟s work or otherwise presents another student‟s work as their own  presents all or part of an assessment item which has previously been submitted by them for assessment in another subject or by another student (past or present) for assessment in the subject concerned or in another subject Plagiarism is not only related to written works, but also to material such as data, images, music, formulae, websites and computer programs.

Aiding another student to plagiarise is also a violation of the Plagiarism Policy and may invoke a penalty and notification of such an event to the student’s

employer.

Students are advised to read the Plagiarism Policy available on APREA Institute’s Learning Management System.

Independent Research Where you are unsure of any of the terms/concepts that are used, you are encouraged to undertake independent research as appropriate.

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PS03  Real Estate Finance & Investment

About this Subject

Final Exam Students who undertake all 4 subjects of the Certificate of Real Estate Investment Finance, submit all 4 Assessment Research Tasks and attend all 4 subject workshops are eligible to sit the final exam. The exam will be 3 hours duration and comprise multiple choice questions and short answers to test reasoning covering all 4 subjects of the Certificate. To receive the Certificate of Real Estate Investment Finance students are to pass a minimum of two out of four Assessment Research Tasks and achieve a minimum 50% pass mark for the exam. Students will be notified of their exam results by mail within 4 weeks of the examination date.

Students are advised to read the CREIF Policy on CREIF Assessment available on APREA Institute‟s Learning Management System.

Further details on examination venues and dates are available on APREA Institute‟s Learning Management System.

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PS03  Real Estate Finance & Investment

Table of Contents

Table of Contents Unit1 Finance ........................................................................................ 9 Introduction ......................................................................... 10 LEARNING OBJECTIVES: ....................................................... 10 Capital Markets ..................................................................... 11 Property Level Debt Financing .............................................. 12 Work-out situations/ Restructuring Loans ............................ 20 Private Funds ........................................................................ 27 Real Estate Publicly Listed – Corporates, REITs .................... 28 China Financing – Foreign Investment in Real Estate ............ 29 RECAP: .................................................................................. 30 Unit 2 Investment Strategies .............................................................. 31 Introduction ......................................................................... 32 LEARNING OBJECTIVES: ....................................................... 32 Pricing Listed Real Estate ...................................................... 32 Distribution Models of Income .............................................. 36 Financial Leverage ................................................................ 42 Tax Deductibility ................................................................... 44 Optimal Capital Structure ...................................................... 45 Trading Strategies ................................................................ 47 Property Derivatives ............................................................. 53 Performance Measurement and Benchmarking ..................... 54 Performance Attribution ....................................................... 54 Evaluating Performance Using a Standard Attribution Model ......................................................................... 55 Allocation Effects .................................................................. 56 Selection Effects ................................................................... 57 Alternative Methods of Measurement .................................... 57 Ratios 59 Indices.................................................................................. 61 RECAP: .................................................................................. 66 Unit 3 Accounting & Financial Analysis ................................................ 67

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PS03  Real Estate Finance & Investment

Table of Contents

Introduction ......................................................................... 68 LEARNING OBJECTIVES: ....................................................... 68 Accounting Treatments ......................................................... 68 Ratio Analysis ....................................................................... 71 Financial Analysis of Real Estate ........................................... 72 Financial Analysis of Listed Securities ................................... 74 RECAP: .................................................................................. 76 Unit 4 Prospectuses and Marketing ..................................................... 77 Introduction ......................................................................... 78 LEARNING OBJECTIVES: ....................................................... 78 Preparing the Prospectus ...................................................... 78 Marketing Strategy for Listing............................................... 85 RECAP: .................................................................................. 86 Unit 5 Risk .......................................................................................... 87 Introduction ......................................................................... 88 LEARNING OBJECTIVES: ....................................................... 88 Risk

88

Property Risks ...................................................................... 89 Risks Relating to Investing in Real Estate ............................. 90 Risks Relating to Operations ................................................. 93 Risks relating to Investment in Units in a Fund ..................... 94 Note on other differences ..................................................... 94 Systematic and Unsystematic Risk ........................................ 95 RECAP: .................................................................................. 97 Unit 6 Cross Border Real Estate Investments ...................................... 98 Introduction ......................................................................... 99 LEARNING OBJECTIVES: ....................................................... 99 Cross Border Acquisitions for REITs and Unlisted Funds Macroeconomic and Microeconomic Factors ............... 99 Decision Making Stages ...................................................... 101 Systematic vs Intuitive Decision Process ............................ 103 RECAP: ................................................................................ 108 Unit 7 The Acquisition Process .......................................................... 109 Introduction ....................................................................... 110

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PS03  Real Estate Finance & Investment

Table of Contents

LEARNING OBJECTIVES: ..................................................... 110 Real Estate Acquisition ....................................................... 110 RECAP: ................................................................................ 113 Unit 8 Introduction to Property Derivatives....................................... 114 Introduction ....................................................................... 115 LEARNING OBJECTIVES: ..................................................... 115 What are Property Derivatives? .......................................... 115 Market Development ........................................................... 116 Why Use Property Derivatives? ........................................... 117 Users of Property Derivatives.............................................. 117 Property Derivatives Explained ........................................... 118 Property Derivative Pricing ................................................. 121 Trading Scenarios ............................................................... 122 Settlement .......................................................................... 123 RECAP: ................................................................................ 128 Addendum ......................................................................................... 129 Assessment Research Task ............................................................... 129 Assessment Research Task ................................................. 130

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Unit

1 Finance

PS03  Real Estate Finance & Investment

Unit 1: Finance

Introduction In this unit we look at some of the techniques available to structure and finance listed and unlisted real estate. Real estate is described as a capital intensive industry, meaning that a real estate investment is typically in hundreds of millions. Furthermore, real estate, compared to other industries such as manufacturing, has a lower volatility of earnings. For example, in an economic downturn, a factory will need to keep selling its goods to keep cash inflow, while a real estate investment will continue to collect rent as long as the tenant does not default.

The nature of real estate, being capital intensive and having relatively lower earnings volatility, offers itself to be an ideal industry to be funded by debt.

Debt is a neutral tool because it merely multiplies both the risk and return of an investment. Thus, debt strategies range from zero-debt in private wealth investments to 70%-plus geared as seen with some REITs. As you read through this unit, keep in mind that the key to smart debt financing is to create the appropriate risk-return profile.

That is, the unit identifies different finance models, asset rehabilitation and the advantages of debt capital market instruments versus bank finance.

LEARNING OBJECTIVES: The learning objectives in this unit include:  Comprehend characteristics of private and public markets  Differentiate between different classifications of debt  Understand the Capital Structure – between various forms of debt and equity  Financial leverage role in real estate investment  Understand risks/benefits of debt leverage  Basic ownership structure considerations  Understand the basis for making projections of future cash flows depending upon market trends and specific property information

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PS03  Real Estate Finance & Investment

Unit 1: Finance

Capital Markets Participants within institutional real estate market are broadly defined as Public or Private and Debt or Equity. Public refers to companies with a listing on a major exchange such as REITs, development companies and asset holding companies. Public debt refers to loan facilities with a public registration such as corporate bonds to a listed entity or securitisation issuance such as Commercial Mortgage-Backed Securities (CMBS) and Collateralised Debt Obligations (CDO).

Private side equity capital can include private equity funds, sovereign wealth funds, limited partnerships, joint ventures and family investors. Bank loans made directly to real estate investors are generally classified as private transactions, even though the bank is a listed company. The table below outlines the four quadrants of the private/public structure: Public/Private - Debit/Equity Debt

PRIVATE

PUBLIC

Equity

Bank (Bilateral, Club, Syndications)

Private Investors (Families)

Insurance Company (Clubs)

Private Equity Funds (Wide range in size/shape)

Private Funds (B-Notes, Mezzanine) Local Banks (Hold)

Syndications (Institutional or Wenzhou Effect)

CMBS (Conduit, Large Loan) CDO‟s (CMBS tranches)

REITs (J-RIETs, S-REITs, US-REITs, HKREITs)

Investment Grade Bonds (Corporate)

Corporates

High Yield Bonds (Corporate)

• HK Corporates • PRC Developers

Convertible Bonds (Corporate)

• Conglomerates • Hotel Operating Companies • Non Real Estate Companies • Construction Companies

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PS03  Real Estate Finance & Investment

Unit 1: Finance

Property Level Debt Financing Real estate owners typically utilise debt financing in order to reduce capital outlays and increase investment returns. Property level debt financing can take on a variety of forms and structures which adapt to changing market conditions and vary widely across geographies and jurisdictions. Providers of real estate debt loans have historically been large commercial banks at both local and international levels. Other providers in local markets may include savings banks in the U.S., land banks in Europe or trusts in Asia.

Providers

Geographies

Structures

Terms

Asia Activity

Regional Banks

Local Markets

Bilateral, Clubs

Short/Floating

Active

Intl. Banks

Major Markets

Syndications

Short/Floating

Moderate

Insurance/Pension

U.S.; Europe

Clubs

Long/Fixed

Low

Wall Street

U.S.; Europe; Japan

Securitisation

Various

Low

Real estate investments are well suited for debt financing for the following reasons: • Real estate assets provide a stable base for collateral security • Income producing assets produce cash flow streams covering required debt service payments • Long term use or investment profile matches long term funding • Size and importance of real estate creates the required economy of scale needed to support large industry group of skills and disciplines

Financial Leverage Financial leverage refers to the use of debt to reduce the equity capital funding required for real estate investment. Financial leverage can also increase the equity return by applying a lower debt rate compared to the asset yield – referred to as positive leverage. The charts below highlight a real estate investment scenario under both a leverage and non-leverage basis („equity only‟).

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PS03  Real Estate Finance & Investment

Unit 1: Finance

All Equity Scenario • Acquisition price of 100 is funded all with cash equity • Cap Rate defined as Property Cash Flow / Acquisition Price • Cash on cash defined as Property Cash Flow / Cash Equity • IRR calculated by “net present value analysis” of cash outlays from acquisition price; property cash flows; and sale price at end of term Equity Only (Acquisition Price) Debt Funding Property Cash Flow Sale Price Net Cash Flows Cash on Cash Return Indicated Cap Rate IRR

Year 1 -100 0 8

Year 2

-92 8.0% 8.0% 20.8%

9 9.0%

Year 3

Year 4

Year 5

100% 9

10

11

10 10.0%

Cash Equity 100

11 11.0%

Debt Amount: LTV: Rate: Payment:

12 140 152 12.0%

Equity

0 0% n/a n/a

Leverage Scenario • Equity investment reduced from 100 to 50 • Rate on debt of 5% is below the yield on Property (starting at 8%) – creating positive leverage • Cash on Cash returns increased through positive leverage • IRR increase through positive leverage

Leverage (Acquisition Price)

Year 1 -100

Debt Funding Property Cash Flow (Debt Service)

50 8 -2.5

Sale Price Net Cash Flows Cash on Cash Return Indicated Cap Rate IRR

-44.5 11.0% 8.0% 45.1%

Year 2

Year 3

Year 5

50% Equity 9 -2.5

6.5 18.0%

10 -2.5

7.5 20.0%

Cash Equity 50

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Year 4

13

11 -2.5

12 -2.5

8.5 22.0%

140 149.5 24.0%

Debt Amount: LTV: Rate: Payment:

50 50% 5% 2.5

50% Debt

PS03  Real Estate Finance & Investment

Unit 1: Finance

Bank Debt Financing v. Securitisation – CMBS Traditionally, property level debt was provided by major financial institutions such as commercial banks as direct balance sheet loans („bilateral‟) or through syndications/clubs which multiple banks. Syndications and club arrangements co-operate on a parri-passu basis meaning that the banks are equal to each other in terms of ranking, security, terms, etc. This is referred to as „vertical slicing‟ with bank lenders taking identical levels of risk.

Securitisation refers to loans being placed in a pooled-vehicle and then registered as a public security – rated by outside agencies where multiple tranches are assigned credit ratings – from the highest of “AAA” through lower tranches such as “B” – depending upon a set of risk criteria stipulated by rating agencies, such as LTV (Loan to Value), DSCR (Debt-Service Coverage Ratio), composite mix of the pool collateral, etc. Securitisation is often termed „horizontal slicing‟ since the pieces of loans sit on top of each other, ranking from senior to junior („subordination‟).

Capital Stack Comparison CAPITAL STACK COMPARISON Bank Financing

CMBS Conduit

LTV EQUITY 100% 95% 90% 85% 80% 75% 70% 65% Senior Mortgage 60% Loan 50% 45% 40% 35% 30%

CMBS Large DSCR @9%K

EQUITY

EQUITY

JR MEZZ UNRATED B BB BBB A

1.05X 1.15X 1.20X 1.30X 1.40X

AA

1.60X

AAA

1.75X

SR MEZZ B-NOTE A AA AAA

Lenders:

Banks, Insurance

Wall Street

Wall Street

Structure:

Club, Syndicatins

Securitisation

Structured

Term :

3-5 years

10 years

3 years

Pricing:

Float over Libor

Over Treasury

Float over Libor

Investors:

Regional Banks

Money Managers

Money Managers

Intl. Banks

Insurance

Private Funds

Pension

CDO‟s

Banks Prop. Type:

Large, Institutional

Small Loans

L a rg e , Institutional

Major Types

All

Portfolios Major Types

Key Points:

Pricing

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Fixed Income Market

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Intercreditor Rights

PS03  Real Estate Finance & Investment

Unit 1: Finance

Development Financing Development finance can be described by a number of names including construction finance, construction loan or an interim loan. The costs generally covered by a construction loan are the hard costs of construction including material and labour but not necessarily the soft costs such as leasing and planning costs.

Developers may use one of a number of structures in relation to construction finance. These include but are not limited to: • The property may be sold on completion of the construction and initial leasing. This is attractive to investors who do not want to bear the risk of construction and initial leasing. The difference between the construction cost and the price the property is sold for represents the profit for the developer.

The developer will in this case choose financing structures that match the duration of the expected construction and initial lease period.

• The developer may retain ownership and will manage the property upon completion. In many cases relationships will be maintained between developer and tenant if the tenant requires further floor space. As the property is to be held for the long term the developer will access finance consistent with the longer term. This has the added benefit of not requiring frequent financing renegotiations. This is one of the issues that many developers have felt with the current sub-prime mortgage crises where financing has had to be renegotiated at a substantially greater cost.

• Alternatively, a developer may consider the sale of the property or the refinancing of the property upon completion. This is essentially a combination of the two options above. The developer may undertake short term financing during construction and then have an option for longer term financing once construction is complete. This new form of financing is often referred to as take-out finance. The renegotiated finance should be a substantially cheaper source of funding as the risk is substantially reduced upon completion. This take-out finance will often require a number of contingencies to be met before the take-out finance comes into effect. These contingencies may include factors such as: – The maximum time for the developer to secure a construction commitment – The completion date for construction to be finalised – Minimum rent-up provisions – Provisions for gap financing should the rent-up requirements not be met – Expiration date of the permanent loan commitment – Approval for design or other substantial changes The use of these two finance sources comes at the additional cost of satisfying two different lending criteria in many cases. Some criteria may be the same; some may be specific to the lender while others may be specific to the stage of the property lifecycle.

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PS03  Real Estate Finance & Investment

Unit 1: Finance

Mezzanine Finance Mezzanine capital can take many forms but is generally described as the portion of the capital stack between senior debt and straight equity. The essential purpose of mezzanine financing is to provide higher leverage to the borrower.

Mezzanine loans contain a higher risk profile than senior loans because mezzanine loan comprises the higher LTV portion of the financing and security is weaker through an equity pledge rather than mortgage security. Therefore, mezzanine loans receive a higher yield and contain more structuring features to protect the mezzanine lender. The table below outlines primary differences between the senior lender and mezzanine lender.

Senior Debt

Mezzanine

Ranking:

First Priority

Subordinated

Security:

Mortgage Secured

Pledge of Equity Shares

LTV Caps:

40-60%

60-80%

Yield:

Single Digits

Mid Teens and up

Payment:

Current

Current and or Accrual

Providers:

Banks, CMBS, Insurance

Funds, Yield Investors

Control under EOD:

Foreclosure Mortgage

Share Control Mechanism

Other Protection Rights:

Intercreditor Agreement Information Sharing Notification Standstill Period Right to Cure

Event of Default (‘EOD’) Mezzanine loans are without mortgage security and typically enforce rights through a legal action to take control over the ownership rights of the borrowing vehicle. Under EOD, the senior lender will typically enforce through a foreclosure action taking title to the real estate property. Whereas, the mezzanine lender intends to control the ownership at which time it can protect the value of the underlying property. The contractual rights of the mezzanine lender are outlined within the loan agreement with the borrower detailing such items as information sharing, asset management activities, repayment of principal and interest and the enforcement process under EOD.

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PS03  Real Estate Finance & Investment

Unit 1: Finance

Intercreditor Agreement The intercreditor agreement is a contract between the senior lender and mezzanine holder outlining the rights and provisions of the parties. Intercreditor agreements are highly negotiated documents and may or may not contain any of the following provisions: • Mezzanine lender is recognised by the senior lender as being a participant in the financing structure • Senior lender shares information such as performance of the senior loan, property information received from the borrower, asset management, etc.

• Mezzanine lender receives notice in the case of delinquency or EOD („Notification‟) • Senior lender delays its foreclosure process for a set period of time („Standstill Agreement‟) • Mezzanine lender is allowed rights to cure monetary defaults to prevent foreclosure („Right to Cure‟) • Senior loan remains in place after mezzanine lender has taken ownership control of borrowing vehicle

Ownership Structures Real estate can be held in many different forms of ownership including individual, corporate, partnership and trust ownership.

The choice of such ownership methods is driven by a number of factors.

First and foremost are taxation considerations as well as legal factors such as personal liability. In most jurisdictions, property funds, whether listed or unlisted, can represent a tax effective investment structure.

Alternatively, in terms of liability there are a number of issues. Individuals and partnerships generally assume the liability for the investment while private and public companies allow the separation of ownership and liability.

It is also worth noting that REITs, business trusts and public companies offer the structure greater access to capital markets and cheaper forms of funding than do other structures.

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PS03  Real Estate Finance & Investment

Unit 1: Finance

Distressed Assets For many countries, selling distressed assets to foreigners has been one way of resolving economic problems in the aftermath of an investment bubble.

Distressed assets include loans, mortgages or other types of financial assets that are nonperforming. This non performance can be due to a number of reasons. Investing in these assets has become a recent trend whereby investors purchase these assets from banks and other financial institutions usually at a discount to face value. A gain is obtained by working out the assets and reselling for a higher value.

There are a number of ways that these assets can be rehabilitated.

These include: • Long term financing – this may reduce the servicing charge attached to debt as well as the need to renegotiate finance and other transaction costs. This can also reduce interest rate risk as there may not be a need to invest in short term higher cost finance. This is particularly relevant given the recent sub-prime credit crisis.

• Equity financing – equity refinancing may reduce the debt burden on an organisation. It allows flexibility of the funding process.

• Mezzanine financing - as with equity financing it can allow financial flexibility within the organisation • Technical assessment and action – this employs the use of experts to make an assessment of any technical issues that may be impacting on the asset.

For real estate this may be in the realm of engineers etc.

• Professional advisory – this is similar to the above but may involve professional property and asset managers to advise on strategies to improve the fundamentals of the asset, including revenue, leasing, outgoings etc.

Such bodies may have access to a network of contractors ideally suited to this situation.

• Professional management – at an asset level it may be a simple case of ensuring that the asset is managed by a capable and competent property manager One of the critical success factors for investors is a need to adopt a long term view and show patience in the process. This is consistent with the views of economist Joseph Schumpeter who believes that assets migrate into the hands of investors that are better able to make productive use of them.

One critical factor is that once the problem is recognised it is often a faster process to revive the assets than if it is not recognised.

One of the first issues to address when investing in distressed assets is to understand the investment climate of the country in which the investor has an interest in. Fundamental to this is the nature of the country‟s legal system and the investor‟s ability to rely on it. www.apreainstitute.asia

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PS03  Real Estate Finance & Investment

Unit 1: Finance

According to Altassets by Almedia there are a number of questions that should be asked in any evaluation of the legal system: • Are the legal rules affecting the investment comprehensive?

• If comprehensive, are the rules effective?

• If effective, are the rules enforced?

If these questions can be answered in the affirmative it can mean that the investor will receive good title to the assets that it is purchasing. This has been demonstrated with Japan receiving large percentages of distressed debt investment which is contrary to China that does not have the same legal protections.

Whether the purchase is via an auction or private purchase it is essential that investors get what they paid for and that title transfer is completed. As many distressed asset purchases do not provide time for due diligence it is up to the seller to provide the purchaser with assurances such as: • The property is in the state of repair quality expected • Leases are in place and vacancy rates are as offered • Arrears are as detailed in any terms of agreement It is essential that any buyers of distressed assets attempt to reduce the tax burden on the investment. There are a number of techniques that can be used to manage the tax burden. These include: • Using pass through entities to reduce the layer of tax on investment • Create deductions to reduce taxable income • Characterise profits as capital gains etc. if this can be treated more favorably for taxation • Recognising income in low taxation jurisdictions • Making use of favourable tax treaties It is essential in these cases that an expert in taxation of the relevant jurisdiction be utilised.

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PS03  Real Estate Finance & Investment

Unit 1: Finance

Work-out situations/ Restructuring Loans

Data Source: RCA Global Currents Jan.2010

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PS03  Real Estate Finance & Investment

Unit 1: Finance

Data Source: RCA Global Currents Jan.2010

ďƒ„

Workshop Preparation 1.1 Real Estate Level Underwriting Lenders create cash flow projections in order to determine if cash flows will be sufficient to cover debt service, captured within a DSCR (Debt-Service Coverage Ratio) or ICR (Interest Cover Ratio) defined as Property Cash Flow / Principal and Interest payments. Lenders create cash flow projections in a similar form as real estate investors with estimates of rental revenues and operating expenses based upon in-place leasing and market assumptions going forward. Lenders often create several scenarios of cash flows representing downside cases to stress DSCR in periods of distress or weakening market conditions.

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PS03  Real Estate Finance & Investment

Unit 1: Finance

1. Rent Roll Analysis

The rent roll is defined as a schedule of tenancy with an outline of key financial terms. The rent roll provides a picture of the property indicating quality, location, risk profile, market conditions and future cash flows. From the rent roll shown below, what are your answers as to the following: • Is this a Class A or B; CBD/Suburban and which industry sector?

• What are the historical trends in the leasing market and what is the current condition of the market?

• How stable is the cash flow going forward?

• What are the risks to the future cash flow?

• Is today‟s cash flow a good indication of valuation?

• Would you acquire the building based upon a going-in cap rate? Or which valuation approach would be more appropriate?

Rent Roll Tenant Name

SF

Rental Rate

Tenant #14

15,000

$ 80.00

$ 1,200,000

Year 4

Tenant #18

15,000

$ 52.50

$ 787,500

Year 5

Tenant #12

18,000

$ 80.00

$ 1,440,000

Year 4

Tenant #7

20,000

$ 70.00

$ 1,400,000

Year 3

Tenant #13

20,000

$ 80.00

$ 1,600,000

Year 4

Tenant #4

25,000

$ 60.00

$ 1,500,000

Year 2

Tenant #10

25,000

$ 70.00

$ 1,750,000

Year 3

Tenant #15

26,000

$ 80.00

$ 2,080,000

Year 4

Tenant #11

28,000

$ 80.00

$ 2,240,000

Year 4

Tenant #2

32,000

$ 50.00

$ 1,600,000

Year 1

Tenant #5

35,000

$ 60.00

$ 2,100,000

Year 2

Tenant #9

35,000

$ 70.00

$ 2,450,000

Year 3

Tenant #3

40,000

$ 55.00

$ 2,200,000

Year 1

Tenant #6

40,000

$ 60.00

$ 2,400,000

Year 2

Tenant #17

40,000

$ 62.50

$ 2,500,000

Year 5

Tenant #1

44,000

$ 50.00

$ 2,200,000

Year 1

Tenant #16

142,000

$ 80.00

$ 11,360,000

Year 4

Tenant #8

300,000

$ 70.00

$ 21,000,000

Year 3

900,000

$ 68.68

$ 61,807,500

Total GLA

1,000,000

Leased Rate

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90%

22

Effective Rent

Expire Date

PS03  Real Estate Finance & Investment

Unit 1: Finance

2. Lease Expiration Schedule Grouping the tenants by the year of their lease expiration provides an even better view of the building.

• What is the expiration concentration profile of this building?

• List a few asset management strategies which could be utilised going forward to lessen concentration issues.

• Can 7 or 10 year leases be signed in markets dominated by 5-year leases?

• How does the expiration schedule affect the debt financing? What mitigating structures could the lender implement to mitigate the impacts from lease expirations?

Lease expiration schedule SF

% Expiring

Year 1

116,000

11.6%

Year 2

100,000

Year 3

% Rent Expiring

Avg Rents

# of Tenants

$ 6,000,000

9.7%

$ 51.72

3

10.0%

$ 6,000,000

9.7%

$ 60.00

3

380,000

38.0%

$ 26,600,000

43.0%

$ 70.00

4

Year 4

249,000

24.9%

$ 19,920,000

32.2%

$ 80.00

6

Year 5

55,000

5.5%

$ 3,287,500

5.3%

$ 59.77

2

900,000

90.0%

$ 61,807,500

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Gross Rent

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PS03  Real Estate Finance & Investment

Unit 1: Finance

3. Rental Rates – Historical/Trends In the table below, Years -5 through -1 represent historical leasing market conditions; Year 0 represents current conditions; and the plus years represent the underwriter‟s expectations for future years.

• Please reconcile the historical leasing trends with the rent roll schedule.

• List 5 major markets where this trend may have recently applied to market leasing conditions.

• Provide a reasonable explanation for this schedule in terms of supply of office space; recent development of office space – connected with demand drivers during this period.

• Are you of the opinion that leasing rates move in smooth lines or spikes/drops?

• How does an equity investor approach such cycles?

• How should the lender protect itself from wild swings in the cycle?

Market rents % change

market occupancy

Yr -5

$ 50.00

5%

82%

Yr -4

$ 60.00

20%

87%

Yr -3

$ 70.00

17%

92%

Yr -2

$ 80.00

14%

96%

Yr -1

$ 65.00

-19%

94%

Yr 0

$ 45.00

-31%

91%

Yr +1

$ 45.00

0%

87%

Yr +2

$ 50.00

11%

85%

Yr +3

$ 55.00

10%

85%

Yr +4

$ 65.00

18%

87%

Yr +5

$ 67.50

4%

90%

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PS03  Real Estate Finance & Investment

Unit 1: Finance

4. Cash Flow Projections An In-Place cash flow analysis represents a point-in-time picture of the revenues and expenses, based on the current status such as the current leases, revenue levels and operating expenses. It represents the current cash flow available to cover debt service.

Cash Flow Projections are expectations for future conditions. Assumptions are made for leasing velocity, rental rates, expense levels, etc. to create a stream of cash flows. Cash flow projections can be made for all property types including both income-producing and for-sale properties.

• Please reconcile this cash flow forecast with the current rent roll and the expected trend in leasing rates.

• Explain the timing effects of market conditions to the cash flows.

• Explain your approach to value this building.

• Explain how you would approach the debt financing from the lender‟s point of view.

• Make an argument that the future cash flows should be higher based on the rent roll and market conditions.

• Make the counter argument that this building is not financeable from a lender‟s viewpoint.

CASH FLOW PROJECTIONS In-Place Leased Area Gross Rent Management Fees Net Effective Income Leased Rate Average Rental Rate

Yr 1

Yr 2

Yr 3

Yr 4

Yr 5

900,000

888,400

888,400

878,400

840,400

815,500

61,807,500

62,932,500

62,042,500

61,417,500

51,767,500

45,002,500

9,000,000

8,884,000

8,884,000

8,784,000

8,404,000

8,155,000

70,807,500

71,816,500

70,926,500

70,201,500

60,171,500

53,157,500

90%

89%

89%

88%

84%

82%

$ 68.7

$ 68.9

$ 68.1

$ 67.2

$ 60.9

$ 56.2

Operating Expenses Property Taxes

5,664,600

5,721,246

5,778,458

5,836,243

5,894,605

5,953,552

Building Utilities

2,832,300

2,860,623

2,889,229

2,918,122

2,947,303

2,976,776

Maintenance

7,080,750

7,293,173

7,511,968

7,737,327

7,969,447

8,208,530

Property Mgment Fees

1,770,188

1,795,413

1,773,163

1,755,038

1,504,288

1,328,938

708,075

729,317

751,197

773,733

796,945

820,853

18,055,913

18,399,771

18,704,015

19,020,461

19,112,587

19,288,648

52,751,588

53,416,729

52,222,485

51,181,039

41,058,913

33,868,852

Building Insurance

NOI Leasing Commissions

-

168,750

766,500

806,250

2,542,500

1,973,250

Tenant Improvements

-

625,000

1,250,000

1,875,000

2,500,000

1,875,000

250,000

250,000

250,000

250,000

250,000

250,000

250,000

1,043,750

2,266,500

2,931,250

5,292,500

4,098,250

52,501,588

52,372,979

49,955,985

48,249,789

35,766,413

29,770,602

CapEx

Property Cash Flow

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PS03  Real Estate Finance & Investment

Unit 1: Finance

DSCR Analysis The table below outlines DSCR for the Cash Flow Projections discussed above.

Debt service is often tested using a fixed constant – which accounts for possible future increases in borrowing rates. The table below calculates DSCR using a 5% constant; a spread above Libor and a fixed amortisation schedule.

• What benchmarks and indexes can the lender use to forecast interest rates going forward?

• What financial instruments can the borrower/lender use to mitigate changes in interest rates?

• Please reconcile the DSCR analysis with the Cash Flow projections, rent roll and market trends.

• Should a bank be willing to finance this property at these levels? Discuss the acquisition price being paid by the investors?

• How could expected downturns in the market and lease expiration concentrations be mitigated by the lender?

DSCR Analysis In-Place

Year 1

Year 2

Year 3

Year 4

Year 5

Property Cash Flow

52,501,588

52,372,979

49,955,985

48,249,789

35,766,413

29,770,602

DS at 5% Constant

26,250,794

26,250,794

26,250,794

26,250,794

26,250,794

26,250,794

2.00

2.00

1.90

1.84

1.36

1.13

3.50%

4.50%

5.00%

5.25%

5.50%

5.50%

23,625,714

26,250,794

27,563,333

28,875,873

28,875,873

2.22

1.90

1.75

1.24

1.03

36,830,286

36,830,286

36,830,286

36,830,286

36,830,286

1.42

1.36

1.31

0.97

0.81

DSCR Rate at L+3% (forecast) DS at L+3% (forecast)

18,375,556

DSCR 25-Year Amortization (5%)

2.86 36,830,286

DSCR

1.43

Cap Rate Purchase Price

875,026,458

Loan

525,015,875

LTV

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6.00%

65

26

PS03  Real Estate Finance & Investment

Unit 1: Finance

Private Funds Private Funds is an investment structure created to attract/raise large institutional investors for the purpose of investing in real estate assets. The Fund is typically organised under a General Partner („GP‟) and Limited Partner („LP‟) structure where the GP raises and operates the funds on behalf of its LP investors. The following are typical characteristics: • Not listed on an exchange • Open or closed structure • Set investment life cycle such as 7 years • Set investment criteria such as geography, investment types, return targets • Global, regional or local focused • Asset types may include stabilised, development, value-add, whole assets v. equity shares/joint ventures, or can even include debt instruments such as mezzanine loans, CMBS, etc.

• GP is the party raising and investing capital – responsible for strategic planning, execution and exit.

• LP may be silent or have more influence on the decision making process • GP fees may be a combination of fixed fees and performance fees • GPs may raise a series of funds – each with the same or varying investment strategies • GPs performance is not publicly tracked – only LPs with a large selection of positions are in a position to appropriately measure returns within the community • Funds are raised on a basis of unfunded capital commitments which are “called” as investment targets are identified. The financial strength of the Fund is inherently tied to the backing of the LPs and their abilities to fund commitments through the duration of the Fund.

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PS03  Real Estate Finance & Investment

Unit 1: Finance

Real Estate Publicly Listed – Corporates, REITs Debt may also be issued by corporations via debt capital markets. These issues can be short or medium term in nature. These forms of finance generally require credit ratings by a rating agency such as S&P, Fitch and Moody‟s. While this area of finance is particularly specialised we will look at it in some detail.

The capital markets have been closed for debt financing for more than 12 months and the consensus among industry experts is that it could take several years for the CMBS market to stabilise. However, given the increasing important role this market played in real estate financing in recent years and also the problems arising from the increasing number of CMBS loans which are defaulting around the world and also the number of CMBS transactions coming up for refinancing over the next few years it is necessary to understand how this market operates.

A corporation issues commercial paper or medium term notes using its own corporate credit rating. The credit rating is a function of the entity‟s ability to meet its debt obligations as they fall due. While a secured issuance can have a higher credit rating than the issuer, it is not a common practice to issue in this manner as it is not generally cost effective to do so.

The rating on a structured note issuance reflects the characteristics of the note issued rather than the issuer. Common types of property backed securities include commercial mortgage backed securities and credit lease transactions.

They are generally used in cases where the issuer would not be able to achieve an acceptable grade of debt in its own right. The structured issue may then be able to issue a security with a rating similar to that of a high quality corporate issuer.

In the case of mortgage backed securities the notes are sold to investors while the funds are then lent to the trust or applicable entity. The securities are held on behalf of the investors and obtain a credit rating depending on their loan to value ratio, interest coverage etc. These securities usually comprise two classes.

That is, senior and subordinated tranches with a number of subclasses within each tranche.

The substantive difference between the tranches is a function of the priority of claims of all payments flowing into the pool as well as different maturities and credit risk. Additionally, unlike residential commercial backed securities there is expected to be little or no principal repayments for a number of years due to lockouts. In addition there is a greater chance of default risk given that the mortgages may not have any form of insurance as may be present in residential mortgages.

Inherent in this type of finance is extension risk which is the risk that borrowers will not be able to refinance their properties when the loan matures.

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PS03  Real Estate Finance & Investment

Unit 1: Finance

The margin reductions as a result of this superior rating are a function of the credit enhancements held by the structured note. These can include, amongst others, the use of: • Special purpose vehicles • Notes secured against real property as a bank loan would be • Enhanced LVR‟s and coverage ratios • Third party guarantees • Surety bonds and letters of credit • Advanced payment agreements • Lease assignments Credit lease transactions are based around the cash flow commitments of a lease covenant from a high quality corporate tenant. This usually requires all outgoings to be paid by the tenant - hence it is „triple net‟. This occurs where the covenant is robust enough to allow an investor to rely on the cash flow from the underlying lessee. In this vein however the tenant needs to have strong credit (government department) or the lease needs to contain a credit enhancement. Additionally the lease needs to be long term and contain fixed or minimum rental increases.

China Financing – Foreign Investment in Real Estate PRC regulations have created a very unique system of capital and ownership for foreign investors in China real estate. The aim of this chapter is to provide a brief outline and description of how foreign investors participate in the China market.

Since the passage of Circular 171 in July 2006, foreign investors are required to establish onshore entities to own real estate projects in China creating a twotiered ownership and financing structure known as Onshore / Offshore.

Circular 171 • Titled „The Opinions Regulating the Entry into and the Administration of Foreign Investment in the Real Estate Market‟ • Prohibits foreign investors from acquiring real estate projects directly from an offshore entity (subject to grandfathered provisions) • Allowable entities Foreign Invested Entities („FIE‟) include Joint Venture (i.e.

EJV, CJV) and the Wholly Owned Foreign Entity (WOFE) • All FIEs must be approved by the Ministry of Commerce in Beijing („MOFCOM‟), or one of its local branches • FIEs are required to have a registered capital to total investment ratio of 50% indicating maximum borrowings of 50% - at the onshore level

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PS03  Real Estate Finance & Investment

Unit 1: Finance

Financing Regulations • Loans cannot be made to an FIE real estate developer until all registered capital has been contributed • Onshore loans cannot be used to finance the purchase of land use rights • Onshore lenders cannot fund until the borrower has already obtained land use rights and all construction and zoning permits for a project • All onshore loans must have a minimum interest rate within 90% of the benchmark set by the People‟s Bank of China • Residential mortgages cannot exceed 70% of the purchase price or 80% for properties with a floor area under 90 square meters Circular 130 • Dated June 1, 2007 and titled „Notice by the General Division of the SAFE on the Release of the First Group of Real Estate FIEs that have Passed Registration with MOFCOM‟ • Real Estate FIEs established or approved after June 1, 2007 are no longer able to borrow any foreign debt, including shareholder loans (subject to grandfathered provisions) • All offshore loans, including almost all related loan documents, must be registered by the borrower with SAFE, the foreign exchange authority, failing which they are technically unenforceable • Once an FIE borrowing limit is used up, it will not be allowed to borrow any additional offshore loans unless it increases its registered capital

RECAP: At the end of this subject you should have an understanding of the following concepts: • the classification of the real estate institutional market into four quadrants public or private and debt and equity • how property level debt financing can take on a variety of forms and structures depending on market conditions • the impact of financial leverage on equity returns • the characteristic differences between the various classifications of debt • basic ownership structures • cash flow underwriting and how making projections of future cash flows are dependent on market trends and specific property information • methodologies involved in the rehabilitation of assets • foreign investment considerations associated with financing in China

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30

Unit

2

Investment Strategies

PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Introduction This unit looks at the issues surrounding strategies for investing in listed real estate. We will first review the various pricing models we have discussed in Subject 2, and then we will go over issues which include distribution models, returns and trading strategies. We will discuss tools used by portfolio managers to analyse portfolio performance. The role of indices will also be explained.

LEARNING OBJECTIVES: As a result this unit will look at the following issues:  Understand the concepts behind the pricing of listed real estate  Understand the concepts behind distribution models of income  Understand concepts behind dividend policy  Understand concepts relating to financial leverage  Understand the concept of “Optimal Capital Structure”  Understand issues and concepts surrounding trading strategies  Understand what property derivatives are  Understand performance evaluation and benchmarks  Understand the role of indices

Pricing Listed Real Estate The listed entity valuation is, to an extent, dependent on the assets and the structure in which they are held. A simple vanilla REIT, a warehouse of real property assets with secured debt at the asset level and unsecured debt at the trust level is the simplest example. In this instance understanding the underlying asset values is the key, as debt and any withholding taxes are usually a publicly known variable. Equity is essentially what is left.

Companies like Centro (CNP.ASX) in Australia and others have pushed the funds management concept in addition to the passive real estate trust approach. This proved extremely difficult to value, and listed property companies with funds management or development models have seen wild swings in their share prices of late after the onset of a lack of liquidity (absence of debt funding), triggered by the US sub-prime induced credit crunch.

Ultimately at some point, irrespective of the type of legal structure, an assessment of the underlying property valuations is required.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

There are several components to valuations. The approaches to valuation, in very simplistic terms consist of: • The top down approach (market comparables, peer valuations, PE multiples, PEG ratios, etc.)

• The bottom up approach (first principle valuation assessments of the real estate assets or of the cash flow generating components) or DCF method(s) The approach that represents best practice is to use both, keeping in mind that there is an aspect of art to the science of valuation. A particularly useful concept is to determine the key drivers of a business.



Case Study Consider the case of the analysis of a widget manufacturer in the widget market. In the case of a widget market there are a number of factors that drive performance.

These include: • volumes • prices • cost to produce When analysing this, the best approach is to remove what the market price suggests the market view on the drivers are: i.e. high share prices may indicate • high assumption for the volumes of widgets • high assumption as to the prices of widgets, or • a combination of both The next issue when analysing the company is to look at whether it is a price maker or price taker on these key drivers?

We can apply this style of analysis to the listed property market. „ REITs are price takers in terms of market interest rates if they are unhedged.

This is particularly useful when the first principles valuation comes up with a result that is markedly different to current or implied market values.

Who do you believe? The valuation or the market?

We need to keep in mind that whilst equity markets demonstrate semi strong form efficiency, they are not always right, as evidenced by every asset bubble in history from Dutch Tulips to the Dot com mania boom and subsequent bust in 2001. This implies that there is a need to be sceptical about whether the market is indeed correct at a particular point in time.

Having said that listed structures have an advantage to the outsider because the non-development aspects of the business are a significant (or sole) portion of the business parameters (key drivers) and they are in the public domain.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

For the underlying assets the most commonly quoted commercial real estate concept is the Income Capitalisation Rate for those properties with cash flow incomes (i.e. completed and leased office buildings). In the most simplistic sense, this is the Net Operating Income for a real property asset, divided by the book or market valuation. In reality it is not this simple, as things like rental growth expectations are built into this rate.

Cap rates are also sometimes referred to in a relative sense as a comparative spread to the 10 year government bond yield. Of note, market competition and recent low interest rates have compressed cap rates in commercial property in many countries over the last several years.

On average, cap rates for each property type rose between 10 and 40 bps overall in 2008, but these averages mask wider country by country cap rate moves. The UK witnessed the largest swing in pricing last year. The spread between cap rates on property acquisitions versus the risk-free rate is a measure of risk and perceived opportunities; the higher the spread, the greater the risks. In the UK, this spread spiked six-fold from less than 40 bps to nearly 250. Hong Kong also saw a significant spike in the cap rate spread but had the lowest 2008 average cap rate at 4.6%. The cap rate spread in the US more than doubled from 175 to 400 bps, currently among the widest globally. Japan, Canada, and Germany have yet to see significant movement in their cap rate spreads although each have more than their fair share of troubled properties.

Source: RCA Global Capital Trend Feb.09

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Capital Markets Valuations Capital markets valuation can usually be undertaken by either: • Discounted Cash Flow • Net Asset Value • Net Tangible Assets • Earnings Before Interest Taxation Depreciation and Amortisation (EBITDA) • Enterprise Value • Return on Enterprise Value • Funds from Operations • Adjusted Funds from Operations • Residual Income Valuation As detailed there are a number of factors that impact on capital markets valuations. These include: • Value of Intangibles • Branding • Quality of Management • Creditworthiness of Sponsor and/or Manager • Taxes and Charges • Cycles One of the primary methods used for capital markets value is the discounted cash flow model. In this model, the most effective for modelling complex structures, cash flows, usually over a period of 10 years are discounted using the weighted average cost of capital. The effect of this is to give the value of cash flows in today‟s dollars.

The weighted average cost of capital is the weighted sum of its equity and debt costs with the cost of debt determined by the effective interest rate.

WACC = interest rate (1-tax rate)  debt/total capital + cost of equity  equity/total capital + cost of preferred  preferred/total capital To determine the cost of equity we can use the capital asset price model Cost of equity = risk-free rate + Beta (equity risk premium) Where the equity risk premium is the market risk less the risk-free rate. This reflects the risk of holding equities as a class of securities.

The risk-free rate is the return the investor would receive if they invested in a riskless asset. Many models use the 90 day bank bill/cash rate as a proxy for the risk-free rate.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Beta is the systematic risk of investing in a particular security or group of securities. It is estimated by calculating the slope of the regression line obtained by plotting price movements of the equity or group of equities against those of the referenced index. A Beta of 2 for example indicates that if the index was to increase 10% the particular equity or class of equities would increase 20% etc.

Distribution Models of Income REITs The distribution requirements of a REIT to receive a tax advantage are listed below: Australia

Hong Kong

Japan

Singapore

United States

Structure

A-REIT

HK-REIT

J-REIT

S-REIT

REIT & UPREIT

Since

1971

2005

2000

2001

1960

Distribution requirement

100% of taxable income (post depreciation)

90% on net income tax.

No depreciation allowed

90% of distributable income

90% of 90% of REIT taxable taxable income (post income depreciation)

Source: Various

These rules primarily drive the factors that affect the distributions that these listed securities pay. For example: • Hong Kong REITs are required to distribute at least 90% of net income after tax with distributions generally made semi-annually • Singapore REITs must comply with a tax ruling granted by the Inland Revenue Authority of Singapore which essentially requires the S-REIT to distribute at least 90% of taxable income each year in order to enjoy tax transparency on taxable income received from Singapore properties. In practice quarterly and semi-annual distributions are made.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Net Profit Generally speaking net profit is calculated as: Revenues

xxx

Less Property operating expenses

(xxx)

= Net property income

xxx

Plus Interest income

xxx

Less General and administrative expenses

(xxx)

Plus Changes in fair values of investment properties

xxx

= Operating profit

xxx

Plus Finance cost on interest bearing liabilities

xxx

Profit before tax and transactions with unitholders

xxx

Less Taxation

(xxx)

= Profit before transactions with unitholders

xxx

NOTE: • Property operating expenses may include property service fees, property tax and „other‟ property operating expenses • General and administrative expenses can include manager‟s fees, performance fees and trust expenses



Workshop Preparation 2.1 Choose a REIT which is not Link or Ascendas and review its financial results to understand the specific style of reporting net profit for the year.

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PS03  Real Estate Finance & Investment



Unit 2: Investment Strategies

Case Study – Link REIT Full Year Financial Results 31 March 2007 Note

Year ended 31 March 2007HK$’M

Revenues

5

3,954

Property operating expenses

7

(1,593)

Net property income

2,361

Interest income

60

General and administrative expenses

(88)

Change in fair values of investment properties

3,514

Operating profit

8

Finance costs on interest bearing liabilities

9

Profit before taxation and transactions with unitholders

11

Taxation

12

Profit for the year/period, before transactions with unitholders

5,847 (578) 5,269 (915) 4,354

Distributions paid to unitholders 2006 final distribution

(467)

2007 interim distribution

(702) 3,185

Represented by: Change in net assets attributable to unitholders

3,074

Amount arising from the cash flow hedging reserve movement

21

111 3,185

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Distributions Generally speaking distributions are calculated as: = Profit before transactions with unitholders

xxx

Adjustments Less Change in fair values of investment properties

(xxx)

Plus Deferred taxation on change in fair values

(xxx)

Less Other non-cash income

(xxx)

= Total Distributable Income

xxx

NOTE: • Some distributions may be up to as much as 100% of distributable income • The total distributable income is divided by the number of units on issue



Workshop Preparation 2.2 Choose a REIT which is not Link or Ascendas and review their financial results to understand the specific style of reporting distributions for the year.



Case Study – Link REIT Statement of Distributions for the year ended 31 March 2007 Year ended 31 March 2007 HK$’M Profit for the year/period, before transactions with unitholders Adjustments: Change in fair values of investment properties

4,354 (3,514)

Deferred taxation on change in fair values of investment properties

614

Other non-cash income

(13)

Total Distributable Income

1,441

Interim distribution, paid

702

Final distribution, to be paid to the unitholders

739

Total distributions for the year/period

1,441

As a percentage of Total Distributable Income Units in issue

100% 2,137,454,000

Distributions per unit to unitholders: Interim distribution per unit, paid

HK32.81cents

Final distribution per unit, to be paid to the unitholders

HK34.62cents

Distribution per unit for the year/period

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HK67.43cents

39

PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Equity Unlike REITs, listed and unlisted equities, including listed property companies do not generally have the same requirements when it comes to the payment of dividends. It is in fact a function of the capital structure that the company wishes to employ.

Dividend policy is an important subject in corporate finance with dividends a major source of cash outlay for many corporations. The heart of the dividend policy question is: should the firm pay the money to its shareholders or should the firm use the money and invest it for its shareholders?

Having said this, determining the most appropriate dividend policy is an important policy and one that never seems to satisfy all shareholders.

As a refresher it must be remembered that: • A company is usually under no obligation to make dividend payments to ordinary shareholders • The amount of dividend payment need not be a function of the firm‟s profit. It may elect not to pay a dividend or it may pay out more than net profit using retained earnings from previous periods.

• Different jurisdictions have differing rules and regulations relating to the taxation of dividends received by individuals and corporations • Dividends are generally paid twice a year – an interim and a final dividend There has been a lot of debate as to whether dividend policy actually matters?

The answer seems to be “yes” given the impact this has on the cash flow of the organisation.



Case Study Consider a case of a company that is to be liquidated within the next two years.

There are 100 shares on issue The cash flows for the next two years are $10,000 Assume a 10% required rate of return Scenario 1 If a dividend of $100 is paid each year that means that the dividend is equal to the cash flow in years 1 and 2. This will give a NPV of $173.55 Scenario 2 Assuming a total dividend of $11,000 is paid out this will require the issuing of $1,000 of new shares or debt. Assume shares are used. Therefore the cash flow to existing shareholders will be $11,000.

In year 2 there will be $8,900 available to existing shareholders. (This is $10,000 less the $1,000 repaid to new shareholders less the $100 i.e. 10% return that they expect.)

Assuming the same required rate of return and cash flows of $11,000 in year 1 and $8,900 in year 2 this will give a NPV of $173.55. Therefore the value of the company is not affected by the shift in dividend policy.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

There are a number of factors that affect dividend payout policies: • Local taxation laws may not be beneficial to the payment of dividends and favour capital gains • The process of issuing new shares is complex and costly. If a firm wishes to expand its equity base this may be a more cost effective alternative.

• Debt covenants may place restrictions on the payments of dividends • An ageing population may result in shareholders that have a preference for a higher level of income, hence a greater dividend payout • High payouts favour the reduction in uncertainty as valuations are more certain where dividends are higher in the near than long term In addition we must also consider the concept of the information content of dividends and the clientele effect.

Information Content Effect It is a common understanding in finance that dividends convey information to the market. A cut in dividends is often seen by the market that the company is facing financial difficulties. This will cause a downgrade in people‟s expectations of future dividends and therefore valuations of the firm.

Alternatively, an unexpected increase in dividends signals good news.

Management will normally only increase a dividend when they expect to be able to maintain it into the future and not have to cut them. This signals to the market that the company is in a healthy situation.

Clientele Effect The clientele effect states that different groups of investors desire different levels of dividends.

Establishing a Dividend Policy As we have seen there are a number of factors that may impact on the decisions that a firm makes with regard to the payment of dividends. We do know however that companies do not like to cut dividends.

One policy is the residual dividend approach. This approach states that the company‟s aim is to meet its investment needs and maintain its desired debt/equity ratio before paying any dividends.

An alternative policy is to undertake a practice of dividend stability rather than increasing and decreasing dividends dramatically. Many companies therefore like to maintain dividends or slightly increase them each period.

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Financial Leverage Financial leverage is the use of debt to finance a portion of a real estate investment. The benefit of leverage is defined as the benefits that may result for an investor who borrows money at a rate of interest that is lower than the expected rate of return on total funds invested in a property.

That is, if the return on the total invested is greater than the rate of interest on the debt, the return on the equity is magnified.

As an example, assume that there is an asset valued at $100 which produces cash flows of $10 in perpetuity. Now consider an investor who has $100 in wealth in cash. If that person uses their $100 the expected return on the investment will be 10% (i.e. 10/100 = 10%).

If, however, the investor was to borrow 80% of the value of the asset for say 7.5% they can purchase the asset using only $20 of their own equity. From the $10 cash flow they will pay $6 (7.5% of $80) in interest. The residual of $4 represents a 20% (4/20=20%) return on their investment.

The remaining assets held by the investor could be used to potentially purchase 4 other similar or different assets. Total expected cash flow from 4 similar assets would be $4 ď‚´ 5 = $20. Given the original wealth of $100 this would represent a return of 20%.

We can compare this to the original investment of $100 in just one asset. This would have only given us a return of 10%. The opportunity demonstrated in this case comes from the ability to borrow at a cost less than the return acquired from the borrowed funds.

This can be analysed another way if we consider the manner in which we value a perpetuity.

Consider the example above where the wealth of the individual was $100. If we consider a discount rate of 10% we can use the formula for perpetuity valuation.

Wealth = CF/R Unit 2 Where: CF

= Cash flow in the analysis

R

= Discount rate

Therefore: Wealth = $20/.1 = $200

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This means that the use of leverage magnifies the wealth of the individual investor from $100 to $200. Consider the example above except that there is a 50% chance that the cash flow is $7 and 50% chance that the cash flow is $13.

The effect of this is to magnify the risk to the equity held as a result of the leverage. From this we can calculate the following: Scenario 1: Assuming a cash flow of $7 and the cost of servicing debt to be $6 (7.5%  $80). This will give us a return of: Return = $1/$20  100/1 = 5% Scenario 2: Assuming the cash flow of $13 and the cost of servicing the debt to be $6. This will give us a return of: Return = $7/$20  100/1 = 35% This means that our returns will be either 5% or 35%. It may be argued that the increase in risk as a result will in fact eliminate the value enhancement. If we were to argue that our risk position increased such that our discount rate increased from 10% to 20% then using the earlier formula: Wealth = $20/20% = $100 This is no different from the 100% equity investment in the asset.

This means that debt holders will take on less risk for less return while equity holders will expect greater returns given the greater risk.



Workshop Preparation 2.3 An investor has $1m to invest in property. The property that he is looking to invest in has a return of 12% p.a.

The investor is considering the use of leverage to invest $200k each in five similar properties (i.e. $1m total).

The properties each have equal probabilities of returning 5%, 15% and 20%.

1. Assuming that debt is not tax deductible, determine the possible returns under this scenario.

2. Assuming that debt is tax deductible, determine the possible returns under this scenario. Assume a 15% tax rate.

3. What other considerations apart from

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PS03  Real Estate Finance & Investment



Unit 2: Investment Strategies

Case Study Scenario 1 Consider a property that has no leverage and a value of $100,000.

With no leverage the investment performance matches that of the property.

A 20% increase in value will see a 20% return while a 20% decrease will result in a 20% loss on investment.

Scenario 2 Consider the above property except that instead of $100k of equity there is $50k of equity and $50,000 of debt.

A 20% increase in value will give a return of $20/$50 = 40%.

A loss of 20% will therefore result in a loss on equity of -40%.

Scenario 3 Consider the above property except that there is 67% leverage and 33% equity.

That is $67,000 of debt and $33,000 of equity.

A 20% increase in value will give a return on investment of $20K/$33K = 61% A 20% decrease in value will give a return on investment of -61%.

Tax Deductibility In most jurisdictions interest payments are a tax deduction. For each dollar of interest that is paid by an organisation or individual it reduces the taxable income by $1. This means that if the tax rate of the investor was 20% the after tax cost of debt is only 80 cents for every dollar of interest expense.

The effect of this is to reduce the cost of debt (in our case above the after tax cost of debt is (1 - t)  7.5% = 6% and makes the use of leverage advantageous.

When analysing the effects of leverage on the value of real estate it is important to understand that cash flows are multi-dimensional in a real estate project.

Cash flows are received in the form of operating cash flows i.e. rent and cash flows from the resale of the property.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Optimal Capital Structure Optimal capital structure is that breakdown of debt and equity that maximises the value of the property. If value can be created as demonstrated in the simple example above then what is the optimal amount of debt that should be employed?

One immediate reaction is that given that debt maximises returns in a positive return environment then 100% leverage or close to it should be employed. This however is not a practical solution.

As discussed in other parts of this course the increased use of debt increases the possibility that default may occur. This is exemplified by rating agencies reducing their rating depending on the increase in LVR on a project. As the rating decreases investors expect the project to be more risky and therefore demand a higher margin on their investment.

Cash flows are also required to service the debt. As we stated earlier we had a 50% expectation of a $7 cash flow and a 50% expectation of a $13 cash flow.

That is, the cash flows are expected but not guaranteed in any investment. If the cash flows are lower than expected then this will reduce the value of the property and the ability of the entity to meet its debt repayments. In this case the owner of the property may have a put option in place whereby he can put the value of the property to the lender to satisfy his debt obligation. The lender can reduce the value of the put option by reducing the amount that can be borrowed (LVR) against the particular property.

An alternative to this is that the lender may charge a higher rate of interest to compensate them for the risk that they are carrying.

Since the greater use of debt increases the probability of default and loss to the lender it is reasonable to demand a higher interest rate. If the interest burden is too great there is a greater chance of default and as a result the benefit of leverage will disappear if there is default.

From this we know that if the after tax cost of debt exceeds the after tax rate of return then more debt will cause the value of equity to fall.

This analysis suggests that debt creates value.

Miller and Modigliani The first to propose that the use of debt would not create value were Miller and Modigliani in the context of corporate finance and stock values. That is, they believed that value would not be created or affected by the use of debt. They argued that the value of the corporation was a function of the size of cash flows and the risk of those same cash flows. The division of the cash flows into the debt and equity components would not increase value.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

They argued that this division of the cash flows by the corporation was outside the organisation through the use of artificial leverage. Investors as a result will not value this leverage as they can perform that same action themselves.

This may be difficult to reconcile to today‟s environment as there is a widespread use of debt in the property market.

Practical Considerations While the argument above is theoretical and the flaws in the Miller and Modigliani model have been well analysed by industry and academics alike there are a number of practical considerations as to the use of debt to finance real estate.

These include: • Access to equity capital markets – the equity market for real estate is somewhat limited. While access can be gained through REITs or other listed property or development assets there is little market for other forms of equity interests. While pension funds own substantial parcels of equity real estate, the funds are not listed on any market and the real estate is held as long term investments. Non institutional investors will usually have to rely on debt to be able to access property markets and use a larger proportion of debt to acquire larger properties.

• Risk – lenders that provide finance in the form of debt for property are risk averse. They will require large equity contributions for properties that they perceive to be risky. This is consistent with the methodology employed by the rating agencies as discussed earlier.

• Bankruptcy – lenders will prefer to advance greater amounts of debt only on less risky properties and only if the note is a recourse note. Investors will prefer non-recourse notes on all properties but especially those that are risky. Investors will maximise the use of debt when it is non-recourse. Nonrecourse debt is a type of debt that is secured by collateral, which is usually property. If the borrower defaults, then the issuer can seize the collateral, but not seek out any further compensation, even if it does not cover the full value of the default amount.

• Interest Rates – one expects that the lower the interest rate the more debt that will be used. That is, a lower cost of debt, all things being equal, will reduce the possibility of default.

Debt will make up a greater proportion of property investments when the corporate structure is used to acquire the investments, the investment is large, the risk of the property is small, the cost of bankruptcy is low, the tax rate is high or the market interest rate is low.

Two major institutional factors drive the use of debt for the acquisition of real estate properties. They are the tax deductibility of debt and the priority that debt has in the event of default. www.apreainstitute.asia

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Trading Strategies At the present time the current state of research into property investment is not as advanced as the research into equity or fixed income investment. One issue is that many decisions are based on valuations that are essentially matters of opinion. It is important to remember that investment strategy is concerned with ex-ante decisions while performance measurement is concerned with ex-post evaluation. There are a number of misconceptions that many argue not to be true: 1. The property market is grossly inefficient. This would suggest that it would always be possible to identify mispriced assets. If this is the case investors would buy property in preference to other assets. The research suggests that property appears to be correctly valued.

2. Returns are stable. This is based on the view that rents are stable over time and represents one of the main reasons for property investment.

This is only one part of the return function and ignores the fact that investors are interested in total returns.

3. Property is a long term investment. When looking at the uncertainty of property investment it can be argued that as investment horizons increase then in fact the risk (measured by standard deviation) of the terminal value will increase.

4. Property portfolios are well diversified. Many financial economists argue that it is hard to create a diversified property portfolio and that geographical diversification is not a true form of diversification.

5. The objective of the strategy is to track the index. It has been shown that in a number of jurisdictions that the tracking of the index is highly problematic at best and results in large tracking errors.

6. The Capital Asset Pricing Model (CAPM) is irrelevant. It is not so much that the CAPM is irrelevant it is more important to ensure that there is a correct definition of the market portfolio. There is nothing in theory to support the notion that the CAPM only applies to equities.

One of the fundamentals of strategy identification is that it goes hand in hand with performance measurement. Strategy identifies the investment objectives for a fund which are then evaluated by performance measurement. A process of review is required after which each property in a portfolio is evaluated. Once this is done, changes to the portfolio can be acted upon. These changes can be made to ensure that the portfolio stays consistent with the intended strategy of the portfolio.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

The development of a strategy revolves around an understanding of portfolio theory and the characteristics of property per se. Central to this is the identification of the strategy of the portfolio and as such expected return. In this manner it is important to take account of and evaluate the risk preferences of the fund. This will allow an assessment of the types of properties that should make up the fund.

According to Brown & Matysiak (2000) there are a number of characteristics of property as an investment class.

These include: • Valuations are probably a fair reflection of market prices • Property is better at hedging inflation in the long term • The returns from individual properties are not highly correlated • Individual properties carry high levels of specific risk • Most portfolios hold fewer than 50 properties and are poorly diversified • Property portfolios have high tracking errors so that it is not possible to track an index.

At one end of the investment management strategy is perfect forecasting ability and at the other end no forecasting ability. In all aspects, most people have some forecasting ability. This has led to the active – passive strategy with the portfolio split into two parts.

Passive Strategies Passive strategies involve tracking a recognised index. Problems relate to whether the index can be followed with minimal tracking error and also whether the index is not dominated by a small number of large players.

Active Strategies There are a variety of active strategies that can be employed in a portfolio.

These may include: • long index • short index • long short individual stocks • long vol individual stocks or the index

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PS03  Real Estate Finance & Investment

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Active Passive Strategy The first involves creating a portfolio that tracks an index. Specific risk can be eliminated through diversification so that returns are in line with an index. The second part involves reserving a portion of the funds that can be used to back beliefs concerning the expected performance of individual assets. This means that the returns should be superior in the long term to those offered by a passive portfolio with substantially less risk than an active portfolio.

Balanced Portfolios Modern portfolio theory introduces the concept of the efficient frontier. It proposes that a rational investor will diversify its portfolio so as to optimise the portfolio. That is, so the investor can maximise the expected return for a given level of risk. The model assumes the asset‟s return as a random variable, and models a portfolio as a weighted combination of assets so that the return of a portfolio is the weighted combination of the assets‟ returns. Additionally, the portfolio‟s return is a random variable, and consequently has an expected value and a variance.

With this in mind property forms an important part of any investor‟s diversification strategy. A balanced portfolio is one that will contain property, cash, domestic and foreign equities and domestic and foreign fixed income securities. Despite some literature to the contrary, the allocation to various assets to achieve diversification is a function of the assets‟ correlations.

Correlations of Real Estate The need to diversify is one that is globally recognised. However, it is not just a matter of investing in a wide variety of securities. Those securities with little correlation to each other will provide diversification benefits while those with high correlations will have the opposite effect.

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Figure 2.1: 36 Month EUR Correlations Global RealEs tate

Europe RealEs tate

Nth Americ aReal Estate

Asia RealE state

Global Equiti es

Europe Equitie s

NorthA merica Equitie s

AsiaEq uities

Global Bonds

Global Real Estate

1.00

0.70

0.93

0.83

0.48

0.41

0.49

0.42

-0.08

Europe RealEstate

0.70

1.00

0.57

0.48

0.37

0.38

0.38

0.26

0.09

Nth America Real Estate

0.93

0.56

1.00

0.61

0.42

0.34

0.47

0.32

-0.07

Asia Real Estate

0.83

0.48

0.61

1.00

0.44

0.38

0.40

0.50

-0.13

Global Equities

0.48

0.37

0.42

0.44

1.00

0.93

0.96

0.86

-0.20

EuropeEquities

0.41

0.38

0.34

0.38

0.93

1.00

0.84

0.74

-0.22

North America Equities

0.49

0.38

0.47

0.40

0.96

0.84

1.00

0.74

-0.18

Asia Equities

0.42

0.26

0.32

0.50

0.86

0.74

0.74

1.00

-0.16

Global Bonds

-0.08

0.09

-0.07

-0.13

-0.20

-0.22

-0.18

-0.16

1.00

Source: European Public Real Estate Association Monthly Statistical Bulletin May 2008

Figure 2.2: 36 Month USD Correlations Global RealEst ate

Europe Real Estate

Nth America Real Estate

Asia RealEs tate

Global Equitie s

Europe Equitie s

NorthA mericaE quities

AsiaEqu ities

Global Bonds

Global Real Estate

1.00

0.72

0.92

0.81

0.54

0.49

0.53

0.45

0.11

Europe RealEstate

0.72

1.00

0.57

0.47

0.43

0.47

0.40

0.29

0.18

Nth America Real Estate

0.92

0.57

1.00

0.56

0.43

0.36

0.47

0.31

0.09

Asia Real Estate

0.81

0.47

0.56

1.00

0.52

0.47

0.45

0.57

0.05

Global Equities

0.54

0.43

0.43

0.52

1.00

0.94

0.94

0.82

-0.09

EuropeEquities

0.49

0.47

0.36

0.47

0.94

1.00

0.83

0.68

-0.07

North America Equities

0.53

0.40

0.47

0.45

0.94

0.83

1.00

0.66

-0.10

Asia Equities

0.45

0.29

0.31

0.57

0.82

0.68

0.66

1.00

-0.10

Global Bonds

0.11

-0.09

-0.07

-0.10

-0.10

1.00

0.18

0.09

0.05

Source: European Public Real Estate Association Monthly Statistical Bulletin May 2008

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Figures 2.3, 2.4 & 2.5: 36 Month Local Correlations Japan- RE

Japan -Nikkei

Japan -Bonds

Japan - RE

1.00

0.75

-0.26

Japan - Nikkei

0.75

1.00

-0.41

Japan - Bonds

-0.26

-0.41

1.00

Source: European Public Real Estate Association Monthly Statistical Bulletin May 2008

HK- RE

HK - Hang Seng

HK - Bonds

Hong Kong - RE

1.00

0.79

0.19

Hong Kong -Hang Seng

0.79

1.00

0.10

Hong Kong - Bonds

0.19

0.10

1.00

Source: European Public Real Estate Association Monthly Statistical Bulletin May 2008

Singapore- RE

Singapore - STI

Singapore - Bonds

Singapore - RE

1.00

0.67

-0.07

Singapore - STI

0.67

1.00

-0.08

-0.07

-0.08

1.00

Singapore - Bonds

Source: European Public Real Estate Association Monthly Statistical Bulletin May 2008

As can be seen there are diversification benefits between bonds and real estate in the region.

ďƒ„

Workshop Preparation 2.4 Using the data above and any independent research you wish to undertake prepare a report on the securities that offer the best diversification benefits in a portfolio. Explain what you believe the reason for this is.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Volatility When looking at volatility the usual measure of this is standard deviation. This measures the divergence of the returns to the average return. It is a relative measure of risk.

Research shows that volatility is historically greater in Asia than other markets.

This is demonstrated by the graph below when compared to other markets.

Source: European Public Real Estate Association Monthly Chart Booklet April 2008

ďƒ„

Workshop Preparation 2.5 Using the information you have learnt in this course, your own knowledge as well as independent research, write down and explain the reason for the greater volatility in Asian real estate markets.

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PS03  Real Estate Finance & Investment

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Property Derivatives Derivatives are contracts or financial instruments which give an investor the right to return based upon the change in value or income generated by assets which are not owned by the investor.

In recent times there has been a greater focus on the use of property derivatives such as certificates, swaps, options and futures traded on a property index or pool of properties.

These derivatives provide managers with investments that reflect the average returns of property markets. While derivatives are not common in property in many jurisdictions many experts believe there is the potential for widespread acceptance similar to that in equities, financial and commodity markets.

Expected products include property certificates that entitle the holder to the right to receive income periodically or compounded forward until expiry, calculated by reference either to a property index or to average returns from a portfolio of properties. These can be bought or sold through a broker. A manager who believed its property was over or under weight in properties could buy or sell certificates as appropriate to increase its exposure and earn average returns without the high transaction costs.

A futures contract is an agreement to buy or sell investment rights or a commodity at a specified future date. A contract to buy or sell a property index at its future levels can provide a return equivalent to a very highly geared property because only a small deposit is required.

An option is a contract giving a right but not an obligation to buy or sell a commodity, property or investment asset at or before a specified date for a price agreed today. They can be traded “over the counter� (OTC) or via an exchange. As property derivatives these would be rights to trade property certificates, futures, shares or units.

Property swaps are an agreement to swap rights to income and capital gain from one group of properties with rights to returns from other properties or investment assets. Asset ownership in this case does not change but there is a swap of entitlements.

Property derivatives are covered in more detail in Unit 8.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Performance Measurement and Benchmarking Setting and meeting realistic performance expectations is becoming one of the defining factors in the choice of investment managers. Doing this effectively requires the ability to measure and analyse investment performance and understand where investment policy is succeeding or falling short of expectations.

Performance Attribution measures the effectiveness of an organisation‟s asset allocation, currency allocation and security selection strategies. This enables managers to better understand the impact of their investment decisions and to monitor and control the activities of their specialists.

Relative returns are critical to investment managers but it is also important to understand portfolios‟ risk-return characteristics. As such, ratios such as the Sharpe Ratio, Ex Post Tracking Error, Jensen‟s Alpha and the Information Ratio are also examined to assess the performance of a portfolio against its benchmark.

Performance Attribution Fund managers/portfolio managers go through a series of decision-making steps.

• First set of investment decisions: Strategic allocation decisions involve factors, such as allocations to different countries or to different sectors • Second set of investment decisions: Second set of allocation decisions, such as allocations to different sectors. No selection of individual securities occurs at this decision-making level.

• Third set of investment decisions: Selection of individual securities. These investment decisions occur after all group level asset allocations have been determined.

The number of investment decisions made can vary from fund to fund. The two levels of decision-making described in the above example are purely for illustration purposes. Some investment processes may have more or less decision-making steps.

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Evaluating Performance Using a Standard Attribution Model This example examines the standard attribution analysis for a Global Property Fund that invests in three regions: Europe, North America, and Asia. The asset allocation decisions made by the portfolio managers are described below.

• First set of investment decisions: Strategic regional asset allocations. The strategic regional manager decided to underweight Europe by 10%, underweight North America by 20%, and overweight Asia by 30%.

• Second set of investment decisions: Second set of allocation decisions, such as allocations to different sectors. No selection of individual securities occurs at this decision-making level.

• Third set of investment decisions: Selection of individual securities: These investment decisions were made by the security analysts. This example focuses on the security selections made within the Asian sector: Stock A 15%, Stock B 15%, and Stock C 10%.

An attribution analysis applying the above top-down investment process using a standard attribution model yields the following results: Portfolio

Return

Benchmark Weight

Return

Weight

Attribution Asset Allocation

Selection Effect

Total Effect

Europe

10.00%

-5.00%

20.00%

-7.00%

1.50%

0.20%

1.70%

Asia

60.00%

12.83%

30.00%

9.42%

0.43%

2.05%

2.47%

Office

40.00%

15.00%

15.00%

14.67%

1.67%

Stock A

15.00%

25.00%

5.00%

25.00%

1.70%

1.70%

Stock B

15.00%

7.00%

5.00%

7.00%

-0.10%

-0.10%

Stock C

10.00%

12.00%

5.00%

12.00%

0.20%

0.20%

Retail

10.00%

7.00%

10.00%

5.00%

0.00%

Industrial

10.00%

10.00%

5.00%

2.50%

-0.28%

North America

30.00%

10.17%

50.00%

13.20%

-1.04%

-0.91%

-1.95%

100.00%

10.25%

100.00%

8.00%

0.89%

1.34%

2.22%

Total

Note: All calculations are based on a single period.

Currency effects are implied in the allocation and selection effects.

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Allocation Effects 1. First set of investment decisions: Strategic regional asset allocations.

The benchmark had a 20% allocation to Europe, a 50% allocation to North America, and a 30% allocation to Asia. The portfolio had a 10% allocation to Europe, a 30% allocation to North America, and a 60% allocation to Asia. The strategic asset manager chose to underweight Europe and North America and overweight Asia.

Allocation Effect = each region‟s relative over/under weighting  (the benchmark performance in the region the aggregate benchmark performance) Allocation = (WPG -WBG)  (RBG-RB) W=Weight R = Return G = Group/Sector P = Portfolio B = Benchmark Allocation Effect for Asia = over/under weighting in Asia (+30%) * (performance of Asia in the benchmark (9.42%) - the aggregate benchmark performance (8.00%))

2. Second set of investment decisions: Sector asset allocations. This example focuses on the sector allocations within Office.

The benchmark had a 15% allocation to Office, a 10% allocation to Retail and a 5% allocation to Industrial. The portfolio had a 40% allocation to Office, a 10% allocation to Retail, and a 10% allocation to Industrial. Therefore, the Asian regional sector manager overweighed Office, equally weighted Retail, and overweighed in Industrial.

Allocation Effect for Asian Office = Over/under weighting in Asian Office (+25%)  (Asian Office performance in the benchmark (14.67%) - aggregate benchmark performance (8%))

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Selection Effects The third set of investment decisions: Individual security selections within each sector - this example focuses on the security selections within Asia. The calculation is as follows: Weight of the benchmark‟s group times the total return of the portfolio‟s group minus the total return of the benchmark‟s group.

Selection = WBG  (RPG - RBG) = Passive Group Weight x Return Differential In this instance, the benchmark had a 5% allocation to Stock A, a 5% allocation to Stock B, and a 5% allocation to Stock C. The portfolio had a 15% allocation to Stock A, a 15% allocation to Stock B and a 10% allocation to Stock C. Therefore, the Asian security analyst overweighed all three Asian securities.

Asia has a positive selection effect because the portfolio‟s performance in Asia (12.83%) was better than the benchmark‟s performance in Asia (9.42%). This over performance is multiplied by the weight of Asia in the portfolio (60%) to determine the selection effect.

Note: A good attribution model must follow an investment process. If a portfolio is managed in a manner where asset allocation and security selection decisions are made concurrently, a standard attribution model will properly explain the value added.

Alternative Methods of Measurement Another way of looking at performance measurement is how much value-add to the portfolio was through active versus passive management from the portfolio manager. There are three ways value can be added.

1. Market timing (or market allocations). The manager attempts to reallocate the portfolio between various market segments in an attempt to pick up excess returns relative to a benchmark. The effects from market timing represent the return you would have achieved had your active allocation generated benchmark returns minus the actual passive index return.







N N Markettiming   active allocation passivereturns    active allocation passivereturns i i i i   i 1 i 1

2. Property selection. The manager tries to enhance portfolio return by selecting above average performers







N N Property selection    active allocation passivereturns    active allocation passivereturns i i i i   i 1 i 1

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



PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

3. Diversification can be used to decrease portfolio risk while maintaining the current level of portfolio return The effects from property selection represent the return you would have achieved if your active returns were earned using the passive allocation minus the actual passive index return.

Example: Property Type

(A)

(B)

(C)

(D)

Active

Passive

Passive

Allocation

Allocation

Active Returns

Returns

Office

50%

30%

12%

9%

Industrial

10%

30%

7%

12%

Apartments

40%

40%

4%

6%

Passive benchmark return = 0.3  9%+0.3  12% + 0.4  6% = 8.7% Active portfolio return = 0.5  12% + 0.1  7% + 0.4  4% = 8.3% Effects of market timing = (A  D) - (B  D) = [0.5  0.09 + 0.1  0.12 + 0.4  0.06] - [0.3  0.09 + 0.3  0.12 + 0.4  0.06] = –0.6% Effects of property selection = (B  C) - (B  D) = [0.3  0.12 + 0.3  0.07 + 0.4  0.04] – [0.3  0.09 + 0.3  0.12 + 0.4  0.06] = –1.4% Net effects of active management = 8.3% – 8.7% = -0.4%

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Ratios Sharpe Ratio Developed by William F. Sharpe, this calculation measures a ratio of return to volatility. It is useful in comparing two portfolios or stocks in terms of riskadjusted return. The higher the Sharpe Ratio, the more sufficient are returns for each unit of risk. It is calculated by first subtracting the risk free rate from the return of the portfolio, then dividing by the standard deviation of the portfolio.

Using Sharpe Ratio to compare and select among investment alternatives can be difficult because the measure of risk, portfolio standard deviation, penalises portfolios for positive upside returns as much as the undesirable downside returns.

The Sharpe Ratio is calculated as follows:



rp  rf

p

Where:

rp = Expected portfolio return

rf = Risk free rate

 p = Portfolio standard deviation

Ex Post Tracking Error Tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked. It measures the standard deviation of the difference between the portfolio and index returns.

Many portfolios are managed to a benchmark, normally an index. Some portfolios are expected to replicate the returns of an index exactly (an index fund), while others are expected to „actively manage‟ the portfolio by deviating slightly from the index in order to generate active returns or to lower transaction costs. Tracking error (also called active risk) is a measure of the deviation from the benchmark; an index fund would have a tracking error close to zero, while an actively managed portfolio would normally have a higher tracking error. Dividing portfolio active return by portfolio tracking error gives the information ratio, which is a risk adjusted performance metric.

If tracking error is measured historically, it is called „ex post‟ tracking error.

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PS03  Real Estate Finance & Investment

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Jensen’s Alpha The average return on a portfolio over and above that predicted by the capital asset pricing model (CAPM), given the portfolio‟s beta and the average market return. Developed by Michael C. Jensen, this measure of a portfolio‟s alpha value is the most widely used measure of the risk to return trade-off. The Jensen alpha is calculated as follows:

 p  rp  rf   p rm  rf  Where P

= Jensen alpha

rp = Average return of the portfolio

rf = Average return of the risk-free proxy

rm = Average return of the benchmark proxy P

= Beta of the portfolio

Information Ratio A statistic that seeks to summarise the mean-variance of properties of an active portfolio with a single number. The information ratio builds on the Markowitz mean-variance paradigm, which says that the mean and variance (or, equivalently, the mean and standard deviation) of returns are sufficient statistics for characterising an investment portfolio. The information ratio is calculated as follows:

ER IR   ER Where IR

= Historical information ratio

ER = Average value of ERt over the historical period from t = 1 through T . ER = Estimated standard deviation over the same period ERt =Differential or excess return in period t (portfolio over benchmark)

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Indices A benchmark has two important characteristics. First it represents the preferred neutral position for strategic asset allocation. This position provides an investor with the expected risk/return characteristics for each individual asset class. The benchmark represents the passive alternative that replicates asset class performance. The index chosen as the benchmark must be able to capture the risk/return characteristics of the desired market or market segment.

Second, the benchmark should provide an objective yardstick for evaluating the performance of active management. An appropriate index represents a fair benchmark that encompasses all investment opportunities from which an active manager chooses.

The choice of index for benchmarking should consider investment objectives.

With regard to listed property, there are two potential objectives: 1. Listed property as a surrogate property exposure, where an investor wants to boost its exposure to property through the portfolio 2. Listed property as a return source. In general a broader universe provides a better source of returns as it gives access to greater diversification and a wider opportunity set for alpha generation. This would suggest a broader index is preferable.

When multiple indices are available for benchmarking, the index should not only be consistent with investment objectives but also have a number of practical qualities such as: 1. Complete - This characteristic reflects the extent to which the index represents the appropriate investment universe. It should be mean/variance efficient such that no other index representing this market would provide higher returns without taking higher risk. The index should also include all the available securities that are part of a managersâ€&#x; opportunity set.

Therefore, there should be no need for managers to take off-benchmark positions.

2. Attainable - The ideal index contains only securities that are fully investable, representing the true passive alternative. However, in practice the requirement is usually that the index should be easy to replicate at lowest possible cost. Thus low turnover and related transaction costs are also desirable. Ideally the index should use free float adjusted market capitalisation to determine security weights. Therefore, the index must be investable as a truly passive alternative.

Theoretically a perfectly complete index would include all the securities in the market. However, there are securities that are so small and illiquid that they would be difficult to obtain. Therefore, a more complete index is less attainable and, conversely a more attainable index is less complete.

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3. Transparent - The index must be constructed in an objective manner such that it has clear, published rules and an open governance structure.

When an index meets these criteria, investors and managers are able to anticipate more accurately upcoming changes in an index, thus aiding both passive and active management.

4. Accurate - Index data should be accurate, complete and easily available. The data needs to be of a high quality with very low rates of error and recalculation.

5. Acceptance by investors - Since the benchmark largely determines the risk/return characteristics of an asset class, it is important that investors and managers accept it as a valid basis for measurement of returns. An investor also incurs peer risk when it chooses a different index from the one that the majority of investors use.

Hedging When running a global property fund, portfolio managers must consider the issue of currency risk and hedging. A fully hedged benchmark with respect to global listed property has the following advantages; firstly a fully hedged benchmark allows active global listed property managers to focus on stockpicking and regional allocation, rather than currency movements. Secondly, fully hedged returns provide investors with the same market risk premium that local investors receive without any additional risk from foreign currency. The disadvantage of a fully hedged benchmark is the cost and potential value-add.

The four main providers of global listed property indices are FTSE, Global Property Research, S&P and UBS. 1. FTSE - FTSE is a well-known dedicated index provider covering most classes.

The FTSE EPRA/NAREIT Global property index was formed in 2005.

2. Global Property Research - Global Property Research is a subsidiary of Kempen & Co. focusing on real estate securities index products. GPR has a broad market index, the GPR General Index, which reflects the global listed property universe.

3. S&P - S&P is also a well-known dedicated index provider covering most asset classes. Citigroup has a partnership with S&P that calculates and publishes the Citigroup Global Property Index. This index splits into two sub-indices; World Property and Emerging Markets Property. The World Property Index, which focuses on developed countries, is a popular broad market index.

4. UBS - UBS is an investment bank that also provides indices. Unlike the three providers mentioned above, it is not a dedicated index provider. The UBS Global Real Estate Investors Index is a subset of the S&P/Citi World Property Index. The UBS index enjoys a high level of acceptance in Australia, but has very little if any penetration in the rest of the world.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Methodologies for the Different Global Listed Property Indices Inclusion Criteria Real Estate

FTSE/EPRA/NAREIT

GPR250

S&P

UBS

>75% of EBITDA (60% >75% for Asia region) operating profit

>60% revenue from rent

>60% revenue from rent

Size

North America =>0.10% of regional market cap Europe =>0.10% of regional market cap Asia =>0.30% of regional market cap

>US$50m

>US$100m

North America>US$200 m Europe>E75m Asia>US$200m

Liquidity

at least 0.05% of their shares in issue (after the application of any investability weightings) based on their median daily trade per month in ten of the twelve months prior to the review

250 of the most liquid stocks

>US$25m

North America>US$75m Europe>E40m Asia>US$75m

Activity

Index Construction

FTSE/EPRA/NAREIT

GPR250

S&P

UBS

Country Allocation

Predominantly where the company is primary listed

Dominant asset base

Decided on a case by case basis

Decided on a case by case basis

Weighting

Free float

Free float

Free float

Free float

Pricing Frequency

Daily

Daily

Daily

Daily

Returns

Gross & net of withholding tax

Gross returns only

Gross & net of withholding tax

Gross & net of withholding tax

Quarterly

Annually

Annually

Revision Frequency Quarterly

Source: FTSE, Global Property Research, Standard & Poors

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

Market Statistics for Global Listed Property Indices (As at 29 Feb 2008) FTSE

GPR250

S&P

UBS

Total Market Capitalisation (US$ billion) Global

743

640

786

526

North America

287

225

275

259

Europe

157

144

168

148

Asia

299

270

343

119

North America

39

35

35

49

Europe

21

23

21

28

Asia

40

42

44

23

22

23

26

18

2

2

2

2

15

14

18

11

5

7

6

5

Global

295

250

457

251

North America

119

97

140

114

Europe

97

70

115

80

Asia

79

83

202

57

Weights (%)

Number of Countries Global North America Europe Asia Number of Securities

Dividend Yield (%)

4.1

4.0

4.0

4.2

Source: Datastream, FTSE, S&P and UBS

Rental Sub-Indices In December 2006, FTSE launched an Investment Focus Index series that breaks up their FTSE EPRA/NAREIT universe into a Global Rental Index and Global Non-Rental Index. The distinction is that for a property security to be classified as “rental”, at least 70% of total revenue must be derived from rent.

The new FTSE Global Rental Index is often compared to the UBS Global Real Estate Investors Index. The two main differences are the revenue estimates and their universe of property securities. UBS use historical values selected from the S&P/Citi BMI World Property universe, while the FTSE rental securities are selected from their own EPRA/NAREIT Global Listed Property universe.

In addition to listed property indices, it is possible to execute hedging transactions which derive their value from indices that capture the actual return in the commercial real estate asset class. There are several providers but the defining nature is if the index is representative of actual transactions or appraisals.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

The three main providers of transaction /appraisal indices are REAL, NCREIF and IPD. 1. REAL: Real Estate Analytics, LLC (REAL) utilises the data from Real Capital Analytics and the methodology developed by the Center of Real Estate at Massachusetts Institute of Technology (MIT) to publish a series of repeatsale, transaction-based indices. These indices most accurately and timely capture the price movement in the commercial real estate asset class.

Moody‟s and REAL jointly publish these indices.

2. NCREIF: National Council of Real Estate Investment Fiduciaries property Index (NPI) derived from the performance of institutional class properties owned by investment managers and pension funds.

3. IPD: A global information business specialising in the measurement of real estate investment performance, confidential portfolio analysis services and the publication of market indices. IPD indices are derived from the performance of properties which are directly owned by the organisations that contribute data to IPD. Methodologies for the Different Transaction/ Appraisal Indices Inclusion Criteria

CPPI

NCREIF

IPD

Data Starts

2000

1978

1985

Frequency

Monthly Index

Quarterly Unleveraged Returns

at least annual

Measurement

Capital Returns

Total, Income and Capital Returns

Total, Income and Capital Returns

Methodology

Transaction Based

Appraisal Based

Appraisal Based

Methodology Detail

Repeat Property Sales

Appraisals required every 36 months – interim periods are „valuations‟ provided by managers

Portfolio of Leading property companies

Size

Minimum transaction size $2.5mio

Pool size approx $440bio

Varied by countries

Source: REAL, NCREIF & IPD

The major differences between Global Listed Property Indices and transaction /appraisal indices is that global listed property indices are influenced by stock price of selected property companies/ REIT, while Transaction/ appraisal indices are influenced by the income or capital returns of underlying assets. Global listed property indices are indirectly related with the performance of underlying assets but Transaction/ appraisal indices are directly related with that of underlying assets.

Let‟s look at the result of Moody‟s/REAL CPPI & Publicly-traded REITs Correlation studied by Moody‟s /REAL.

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PS03  Real Estate Finance & Investment

Unit 2: Investment Strategies

We studied the correlation between 85 publicly–traded US REITs and the Moody‟s /REAL CPPI that most closely matched each REIT‟s property holdings from Q12000 to Q12008. The purpose of this study was to discern whether there was a relationship between the return of a REIT and its corresponding Moody‟s /Real index‟s return. A majority of the REITs displayed small or no correlation. The findings are summarised in the following table: Table: Moody’s/REAL CPPI & Publicly-traded REITS Correlation None [<.1]

Small [.1 to .3]

National All-Property

6

4

National Apartments

4

6

3

0.148

National Industrial

4

4

1

0.142

National Office

1

7

1

0.157

6

11

0.364

National Retail MSA Office

Medium [.3 to .6]

Large [>.6]

Mean Correlation -0.009

1

2

0.548

MSA Apartments

3

-0.064

West Office

3

0.144

East Retail (ATQ)

3

6

East Apartments (ATQ)

1

2

S. Cal. Office (ATQ)

1

South Apartments (ATQ) Totals

1

0.137 0.106

1

0.101

3 20

44

0.166 19

2

Source: Moody‟s /REAL CPPI

RECAP: At the end of this subject you should be able to understand the following concepts:  The pricing of listed real estate and the factors that affect it  Capital markets valuations  Distribution models of income for REITs and Equity  The concept of financial leverage  Issues surrounding tax deductibility  Optimal capital structure  Trading strategies  Correlations of real estate assets  Concepts related to property derivatives  Performance measurement and benchmarking

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Unit

3

Accounting & Financial Analysis

PS03  Real Estate Finance & Investment

Unit 3: Accounting & Financial Analysis

Introduction This unit seeks to look at issues surrounding accounting and financial analysis.

The concept of accounting issues will also be addressed particularly as a result of the introduction of IFRS and the issues surrounding basic financial analysis.

LEARNING OBJECTIVES: At the end of this unit you should be able to:  Understand the major impacts of IFRS on financial reporting  Understand basic financial ratios relating to real property  Understand basic financial ratios relating to listed entities

Accounting Treatments In recent times there has been a dramatic shift in the financial reporting requirements of entities under International Financial Reporting Standards (IFRS) issued by the International Accountings Standards Board. This has created a reporting regime that has placed an emphasis on the economic substance of the firm and the recognition of fair value estimates or market value estimates for a number of balance sheet categories.

The other benefit of creating a system of international accounting standards that are applied in a similar manner around the world is the fact that accounting information generated by entities is now created on a consistent basis and allows greater comparability in the globalised world in which companies operate.

IFRS has made the analysis of REITs extremely problematical in the last few years. This is particularly the case for those REITs that have: • Aggressively pursued property revaluations via development or targeting growth markets (e.g. Japan) • Expanded into offshore assets and used cross currency hedging (e.g. Centro into the US) Currently, profit and loss and cash flow statements can now bear little resemblance in some instances. Unrealised upwards property revaluations (to book values) pass through the profit and loss and provide an NPAT (net profit after tax) that is much higher than the underlying operating cash earnings.

Variations on mark to market of cross currency derivative positions can similarly increase or decrease profit figures, as the derivative position is generally not realised in a cash sense.

Other items of note that warrant attention are withholding taxes, particularly if you are examining the accounts from the perspective of unsecured debt or as an equity holder. The most critical (and difficult) task for the analyst is to determine how reasonable the book values are. www.apreainstitute.asia

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PS03  Real Estate Finance & Investment

Unit 3: Accounting & Financial Analysis

Regional Differences Four countries including the US, Canada, Japan and South Korea do not comply with IFRS and record their investment properties at cost. Non compliance by the US is presumably a function of its decision not to adopt IFRS. Given that IFRS in its current form was heavily influenced by European Union members, it is not surprising that most European countries have moved to IFRS and use fair value for their investment properties. Hong Kong, Singapore and Australia have followed suit when valuing REIT property investments.



Case Study IAS 40 Investment Property Before the implementation of IFRS many companies were applying accounting standards which allowed investment properties to be reported using an historical cost method.

IAS 40 requires the company to choose between historical cost and fair value accounting to report its investment properties.

Specifically this has been summarised by the IASB as: The objective of this Standard is to prescribe the accounting treatment for investment property and related disclosure requirements.

Investment property is property (land or a building—or part of a building—or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for: (a) use in the production or supply of goods or services or for administrative purposes; or (b) sale in the ordinary course of business A property interest that is held by a lessee under an operating lease may be classified and accounted for as investment property provided that: (a) the rest of the definition of investment property is met (b) the operating lease is accounted for as if it were a finance lease in accordance with IAS 17 Leases; and (c) the lessee uses the fair value model set out in this Standard for the asset recognised

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PS03 ď&#x20AC;ź Real Estate Finance & Investment

Unit 3: Accounting & Financial Analysis

Investment property shall be recognised as an asset when, and only when: (a) it is probable that the future economic benefits that are associated with the investment property will flow to the entity; and (b) the cost of the investment property can be measured reliably An investment property shall be measured initially at its cost.

Transaction costs shall be included in the initial measurement.

The initial cost of a property interest held under a lease and classified as an investment property shall be as prescribed for a finance lease by paragraph 20 of IAS 17, i.e. the asset shall be recognised at the lower of the fair value of the property and the present value of the minimum lease payments. An equivalent amount shall be recognised as a liability in accordance with that same paragraph.

The Standard permits entities to choose either: (a) a fair value model, under which an investment property is measured, after initial measurement, at fair value with changes in fair value recognised in profit or loss; or (b) a cost model. The cost model is specified in IAS 16 and requires an investment property to be measured after initial measurement at depreciated cost (less any accumulated impairment losses). An entity that chooses the cost model discloses the fair value of its investment property.

The fair value of investment property is the price at which the property could be exchanged between knowledgeable, willing parties in an armâ&#x20AC;&#x2122;s length transaction.

An investment property shall be derecognised (eliminated from the statement of financial position) on disposal or when the investment property is permanently withdrawn from use and no future economic benefits are expected from its disposal.

Gains or losses arising from the retirement or disposal of investment property shall be determined as the difference between the net disposal proceeds and the carrying amount of the asset and shall be recognised in profit or loss (unless IAS 17 requires otherwise on a sale and leaseback) in the period of the retirement or disposal.

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PS03 ď&#x20AC;ź Real Estate Finance & Investment

Unit 3: Accounting & Financial Analysis

Fundamentally, this allows the use of a historical cost method that reports property on the balance sheet at cost less accumulated depreciation and any impairment losses. Companies that initially adopted the historical cost method can switch to the fair value method at a later date if this would result in a more accurate presentation of financial results. Any changes to fair values are normally evaluated by external valuers and reported in the footnotes to the annual report. It must be noted that IFRS does not definitively require the use of external valuers. Under the fair value method investment property, but not investment properties under construction or building land, would be revalued and reported in the balance sheet at its current market value with all changes in value appearing in the profit and loss. Fair value is that value at which the property would be exchanged between knowledgeable, willing parties at an armâ&#x20AC;&#x;s length transaction. It is important to note that IFRS is changing to include properties under construction. While IFRS does not prohibit the switching from the fair value method to the historical cost method it does suggest that it is highly unlikely.

Ratio Analysis When undertaking ratio analysis it is important to understand that no ratio is useful in isolation. It should be compared to industry benchmarks, different sections within a firm or against itself over time.

One common mistake is to place complete faith in numbers. Ratios should be part of the answer, not the answer. They should be used in conjunction with other financial and non-financial factors. This non-financial information can be gained by researching a variety of sources including government reports, newspapers and industry journals.

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PS03  Real Estate Finance & Investment

Unit 3: Accounting & Financial Analysis

Financial Analysis of Real Estate When undertaking a successful analysis of a real estate investment there is a number of critical characteristics that are not easily reflected in the maths of financial analysis. These include the long time horizon involved, lack of liquidity and the effect of changes in the investment environment.

The analysis of real estate can be broken into three parts: • Cash flow – cash flows received by the investor less any cash expenses incurred with the exception of income taxes • Tax effect – the amount that the investment edicts the taxes payable by the investor • Future Benefits – expected future benefits The first part in the process is the determination of the pretax cash flows. There are many ways to look at this and the information can be gleaned from the profit and loss and/or the cash flow statement. When looking at the definition below it must be remembered that it can be difficult to glean the vacancies from looking at financial statements.

One definition is: Gross Revenue Less vacancies Less bad debts = Net Revenue Less expenses Less debt servicing costs Less Capital Expenditures = Cash Flow before Taxes The analysis of income should start with base rentals. The first step is the determination of comparables for which to base analysis. This requires the ability to find the greatest amount of useful data and then to use that data in a meaningful manner. It is also essential to understand the factors that make the property comparable such as internal and external features, floor space and location. Trends are useful here when compared to the information contained within lease documents. While lease terms are significant it is important to realise that changes do occur in markets over time.

A reasonable allowance must be determined for vacancies and bad debts. These may be ignored but are an essential part of financial analysis. Comparable data for vacancies are often difficult to assess. The issue here is to access good quality data either formally or informally.

Operating expenses make up one of the key factors in determining the profitability of a property. Items here generally include real estate taxes, administrative, maintenance, supplies, rubbish removal, repairs, utilities and insurance. www.apreainstitute.asia

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PS03  Real Estate Finance & Investment

Unit 3: Accounting & Financial Analysis

Tax effects are a concept that can have an impact on an investor‟s return. There are however a number of different rules in many jurisdictions so these must be considered in any analysis. As detailed in this course the use of a tax consultant is essential.

As stated earlier in this subject there is also the impact of leverage in any investment, and as stated earlier, both positive and negative.

Future benefits arising from sale or refinancing are the final component of return available to the real estate investor. The longer the time horizon the more difficult it is to calculate future benefits.

Issues that need to be considered include future operational changes, physical changes, financial changes and market changes.

Measurement of Return One of the primary issues in return measurement is valuation.

Value = Annual Cash Stream/Capitalisation Rate Under value there would generally be a limit on the pre capex cash flows and these would be adjusted for capital expenditure in the short term.

Return on Assets = Cash Flow (Net Income)/Property Cost This is a static measure of return as it assumes cash flows are stable through time. It ignores the risk or tax consequences of the investment and ignores the capital change associated with disposal of the investment. It is essential for a lender who wants to make sure there are adequate income/cash flows from the first year.

Cash Flow after Financing Return = Cash Flow after Financing/Equity In this case the equity is the initial cash investment. It is a rigid measure of performance as it is essentially the ending cash flow. This is often used for first cut analysis.

Before Tax Cash Flow + First Year‟s Amortisation Return on Equity = Before Tax Cash Flow + Mortgage Principal Payment (Year 1)/ Equity Similar to the earlier ratio except that there is the addition of the amount repaid on the mortgage if applicable.

Other significant measures include Net Present Value and Internal Rate of Return.

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PS03  Real Estate Finance & Investment

Unit 3: Accounting & Financial Analysis

Financial Analysis of Listed Securities It is important to remember at this time that analysts will use a variety of ratios. Some of these may be common while others may have been developed to suit a particular need. We will explore some very common equity analysis ratios used.

One other issue is that financial data audited and published is highly aggregated so this makes analysis that much more difficult.

It is important at this stage to review a number of accounting fundamentals.

The basic accounting equation is: Assets = Liabilities + Owners Equity This is a measure of the wealth of the organisation and appears in summary form on the balance sheet. The balance sheet contains summary information as at a point in time. This is usually the financial year end or balance date. The summary of information impedes financial analysis.

Profit is equal to revenue less expenses. This information appears on the profit and loss account and usually summarises the income and revenue for the accounting period under review e.g. full financial year.

Profit can be retained within the business or paid out as dividends. If it is retained it forms part of owners equity as retained earnings. From this we can summarise that: Assets =

Liabilities + Capital + Reserves + Opening Retained Earnings + Revenue – Expenses – Dividends

This shows the relationship between the Balance Sheet and the Pro. t and Loss Account. Further to this the prior year‟s cash balance in the Balance Sheet will represent the opening cash amount in the cash flow statement and the closing amount in the cash flow statement should equal the current year‟s Balance Sheet cash amount.

Common ratios include: Current Ratio = Current Assets/Current Liabilities This represents the ability of the organisation to meet its short term commitments.

Gearing = Debt/Equity Alternatively, gearing may also be defined as Debt/Total Assets.

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PS03  Real Estate Finance & Investment

Unit 3: Accounting & Financial Analysis

This represents the percentage of debt as a percentage of equity. This can be used to determine the financial stability of the entity.

Interest Coverage = EBIT/Interest Expense This measures the entity‟s ability to service its interest payments.

Distributions per Unit = Total Distributable Income/Units in Issue This is a measure of the returns paid to unitholders.

Dividend Payout Ratio = Dividends Paid and Provided/NPAT This is a measure of the amount of net profit paid out as a dividend.

Return on Assets = NPAT/Total Assets This is the productivity of the assets in turning revenue into net profit.

Return on Shareholders‟ Equity = NPAT/Shareholders Equity This is a measure that allows comparison to other investments without regard for the particular investment. This is the net profit as a percentage of shareholders investment.

Asset Turnover = Sales Revenue/Total Assets This measures the efficient use of assets.



Case Study This looks at the financial results of the Link REIT for 2007 Current Ratio = Current Assets/Current Liabilities = 1,638/1,056 = 1.55 Gearing = Debt/Equity = 17,390/26,789 = .65 This has been prepared using the book value of equity.

Interest Coverage = EBIT/Interest Expense = 5,847/578 = 10.11

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PS03  Real Estate Finance & Investment

Unit 3: Accounting & Financial Analysis

Distributions per Unit = 67.43 cents Return on Assets = NPAT/Total Assets = 4,354/45,235 = .096 Return on Shareholders‟ Equity = NPAT/Shareholders Equity = 4,354/26,789 = 16.25% This has been prepared using the book value of equity Asset Turnover = Sales Revenue/Total Assets = 3,954/45,235 = .0874



Workshop Preparation 3.1 Using the ratios above prepare the same ratios for a listed entity in your jurisdiction for two years. What changes do you notice in the ratios and what can these tell us?

RECAP: At the end of this subject you should be able to understand the following concepts:  Accounting treatments for property including regional differences  International Accounting Standard Number 40 (IAS 40) Investment Property  Financial analysis of real estate  Common analysis ratios and their meaning  Financial analysis of listed securities

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Unit

4 Prospectuses and Marketing

PS03  Real Estate Finance & Investment

Unit 4: Prospectuses and Marketing

Introduction In this unit we will explore many of the issues surrounding the creation of a prospectus and marketing of a new issue. While each jurisdiction will have particular requirements relating to the documentation of an Initial Public Offering there will be a lot of similarities.

LEARNING OBJECTIVES: At the end of this unit you should be able to:  Understand the steps taken in the issuance of a prospectus  Understand the information contained within a prospectus for a REIT  Understand the marketing strategy for listing an entity

Preparing the Prospectus The prospectus is the centrepiece of a company‟s listing on a stock exchange. It is a comprehensive, single source of information on the listing for regulators and potential investors. It is also an IPO (Initial Public Offering) marketing document. It explains the: • Business • Products • Risks involved • Use of proceeds • Who are the executives • Executives‟ view of the financial condition and results of operations • Financials – in essence the most accurate picture of the company • Strategy • Investment Highlights The summary section is the most important part of the prospectus because every investor reads it. The summary section will either boost or dash confidence.

The prospectus is prepared by a combination of the company, legal advisors and the managing underwriter. Because of the complexity of this document, creating a prospectus is very time consuming and costly. The company‟s key responsibilities are: • Preparing and presenting due diligence/financial information • Participating in the prospectus drafting sessions • Making sure the prospectus accurately represents the company‟s business.

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The CEO and CFO will handle the majority of road show presentations. In addition, sales, marketing, operations, and property management executives will need to contribute to drafting the prospectus.

The managing underwriter (the investment bank in charge of the offering) will also assist in the due diligence and the drafting of the prospectus. But its main responsibility is forming the syndicate, organising the road show and marketing meetings, and the overall marketing and selling of the company‟s shares.

The underwriters legal advisors will advise the managing underwriter throughout the process, ensuring it remains compliant with relevant regulators and getting sign-offs from all parties on the prospectus. The lawyers, together with the managing underwriter will also coordinate with the stock exchange representatives, the printer, transfer agent and help negotiate the underwriting agreement.

The company‟s accountants will audit company records, prepare regulator compliant financial statements, identify any weaknesses in the company‟s financial reporting, and help improve them.

A prospectus for a REIT generally includes the following elements: • Key investment highlights – discusses the investment proposition for investors, any differentiating factors between this vehicle and other existing vehicles in the market, growth opportunities/potential, return profile i.e. yield, year on year growth etc.

• Risk factors - the prospectus should describe to the prospective investor the major risks associated with investing in the IPO. Common risks described include: – Risks relating to the properties such as loss of key tenants or a downturn in the business – Risks relating to operations such as potential conflicts of interests with the manager, the property manager and the sponsor, or the acquisitions risks in connection with the sponsor, or risks associated with debt financing – Risks relating to investing in real estate. This is discussed in more detail later.

– Risks relating to investing in the units. Risks for example may include the net asset value per unit being diluted if further issues are priced below the current asset value per unit. Alternatively, the actual performance of the properties could differ materially from the forward looking statements in the prospectus.

– Country risk if the IPO portfolio includes overseas assets.

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• Use of proceeds - the prospectus should state the amount of equity that is to be raised, the subscription price, and the number of units. If debt is being used, the amount of borrowings should be disclosed. These are under the „sources‟ group. In the „application‟ side, the prospectus should disclose the total paid for the acquisition of the properties along with any transaction costs.

• Ownership of the units - whilst the ownership of the units is mainly directed at investors, it is common for the sponsor company to take up a large stake to retain control of the REIT. In addition, partnership units, reserved units and subscription by the directors should also be disclosed. Occasionally the managing underwriters may invite cornerstone investor(s) to commit to a percentage of the offering as part of the marketing strategy to provide third party validation, particularly if the cornerstone investor is a reputable investor in such instruments.

• Distributions - the distribution policy is advised e.g. to distribute 90% of its taxable income etc. If the sponsor has forfeited its distribution for a few years, this should also be disclosed. The frequency of distributions, along with the method of dealing with asset sales which may lead to a payout of a special dividend, should also be disclosed.

• Capitalisation - a summary of the pro forma capitalisation can be shown, which lists the long term unsecured debt, any deferred considerations on certain properties, and the net assets attributable to unitholders. Disclosure on the debt facility and the frequency of drawing down, along with any covenants may also be disclosed.

• Unaudited pro forma balance sheet as at listing date - in this section the company may show historical pro forma statements of total returns, cash flow statements and balance sheet as at the listing date.

• Profit forecast and profit projection - statements contained in this section that are not historical facts may be forward looking statements based on assumptions set out in the prospectus. Generally the forecasts are for greater than one year in duration. Projected statements may include statements of net investment income and distribution, and gross revenue contribution of each property. The background to the assumptions is listed. For example, in predicting gross revenue, assumptions would be made about gross rent, and other income. Property expenses such as property manager‟s fees, property taxes, maintenance expenses, utilities charges and other property expenses will also be listed. In addition, assumptions on the manager‟s management fees, trustee‟s fee, other trust expenses, interest income, borrowing costs, capital expenditure, distribution reinvestment arrangements, issue costs, properties and accounting standards are also disclosed.

• Historical financial statements – in the event that such information on the IPO properties is available, it will need to be disclosed in the prospectus. In the case of Singapore a waiver may be sought from the SGX to not report this information.

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• Strategy – one of the most important parts of the prospectus is the strategy.

This part of the prospectus outlines the intentions and purpose of the IPO. It outlines the geographic and asset class intentions of the REIT. It may also detail the strategies for growth, such as organic or acquisition based growth.

It will also outline the capital and risk management strategies.

A sensitivity analysis is performed to provide a guide on variations in actual performance if there are movements in variables. This is to show that projected distributions are subject to a number of risks which may affect income.

Variations in gross rent, property expenses, offering price and borrowing costs are used to demonstrate the impact on distributions.

• Business and properties - generally the portfolio overview is recapped, with more detailed information on each of the properties. Details may include: – Description of the location – Area – Type of asset – Lettable area – Land lease expiry – Details of the valuer – Valuation – Gross revenue – Occupancy – Tenant information There may also be a section which outlines the competitive strengths of the properties such as: • Strategic locations • Long average lease duration • Long leasehold for underlying land • High quality tenant base • Diverse tenant trade sectors • High occupancy rates of the properties • Low capital expenditure requirements In addition, information about the following may be included: • Ten largest tenants • The gross revenue contribution by tenant trade sector • Expiries • Capital expenditure • Marketing and leasing activities • Tenancy agreements

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• Lease managements agreements • Insurance • Legal proceedings • Competing properties • Future competing developments • Competition for acquisitions.

• Economic background to the markets in which the properties are located -this section depends on the asset class and geography the properties are located. Some possible items to discuss include: – The economy of the countries in which the assets are located, such as real GDP growth, trade, government initiatives etc.

– The business of the asset class/geographic location – Trends beneficial to the asset class/geographic location – Key players in the asset class/geographic location – Factors influencing growth in the asset class/geographic location – Future supply and demand – Rentals and capital value trends – Gross yields – Investment opportunities This section dealing with economic and market conditions is widely varied, and it depends on the asset class and geography in which the entity will have operations.

• The manager and corporate governance - the manager of the REIT is set out in this section, along with the directors of the manager. Details of the Board of Directors are tabulated, along with a detailed biography of industry experience and positions of responsibility held. The age, address and position within the company e.g. Chairman, Independent Director or Executive Director, are listed. The management reporting structure along with the names, positions and responsibilities of the Executive Officers are also listed.

Similar to the Board of Directors, a detailed biography of each of the executives e.g. CFO, CEO, Finance Manager are given. The management reporting structure of the property manager may also be included.

Management fees may be disclosed in this section, although in some countries a separate section is required. Details outlining the base fee, performance fees, acquisition, disposal and any other fees to be paid to the manager may be outlined.

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Annual reporting requirements may be addressed concerning issues such as the time frame in which annual reports will be distributed following each accounting period. Also, other items may be addressed such as: – Details of real estate transactions entered into during the accounting period – Updates on existing assets such as annual valuations, occupancy rates, remaining term for each of the leasehold properties – Amount of distributable income held pending distribution – Details of assets other than real estate – Exposure to derivatives – Investments in other property funds if any – Level of borrowings – Volume and pricing of units during the accounting period – Operating expenses – Fees paid to the trustee and property manager Corporate governance issues such as the following will also be discussed (subject to listing rules in the jurisdiction): – Retirement or removal of the manager – Responsibilities of the Board of Directors – Audit committee – Dealings in units – Conflicts of interest – Related party transactions • The sponsor - information about the sponsor of the REIT, along with its business philosophy and key focus areas are outlined in this section.

• The formation and structure of the trust - the formation and structure of the trust is complex and a summary may be provided. The items which it covers would include: – Background – The trust deed – Operational structure – The units and unitholders – Issue of units – Suspension of issue of units – Redemption of units and the process of redemption – Rights and liabilities of unitholders – Amendment of the trust deed – Meeting of unitholders

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– Substantial holders – Directors‟ declaration of unit holdings – The trustee, along with powers, duties and obligations – Retirement and replacement of the trustee – Trustee fee – Possible changes to the regulatory regime There will be a property management agreement where the services and fees for property management, lease management and property tax services are listed.

Any right of first refusal agreements and call options, if they exist they will also be noted.

• Taxation - this section will outline the taxation of the trust and its unitholders. This includes guidelines on taxation of distributions, disposal of units, and stamp duty. Different rules apply in different countries. The tax experts would be able to give some guidance in this area. This is particularly relevant for portfolios with assets located in different jurisdictions.

• Plan of distribution - the allotment of units and the issue price details are summarised. This includes issues such as over-allotment and price stabilisation, as well as lock up arrangements. It may also show the estimated expenses of the offering.

• Appendices - independent reports are usually in this section. These include independent reports from: – Accountants on the profit forecast/profit projection and balance sheet – Property valuers on individual property valuations – Industry experts on the economics of the industry, asset class and country economy – Taxation experts The appendices may also contain procedures for application and acceptance of the offering units.

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Marketing Strategy for Listing Once the underwriter has been chosen, it will be able to assist in the marketing strategy for listing. It is important to remember that market conditions may vary during the IPO preparation, therefore it is good to be flexible and prepared.

Issuers tend to prefer expediting the IPO preparatory work in order to take advantage of the open market window. The underwriter will create the project timeline for the IPO process and assign both company and underwriting staff to each task.

The marketing phase generally involves the following actions: • Print and distribute „red herrings‟ - a „Red Herring Prospectus‟ is a prospectus which does not have details of either price or number of shares being offered or the amount of issue. This means that as the price is not disclosed, the number of shares and the upper and lower price bands are disclosed. On the other hand, the issuer can state the issue size and the number of shares are determined later. This can be done to gauge the market acceptance of the offer and give flexibility to the IPO as market conditions can change rapidly.

• Analyst presentation to underwriters‟ research analysts - the role of the underwriters‟ research analysts is to communicate to potential investors via a pre-deal investor education process of the details of the IPO. Therefore it is important they are fully informed before targeting investors.

• Target key investors - when selecting an underwriter, one of the purposes is access to their client base via their equity distribution network. Generally, real estate specialist investors or funds with specific real estate allocation are targeted for REIT IPOs given their knowledge of the product and the return profiles.

• Invitation of underwriting syndicate - The rationale for having an underwriting syndicate is usually to expand the distribution network to as wide a group of investors as possible. The lead underwriter(s) will nominate a syndicate of banks to publish research and help sell the IPO (normally between 5-15%) in return for a fee. The underwriting syndicate is determined on a case by case basis.

• Sell-side analyst presentation by company - the sell-side analyst is accountable to the investor. Their role is to perform detailed due diligence on the company and its prospects. They are required to develop financial models and articulate the „story‟ to investors during the IPO marketing. Therefore, it is important the sell-side analyst understands the business of the IPO. Sellside analysts need to maintain close communication with institutions throughout the marketing process and beyond, as well has providing institutions with an analytical framework and be a source of independent valuation. Sell-side analysts generally initiate written research coverage on the company following the 25 day cooling off period. They also provide ongoing support with frequent reports, conference calls, „one on one‟ calls and electronic broadcasts to the investment community.

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• Road show presentations - road shows are an opportunity for management to articulate the story and investment opportunity face to face with investors.

Road shows generally take about 2 weeks, covering around 50-100 meetings with investors. Investors are prepared through reading the prospectus, discussions with research analysts and sales people prior to meeting management. There is usually a combination of group meetings and „one on one‟ meetings. This is a critical point in the deal process as investors ask everything required for an informed investment decision.

There are three different types of meetings with investors on the road show.

1. Group presentations - these allow the company to deliver its story. They range from lunches with a hundred plus investors to smaller presentations of ten.

2. „One-on-One‟ presentations - these are expected to generate the majority of quality institutional demand. They range from meetings with a single portfolio manager/buyside analyst to small group sessions with multiple portfolio managers and buyside analysts.

3. Conference calls - these are conducted on an as-needed basis with investors who are unable to work within the schedule. This will include group as well as „one-on-one‟ sessions.

• Begin development of institutional and retail „books‟ of demand - once the intended pricing date has been determined, investors are informed of the day and time on which the book will be closed. Once the book has been closed, the lead manger, in consultation with the co-managers, reviews the book of demand in order to assess the strength of demand, price sensitivity, investors‟ allocation expectations and the likelihood of after market buying or selling. At the time of pricing the lead manager reviews the book with the issuer and recommends an offering price which will maximise the offering proceeds to the issuer consistent with a favourable aftermarket performance. Once the issuer and the managers have agreed on an offering price, the underwriting agreement and the inter-syndicate agreements are signed. It may be signed prior as well but this depends on the issuers‟ agreement with the underwriters.

RECAP: At the end of this subject you should be able to understand the following concepts.  The steps played in the preparation of a prospectus  The key elements of a prospectus  The marketing strategy for listing securities

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Unit

5 Risk

PS03  Real Estate Finance & Investment

Unit 5: Risk

Introduction Risk can be defined as the possibility or chance of an unfavourable outcome.

Most people focus on negative risks but there are also positives such as increased risk leading to an enhanced return. In this unit we will investigate the risks associated with property investment.

LEARNING OBJECTIVES: At the end of this unit you should be able to:  Understand the risks associated with investment in real estate  Understand specific risks associated with investment in REITs, listed property companies, unlisted funds and direct real estate  Understand the risks relating to operations  Understand the concepts of systematic and unsystematic risk

Risk Investments in real estate are subject to various risks, including: • Adverse changes in political or economic conditions • Adverse local market conditions • The financial condition of tenants and buyers and sellers of properties • Changes in availability of debt or equity financing which may affect the owner to finance future acquisitions on favourable terms • Changes in interest rates and other operating expenses • Changes in environmental laws and regulations, zoning laws and other governmental rules and fiscal policies • Environmental claims arising in respect of real estate • Changes in market rents • Changes in energy prices • Changes in the relative popularity of property types and locations leading to an oversupply of space or a reduction in tenant demand for a particular type of property in a given market • Competition among property owners for tenants which may lead to vacancies or an inability to rent space on favourable terms • Inability to renew tenancies or relet space as existing tenancies expire • Inability to collect rents from tenants on a timely basis or at all due to bankruptcy or insolvency of tenants or otherwise • Insufficiency of insurance coverage or increases in insurance premiums • Increases in the rate of inflation

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• Inability of the portfolio manager to provide or procure the provision of adequate maintenance and other services • Defects affecting the portfolio properties which need to be rectified or other required repair and maintenance of the portfolio properties, leading to unforeseen capital expenditure • Unapproved uses of the portfolio properties which may result in the owner of the properties being in breach of the terms and conditions • The relative illiquidity of real estate investments (with respect to direct investment in real estate) • Considerable dependence on cash flows for the maintenance of, and improvements to, the portfolio properties • Increased operating costs, including real estate taxes • Any interest or encumbrance that has not been revealed by due diligence • Fire or damage to the properties Many of these factors may cause fluctuations in occupancy rates, rental rates or operating expenses, causing a materially negative effect on the value of real estate and income derived from real estate. The annual valuation of the property will reflect such factors and as a result, such valuation may fluctuate significantly upwards or downwards.

Property Risks Risks relating to properties vary from property to property. Some examples of risks related to properties include: • The loss of key tenants or a downturn in the business may have an adverse effect on the property‟s financial return • Encroachment on neighboring properties • Physical damage to the properties may disrupt the business and operations • The appraisals of properties are based on various assumptions and the price at which the owner sells the property may be different from the purchase consideration of the property • Natural phenomena, terrorist attacks. The risk that natural phenomena or, terrorist attacks may affect properties. There are certain events for which insurance cover is not available or for which the fund does not have cover. If the fund is affected by an event for which it has no insurance cover, this would result in a loss of capital and reduction to the entry/exit price and overall returns.

• Property contamination risk, where the property income or valuations of properties could be adversely affected by: discovery of an environmental contamination; incorrect assessment of costs associated with an environmental contamination or with property preservation.

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Risks Relating to Investing in Real Estate • Illiquidity of direct real estate - property investments are relatively illiquid.

This involves a higher level of risk as compared to a portfolio which has a diverse range of investments. Such illiquidity may affect a fund/ company‟s ability to vary its investment portfolio or liquidate part of its assets in response to changes in economic, real estate market or other conditions. For example, the fund/company may be unable to sell its assets on short notice or may be forced to give a substantial reduction in the price that may otherwise be sought for such assets in order to ensure a quick sale. The fund/company may also face difficulties in securing timely and commercially favourable financing in asset-backed lending transactions secured by real estate due to the illiquid nature of real estate assets. These factors could have an adverse effect on the fund/company‟s financial condition and results of operations, with a consequential adverse effect on the fund/company‟s ability to deliver expected distributions to unitholders.

• Properties being compulsorily acquired - in some countries such as Singapore and Hong Kong, the Government has the power to compulsorily acquire any land. In Singapore, The Land Acquisition Act, Chapter 152 of Singapore gives the Singapore Government the power to acquire any land in Singapore: I.

For any public purpose;

II.

Where the acquisition is of public benefit or of public utility or in the public interest; or

III. For any residential, commercial or industrial purposes Compensation of land acquired on or after 27 September 1995 will be based on the lower of: • Market value as at 1 January 1995 or • Market value as at the date of declared intention to acquire In Hong Kong, the Government has the power to acquire compulsorily any land in Hong Kong pursuant to the provisions of applicable legislation including the Lands Resumption Ordinance (Chapter 124 of the Laws of Hong Kong), Roads (Works, Use and Compensation) Ordinance (Chapter 370 of the Laws of Hong Kong), Railways Ordinance (Chapter 519 of the Laws of Hong Kong), Land Acquisition (Possessor Title) Ordinance (Chapter 130 of the Laws of Hong Kong), Land Drainage Ordinance (Chapter 446 of the Laws of Hong Kong), Urban Renewal Authority Ordinance (Chapter563 of the Laws of Hong Kong) and Mass Transit Railway (Land Resumption and Related Provisions Ordinance (Chapter 276 of the Laws of Hong Kong).

In the event of any compulsory acquisition of property in Hong Kong, the amount of compensation to be awarded is based on the open market value of the relevant property and is assessed on the basis prescribed in the relevant ordinances.

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Therefore the main risk is that If the property is acquired compulsorily by the Government, the level of compensation paid to the owner may be less than the price which the owner paid for the property at the time, or that the timing of the compulsory acquisition is done when the economy is poor which would also affect the market valuation. The loss of control in determining the sale by the owner also contributes to the risk. â&#x20AC;˘ Material loss in excess of insurance proceeds - properties could suffer physical damage caused by fire or other causes. Properties may suffer public liability claims, all of which may result in losses (including loss of rent) that may not be fully compensated by insurance proceeds. In addition, certain types of risks (such as the risk of war and losses caused by the outbreak of contagious disease and contamination or other environmental breaches) may be uninsurable or the cost of insurance may be prohibitive when compared to the risk.

Therefore should an uninsured loss or a loss in excess of insured limits occur, the relevant owner could be required to pay compensation and/or lose the capital invested in the affected property as well as anticipated future revenue from that property. Nonetheless, the relevant owner would remain liable for any debt or other financial obligation to that property. It is also possible that third party insurance carriers will not be able to maintain reinsurance sufficient to cover any losses that may be incurred. Any material uninsured loss could materially adversely affect the business, financial conditions and results of operations.

In addition, the owner will have to renew its insurance policies every year and negotiate acceptable terms for coverage, exposing it to the volatility of the insurance markets, including the possibility of rate increases for premiums. There should be regular monitoring of the state of the insurance market, but it cannot be anticipated if coverage will be available on commercially reasonable terms in future policy years. Therefore any material increase in insurance rates or decreases in available coverage could adversely affect the business and operations.

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â&#x20AC;˘ Economic and real estate market conditions - property values and rental rates are cyclical in nature. For example, historically, the office rental property market in Hong Kong has been volatile and has experienced significant price fluctuations. Rental rates for office space declined significantly in 1991 and 1992 when substantial amounts of new office space became available. Rental rates and property values for office space peaked in 1994, decreased sharply towards the end of 1995 and early 1996 and increased again in the latter part of 1996 and the first half of 1997. As a result of the Asian economic crisis, volatile interest rates, a general decline in business activity in Asia and decreased consumer confidence, the Hong Kong economy and property market was adversely affected, resulting in significantly lower rents from the latter half of 1997 through 1999. Rental rates increased sharply again in 2000 during the internet/technology sector boom, and declined again from 2001 though 2003. The office market began its latest recovery in 2004 which continued throughout 2005. Hong Kong property values and rental rates have been affected by supply and demand dynamics, the rate of economic growth in Hong Kong, interest rates, inflation and political and economic developments in Hong Kong and the PRC. Therefore the risk is that rental rates and property values will generally experience a high degree of volatility.

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Unit 5: Risk

Risks Relating to Operations The most common operating risk is debt financing. This includes the risk that the company‟s or fund‟s cash flow will be insufficient to meet required payments of principal and interest under such financing and to make distributions to shareholders or unitholders. These risks may have a material, adverse impact on the company‟s or fund‟s activities, financial position and distributions.

The second common risk is the inability to implement the investment strategy.

For example, the manager may have promised to make acquisitions to expand the portfolio to a specified size and geographical coverage. However, this is subject to opportunities which present themselves at justified pricing levels.

In addition, investing in listed or unlisted funds or property companies means the investor delegates the rights to make decisions on which properties to own.

Therefore investors have no direct choice as to which properties to own.

Distributions may also be affected by a wide range of economic reasons, and the payments may be cut or payment may be delayed.

Litigation risk is also present. In the ordinary course of operations, the fund may be involved in disputes and possible litigation. These include tenancy disputes, environmental and occupational health and safety claims, industrial disputes and any legal claims or third party losses. It is possible that a material or costly dispute or litigation could affect the value of the assets or the expected income of the fund.

Country and foreign exchange risk is also important. There are risks associated with investing in another country, including legal and political risk and the risk that movement in exchange rates will affect capital values and income earned in other currencies. This can be managed by investing in countries with proper understanding of the political, legal and regulatory regime and by adopting hedging strategies where appropriate.

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Unit 5: Risk

Risks relating to Investment in Units in a Fund Often the issue of units under the offering price will be at a premium to net asset value. However, should there be a winding-up, there is no guarantee that an investor under the offering will recover all of its investment. In addition, the trading price of the units may decline after listing if the perceived prospects of the business and investments deteriorate, if there are material differences between the actual financial and operating results and those expected by investors and analysts, or if the intention to implement strategies fails.

The value of units in an unlisted fund may decline if the valuations of investments fall due to economic or market conditions. An investment in an unlisted vehicle also bears the additional risk of illiquidity if there is no facility provided by the manager to exit. A common exit facility in an unlisted fund is a right to redeem the units, but in poor market conditions an investor may need to redeem units at a discount to the current valuation. In severe downturns there may be such a run on redemptions that the manager is forced to impose a freeze because it doesnâ&#x20AC;&#x;t have the cash to pay the investors.

Note on other differences The risk on conflicts of interest for the sponsor and manager for the externally managed REIT or an unlisted fund are higher than for property companies.

Therefore the composition and presence of the Board of Directors is important to mitigate this risk.

For property companies, they are allowed a higher degree of development activities. Therefore there should be greater awareness of development risk for investment into these vehicles.

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Unit 5: Risk

Systematic and Unsystematic Risk The risk factors of real estate investments can also be separated by systematic and unsystematic (diversifiable) risk.

Systematic Risk The systematic risk component of real estate cannot be diversified away.

Systematic risk factors affect all assets in the market. However if a portfolio manager can determine the portfolio‟s sensitivity to these systematic risk factors and can reposition the portfolio according to its anticipated movements, the portfolio‟s risk-return performance can be improved.

Systematic risk is associated with the risk of the NATIONAL market. Examples of non-diversifiable risks are taxation policies, inflation, cap rate (risk premiums), discount rates, and the business cycle.

Unsystematic Risks Unsystematic risks do not affect all properties in the market. Consequently it is possible for the portfolio manager to diversify many of these risk factors away by properly combining properties. The addition of properties, assuming their returns are perfectly correlated, reduces total portfolio risk. This is the most effective way of reducing overall portfolio risk without reducing portfolio returns.

Therefore a diligent portfolio manager will be looking for ways to combine real estate assets to maximise the benefits of diversification. Accordingly, diversification can become one of the dominant forces in the determination of the real estate portfolio‟s allocations to various property types and geographic locations.

Regional market diversifiable risks include: • Demographic trends • Income growth • Vacancies • Growth of the employment base The definition of regional market is more based upon employment base. For example, a region might be defined as a group of metropolitan areas that have a heavy concentration of manufacturing jobs. Hence, the key regional diversifiable risk to remember is the growth of the employment base.

Local market diversifiable risks include: • Construction costs • State and local taxes • Employment base • Income levels • Vacancy rates

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Property level diversifiable risks include: • Location • Lease structure • Financing characteristics • Property age and condition • Property management quality

Source: RCA Global Capital Trend Apr.09

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RECAP: At the end of this subject you should be able to understand the following concepts:  The risks involved in investing in real estate  Property risks  Risks relating to operations  Risks related to investment in the units of a fund  Systematic and unsystematic risk

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Unit

6

Cross Border Real Estate Investments

PS03  Real Estate Finance & Investment

Unit 6: Cross Border Real Estate Investments

Introduction In this unit we look at the concept of cross border transactions.

LEARNING OBJECTIVES: At the end of this unit you should be able to:  Understand concepts associated with cross border transactions for REITs and Unlisted Funds including macroeconomic and microeconomic factors  Understand the decision making stages in cross border transactions  Understand the concepts behind Systematic versus Intuitive Decision Processes

Cross Border Acquisitions for REITs and Unlisted Funds Macroeconomic and Microeconomic Factors International real estate investment does present considerable decision-making, organisational and managerial challenges above and beyond the problems of achieving the desired cash flows at the building level. Some issues may be due to the choice of investment medium, the time-distance gap and different socioeconomic and cultural structures associated with individual national markets.

Therefore, there is a need for a decision making process which addresses the problems and identifies the opportunities in international real estate investment, a due diligence of the managerial issues the organisation may face as well as techniques to implement decisions.

Key real estate market variables can be divided into macroeconomic and microeconomic factors, specific to the country, region, sector or individual asset.

Macroeconomic factors are those that affect entire economies. They include: • Stability of the government • Structure of the government • The stability of the financial system • The structure of laws affecting property ownership • The language, psychology and culture of the country

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Microeconomic factors are those that affect regions or individual firms within an economy. They include: • Local economic activity • Local supply of and demand for real estate • Local politics • Social issues that may conflict with real estate development • The typical structure of lease agreements • The structure of the local government • Local laws and regulations

Source: RCA Global Capital Trend Apr.09

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PS03  Real Estate Finance & Investment

Unit 6: Cross Border Real Estate Investments

Decision Making Stages Stages in the Decision Process for International Real Estate Investing The primary reason for investing in foreign real estate is to enhance an investor‟s opportunity set i.e. foreign real estate may exhibit characteristics that allow an outward shift in the investor‟s efficient frontier. The international real estate portfolio decision making process consists of five basic steps: 1. Reduce the world to a manageable size 2. Select local markets 3. Compare local market returns 4. Select individual properties 5. Monitor portfolio and manager performance Reducing the world to a manageable size • Comparison of national economic/political variables • Macro risk assessment: weighting the variables • Selecting a country “short list”

Initial study of tax-legal issues on short list countries

Selecting local markets

Comparison of local market returns

More detailed study of market fundamentals and opportunities

Scrutiny of how individual deals work

Comparison of outcomes Internal decisions Board approval submissions blueprint for future action Source: JLW USA Research

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Working through tax legal implications for sample deals

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• Reduce the World to a Manageable Size - the investor must determine the appropriate macro and micro variables to analyse. Appropriate weightings need to be given to each variable. Then a ranking process to order the countries in the investment universe is used, by screening countries based on the macro variables chosen above. This will produce a list of countries that meet the first-pass investment criteria.

• Select local markets - at this point the micro variables become an important part of the analysis. Each individual market must be analysed on the basis of the tenant base, lease structures, dominant industries and other micro variables. The evaluation of the dominant industry in the local market is critical for diversification purposes. For example, you might invest in Hong Kong and Singapore expecting some regional diversification. However, since both of these markets are heavily weighted toward banking and financial tenants, your diversification benefits will be reduced. Simultaneously, an initial study of tax-legal issues should take place on the short list countries.

• Compare Local Market Returns - among the factors to consider are local market patterns, limits to new construction and financing practices. Financing practices for new construction as well as political and bureaucratic restrictions constitute an important factor in regulating new supply on the local scene and encouraging differences between market cycles.

Around the Pacific Rim, regulations on new construction can be a mixture of extreme government planning combined with extreme flexibility in execution. In Kuala Lumpur, construction trends especially in retail indicate the relative ease of development in the country and the tendency of the sources of real estate financial supply to over anticipate the pace of demand for quality new products.

Singapore land use is regulated by a master plan that is revised every five years, but the planning authorities have considerable latitude in reviewing development proposals. Japan is perhaps the ultimate in restrictive land use and construction.

• Select Individual Properties - as with the selection of individual securities, the selection of individual properties involves in depth analysis of value through: – Fundamentals and opportunities – Composition of individual property arrangements – Tax-legal implications for prospective deals • Monitor Portfolio and Manager Performance - performance monitoring involves: – Evaluating micro and macro assumptions made in forming the portfolio – Evaluating appropriateness of benchmarks – Comparing outcomes against appropriate benchmarks – Outlining future actions – Obtaining board approval

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Systematic vs Intuitive Decision Process The real estate portfolio decision making process can be classified into two methods - systematic (top down) and intuitive (bottom up) approach: • Systematic approach - when investors are new to international real estate investing, they typically employ a systematic approach. A systematic approach uses quantifiable macro data to add or eliminate countries to arrive at a set of „investable‟ countries i.e. countries could be screened by market size, GDP growth, employment growth and other factors. Once this list of investable countries has been set, the process of analysing local real estate markets begins.

• Intuitive approach - is more suited for seasoned international real estate investors. Investors using this approach have usually been investing in international markets for a long time. As such they tend to have an intuitive feel for what‟s going on in a particular local market. Here, the investor looks first to particular local markets and economies as a starting point in the property selection process.

Multinational Data Multinational economic data is difficult to analyse for several reasons. Firstly the computation of economic statistics may differ considerably across borders e.g. inflation statistics may be computed using different methodologies. Secondly the domestic investor may interpret foreign economic statistics incorrectly due to a lack of knowledge regarding their construction. Economic data that the domestic investor expects to see may not be available in the foreign market.

Finally, foreign countries may not be up-to-date in their collection of economic statistics. Information advertised as current may represent a forecast based on old information.

Local Market Patterns Local market patterns depend upon the sources of demand e.g. financial services, government, industrial and the relative size of individual holdings e.g. a few larger players or a larger number of smaller players. Unique characteristics exist based on the type of local economy. Therefore, diversification benefits remain because of variation in timing, location and type of product demanded in local markets as well as the local tenant base and employment fluctuations.

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Limits to New Construction From local planning ordinances to federal land use mandates, political and bureaucratic restrictions regulate the supply of real estate, causing differences in market cycles. Also, governmental actions can encourage or discourage new construction based on transportation access, quality of life and technological needs.

Financing Practices Conservative lending practices aid in the retention of a steady development program. Leases also differ significantly among markets with respect to lease terms e.g. length, rent review and rent indexation, lease escalation clauses, responsibility for space improvements e.g. ordinary and structural, responsibility for insurance and special taxes on rental space. Lessors sometimes offer incentives such as the right to cancel after a specified interval, free rent, and space improvement allowances.

Structuring of the Deal One common method of earnings growth for REITs and unlisted funds is through acquisitions. At times this may involve international investments. In addition to considering the country, markets and properties to purchase, the REIT or unlisted fund must consider the impact of the acquisitions on its existing portfolio and capital structure. The overall combination of the acquisition and existing portfolio must be superior to the existing portfolio. Though in a different way, the quality of the acquisitions must be superior to that of the existing portfolio, and also add synergies and diversification benefits. Additional factors that need to be considered include: • Yield accretion on portfolio • Earnings accretion on portfolio • Enhanced portfolio diversification • Greater economies of scale • Tenant diversification • Support of its investors • Risks of investing in another country – political, legal, currency etc.

• Tax

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Currency Hedging When investing in international markets, it is important to consider currency hedging when the income produced from the cross border investment will be denominated in the foreign country‟s currency, and the value of the property is denominated in the foreign currency. This is because foreign currency movements will have an effect on translating the income back to home currency, which may affect distributions and valuations. Surveys of major institutional investors regarding the importance of currency risk management have seen considerable differences between perceived importance and risk management strategies adopted in different countries. In particular, a survey of Asia/Pacific international property investors (Newell and Worzala, 1995) saw currency risk as the major issue concerning international property investment, with 80% of respondents having currency risk management procedures.

• The direction of the foreign currency - this is a difficult task particularly if the fund manager is an expert on property and not currency. However, if a decision can be made on the direction of the foreign currency movement, then the decision to hedge or to leave the currency unhedged becomes very simple. If the forecast is that the foreign currency will appreciate in value against the home currency, then it would be more profitable to leave the portfolio unhedged as future income generated from the foreign currency will be worth more in the home currency in the future. This is the case with investments by Hong Kong developers into China. The prediction that the RMB will appreciate against the Hong Kong dollar has meant many Hong Kong developers have left investments into China unhedged. However, this is in contrast to many investments from Australia into the US, where the US dollar has depreciated against the Australian dollar. The one issue with hedging is that once the hedge rolls over and a new hedge is entered into at another rate, the income generated from a favourable hedge is gone.

• Instruments to use for hedging - given the importance of currency risk management (for both capital and income components) for international property investment, currency hedging techniques available include: – forward contracts: an agreement to exchange a predetermined amount of currency in the future at a set date – currency options: the right (but not obligation) to exchange a predetermined amount of currency in the future at a set date; typically expensive, with up-front payment needed – currency swaps: an agreement to exchange cash flows over time at a predetermined rate – zero cost collars: this involves sophisticated use of foreign exchange put and call options simultaneously

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Other currency risk management strategies available include increasing gearing and borrowing in local currency as a natural hedge, using local cash flow for interest payments, reinvesting in same country, and diversifying via establishing a global property portfolio.

• Income Hedging Policy - income hedging is intended to provide a degree of certainty for unitholders that changes in the exchange rate between the home and foreign currencies will not have a significant impact on the distributions in the home country within the subsequent period The manager may have a policy to undertake foreign exchange hedging (using financial instruments) of the expected distributions of the fund to insulate against movements in exchange rates, both favourable and unfavourable.

For example, a policy may be to arrange foreign exchange hedges on a rolling basis equivalent to: • 100% of the fund‟s estimated distributions for the next three years; and • 90% of the fund‟s estimated distributions for years four and five Such foreign exchange hedging arrangements will be reviewed at the end of each half year and at a time when the manager believes there has been a material change in the expected distributions of the fund.

• Capital Hedging Policy - the use of capital hedging has taken on increased use to reduce NTA volatility for funds. Capital hedging is more important for the merged domestic/international funds to quarantine their international property exposure.

Some degree of uncertainty is evident in the capital hedging process as REITs and property companies, in particular, are not finite life property investment vehicles and their international property investments are not made for pre-determined holding periods, resulting in an inability to exactly match the term of the capital risk and the selected hedging vehicle. Therefore capital hedging is dependent on the views of the manager. Some managers prefer not to hedge at all.

Management of this capital risk is most evident by the natural hedge of offsetting overseas assets and liabilities with borrowings.

• The costs involved in hedging - typically, reasons cited for not using currency risk management strategies included the high cost of hedging. Issues regarding the significant cost of hedging and the effectiveness of capital hedging, given properties uncertain future value and longer holding period, have also been identified. However, usually the cost of implementing these hedges is incorporated into the hedged exchange rate. Security may be given over the direct and indirect assets of the fund to the counterparty to the foreign exchange hedges to protect the counterparty against the risk of default. The policy should be reviewed by the manager from time to time.

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• The decision to hedge - a lot of academic research and market debate has concerned the decision to hedge. The options are to be; fully hedged, not hedged or partially hedged. That decision is one left for currency experts taking the information above into account.

Risk Premium Whether by academic teaching or human nature, investors seem predisposed to expect higher returns on an absolute and a risk-adjusted basis from international investments than from investments in their own country. A valid question to ask, however, is whether or not the foreign risk premium is a myth or a reality.

Conceptually, there is a problem with expecting a foreign risk premium. If all investors expect higher returns by virtue of investing outside of their own country it is not possible, or at the very least, is not sustainable. In theory, the efficiency of a global capital market dictates that capital will flow to take advantage of opportunities where risk is being mispriced such that on a global basis, long-term risk-adjusted returns should converge. The form this convergence takes varies for the different categories of markets – core, core plus and emerging. Hence, for investors placing capital from one core market to another core market, the foreign risk premium is more myth than reality.

However, in core plus and emerging markets, both the types and magnitude of risk are generally greater, sometimes much greater than in core markets.

Because risks in these markets may come from a number of sources – market size, currency, political risks, etc. – investors from core countries should expect higher absolute returns from investments in core plus and emerging market countries. However, on a risk-adjusted basis, if the risk has been appropriately priced– then the risk-adjusted returns should still be similar. Thus, in core plus and emerging market countries, there may be a foreign risk premium on an absolute basis, but little or no premium on a risk-adjusted basis over the longterm.

For example, to develop the risk premium for a country, the following assumptions are made: • All real estate investment involves risk • Non risk-free asset classes have risk premia over the risk-free rate • An appropriate proxy, following investment industry practice, for the risk-free rate prevailing in a country is the country‟s ten year government bond • The ten year government bond reflects the global market‟s perception of the country‟s perceived geo-political risk and accurately reflects inflation expectations and currency movements • The risk premium for holding real estate is the sum of transparency, volatility and liquidity

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The matrix adopted is: Real Estate Risk Premium = Transparency + Liquidity Risk + Volatility This has been adopted as these key components drive the depth, liquidity and maturity of the real estate market and will therefore affect the extent to which the risk premium associated with the asset class should be adjusted.

Based on this model, varying risk premiums can be applied to different countries.



Workshop Preparation 6.1 Examine a REIT in your jurisdiction that undertakes cross border transactions.

Analyse the success of these acquisitions in light of the information above.

RECAP: At the end of this subject you should be able to understand the following concepts:  Macro and micro economic factors to consider in cross border acquisitions  The decision making process involved in cross border transactions  Systematic and intuitive decision processes

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Unit

7

The Acquisition Process

PS03  Real Estate Finance & Investment

Unit 7: The Acquisition Process

Introduction In this unit we look at the concept of property acquisition and the processes undertaken in this regard. Key features of acquisition include determination of a fair market value as well as the need to undertake appropriate due diligence.

It must be remembered that any organisation will have its own methods and processes by which they acquire property. While they may all be fundamentally similar it is reasonable to expect there will be differences based on a company‟s risk preferences.

LEARNING OBJECTIVES: The fundamental learning objective in this unit is to give students an appreciation of the property acquisition process.

Other objectives include:  Understand the real estate acquisition process and the various stages in the process  Understand the role of the lawyer in acquisition process

Real Estate Acquisition There are many ways of looking at this issue. It can be broken down into a number of parts namely: • Appraisal • Negotiation • Heads of Agreement • Due Diligence • Exchange • Settlement/Completion It is important to remember that all entities involved in property acquisitions will follow a course of action similar to this but not the same as this. This can be brought about by sector, country and indeed cultural differences.

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Appraisal The appraisal process within the acquisition process consists of the steps necessary to determine the fair market value of the property being considered for acquisition. This fair market value is then used within the negotiation process to arrive at an agreement.

In terms of the appraisal it can be broken into a number of parts: • Appraisal mapping – mapping is obtained which is used to identify physical characteristics of the property/title issues that impact the value of the subject property • Appraisal contracting – this may be combined with the step above but an independent valuer is engaged to provide valuation services • Once the valuation is completed a final approval is established to reflect the current market value of the property and from this is formed a negotiation strategy

Negotiation Negotiation is the process necessary to reach an agreement on price and terms that are mutually acceptable to both parties. Negotiations are a particularly specialised field.

If negotiations are successful the price and contractual terms and conditions are placed in a contract agreement which is executed by the parties.

Heads of Agreement A heads of agreement is a (generally) non-binding document outlining the main issues relevant to a tentative legal agreement. It is essentially the draft used by lawyers when drawing up the contract. It serves as a guideline for both parties before any documents are legalised.

Due Diligence Due diligence is a particularly complicated process and a function of the asset or property being acquired. As detailed it will involve the use of specialists such as lawyers, accountants, engineers, surveyors and builders.

Exchange The closing steps are the steps in the process that are necessary to close the transaction and acquire title to the particular property.

An important issue here is resolution. Due diligence reports will be reviewed and issues identified, evaluated and resolved. Sellers may be required to settle any remaining issues. www.apreainstitute.asia

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Settlement/Completion The final process is the appropriate approvals from the board/trustees and the delivery of any monies necessary to complete the contract. The title is then transferred.



Case Study CapitaLand agreement to buy IMM Building CapitaLand Commercial Limited is a wholly owned subsidiary of the listed CapitaLand Limited.

It entered into a conditional put and call option agreement to acquire the IMM building.

Interesting to note was that the total acquisition cost was S$262.6m which included the purchase price of S$247.4m after taking into account transaction costs such as stamp duty and other fees and expenses. Costs represent approximately 10% of the property‟s value.

CapitaLand Land Commercial granted CapitaMall Trust a right of first refusal to purchase retail properties which may be acquired by CapitaLand Land Commercial.

The acquisition took approximately 20 weeks. This highlights that the process is not quick or simple.



Workshop Preparation 7.1 Using available information sources including newspapers document the acquisition process for a significant property in your jurisdiction.

Detail: • The process • Any significant issues that affected the negotiations • The amount paid and any particular terms and conditions

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The Role of the Lawyer The role of the lawyer will extend beyond that of due diligence in terms of the contracts in place within the property etc. Lawyers will also be involved in the development of the contract agreement for the exchange of the property. This will be negotiated with the purchaser and the vendor‟s lawyers.

Issues to resolve include: • Consideration • Completion (Terms) • Guarantees • Liabilities The other issues include: • Establishment of registered owner • Is the purchase allowed under local laws • Title searches • Is there a mortgage or lien over the building • Are there any interests noted on the property • Easements • Current or previous insurance claims by vendor • Are there any tax considerations – especially important for distressed asset and cross border purchases

RECAP: At the end of this subject you should be able to understand the following concepts:  The processes and requirements of real estate acquisition  The role of the lawyer

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Unit

8

Introduction to Property Derivatives

PS03  Real Estate Finance & Investment

Unit 8: Introduction to Property Derivatives

Introduction Property derivatives have the potential to re-define traditional property investment. These low cost, flexible, retrospective, hassle free, instantaneous investment vehicles are a vital tool in portfolio management and asset reallocation providing accessibility to global real estate markets.

With over US$45Bn worth of commercial and residential property derivative transactions in the United Kingdom, United States, France, Germany, Hong Kong, Japan, Australia, Italy, Switzerland, Canada and Spain, synthetic crossborder investment in real estate through derivatives is here to stay.

LEARNING OBJECTIVES: The learning objectives in this unit include:  Understand the use of property derivatives  Understand the types of property derivatives  Understand how property derivatives are priced  Describe property derivatives trading strategies and how trades are settled  Understand how property derivatives are used as a hedging tool

What are Property Derivatives?

Derivatives „derive‟ their value from underlying indices or securities.

Property derivatives or index linked property derivatives, as they are sometimes known, are „legally binding financial contracts between buyers and sellers of direct property risk, settled on the performance of direct real estate indices‟.

These indices reflect the performance of the direct real estate market (residential, office, retail, industrial and others) and are not equity or REIT related, a common misconception.

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Market Development • 1994 - PICs – Property Index Certificates launched by Barclays and Protego in the UK • January 2005 - The first over-the-counter (OTC) property derivative trade executed: a three-year total return swap on the IPD (Investment Property Databank) UK Annual All Property Index • June 2006 – First US property derivative transaction, referencing the NCREIF (National Council of Real Estate Investment Fiduciaries) commercial property indices • December 2006 – First French property derivative transaction between Merrill Lynch and AXA REIM • January 2007 – First Germany property derivative transaction • February 2007 – GFI Colliers brokers the first Asia Pacific property derivative transaction: a deal between ABN AMRO and Sun Hung Kai Financial referencing The University of Hong Kong Hong Kong Island Residential Price Index (HKU-HRPI) • May 2007 – First Australian property derivative transaction between Grosvenor and ABN AMRO, a commercial total return swap referencing the PCA/IPD indices • July 2007 – First Asian commercial property derivative deal, a contract between RBS and Grosvenor, referencing the IPD Japan monthly indicator index • September 2007 – First Swiss property derivative, a swap between ABN Amro and Zurcher Kantonalbank (ZNB) • Oct 2007 – First Italian property derivative trade based on the IPD Italian Property Index, between Grosvenor and BNP Paribas • February 2008 – GFI Colliers brokers the first OTC property derivative option in Asia Pacific, a contract based on The University of Hong Kong Hong Kong Island Residential Price Index (HKU-HRPI) between Goldman Sachs and Lehman Brothers Global Real Estate Group • June 2008 – Royal Bank of Scotland and National Bank of Canada trade the first-ever Canadian commercial property derivative • July 2008 – Grosvenor and Santander execute the first Spanish commercial PD transaction, referencing the IPD Spain property index • We can estimate that close to or more than 1,500 commercial and residential transactions have taken place globally with a combined volume of US$45Bn

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Why Use Property Derivatives?

• Contracts are tailor made to suit the clients‟ preferences, i.e. tenure, contract size, settlement dates, swap structure etc.

• They offer an investor a quick, flexible and efficient way to gain a retrospective entry to the generic returns of a property market (beta) • To avoid high transaction costs (stamp duty, legal fees, agency fees, property management costs) and long time lags in comparison to the purchase and sale of direct property, for identical returns • They are tax efficient, e.g. avoidance of capital gains tax and withholding tax in certain countries • They allow a portfolio manager to receive a fixed percentage premium to hedge or risk manage an existing long property exposure without selling the asset (alpha isolation) • A useful tool to short the performance of a real estate market or sector • For direct investment in countries or sectors where the physical property is unobtainable due to lack of supply or restrictions on foreign ownership • To facilitate portfolio diversification and cross-border investment • Property derivatives are not REITs or equities. Their value is not subject to stock market capital flows, poor management decisions, overseas investments or company specific news

Users of Property Derivatives • Fixed Income • Interest Rate Products Investment Banks

• Exotics • Real Estate (Finance)

Banks

Private Banks

• CMBS/RMBS • Business Development

Retail Banks

• Corporate Strategy • Private Wealth Management • Asset Management

• Landlords • Developers • Property Funds/Hedge Funds/Pension Funds/Funds of Funds • Private Equity Groups Effectively any institution that is seeking, invests in, owns or manages real estate can be users of property derivatives.

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Property Derivatives Explained Property derivatives are tailored to suit both the buyer‟s and seller‟s requirements and are typically percentage (capital only) or total return (rental income and capital) swaps based on commercial and residential real estate indices. Property derivatives are commonly referred to as „swaps‟ as this refers to the „swapping‟ of cash flows, not assets.

In its simplest form, two institutions exchange a fixed percentage (buyer pays the seller) for a floating percentage index return (seller pays the buyer) based upon a pre-agreed dollar amount. The fixed percentage rate is negotiated between the buyer and seller and is a forward projection of future real estate returns.

For example, a one-year contract in Hong Kong agreed at 10% can be interpreted as the buyer believing the residential property market will rise by 10% or more over the next year and the seller by 10% or less.

The floating percentage rate is based on the % returns of an underlying property index and is not known until the end of the contract period. Trades are cash settled, and payments can be „netted out‟ between counterparties on the settlement date.

The tenure or the length of the contract is negotiable but generally ranges from three months to ten years; furthermore contracts brokered today can also capture specific time periods in the future (forward starting), for example 31st December 2010 to 31st December 2011. This is particularly useful to trade your view on the future returns of property, i.e. in a bullish or a bearish market.

Such flexibility, coupled with an extensive knowledge of real estate markets, make property derivatives an attractive tool for institutional investors to maximise property returns in volatile times.

In Hong Kong, GFI Colliers brokers index linked percentage swaps and options based on The University of Hong Kong Real Estate Index Series (HKU-REIS).

These „swaps‟ only capture the price appreciation / depreciation of the underlying residential real estate market but not the rental yield (see Figure 1A).

In Australia, Japan and Korea, the underlying IPD property indices are based on total returns i.e. rental income and capital value, where a fixed percentage is exchanged for the total return of a specific sector, like for example the Australian commercial market (see Figure 1B).

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Figure 8.1A: Index Linked Percentage Swap – A buyer exchanges a fixed percentage for a floating percentage over a pre-agreed dollar amount

Index Linked Percentage Swap Fixed Rate (e.g. pre-agreed % of HK$200m)

“Buyer” Looking to gain or diversfy exposure to the HK residential real estate market in the HK$200m

“Seller” Looking to reduce or hedge exposure to the HK residential real estate market in HK$200m

Index Linked Floating Return (% of HK$200m) Capital Value Only

Figure 1B: Index Linked Total Return Swap – A buyer exchanges a total return for a floating percentage over a pre-agreed dollar amount

Index Linked Percentage Swap Fixed Rate (e.g. pre-agreed % of A$50m)

“Buyer” Looking to gain or diversfy exposure to the Australian commercial real estate market in A$50m

“Seller” Looking to reduce or hedge exposure to the Australian commercial real estate market in A$50m

Index Linked Floating Total Return (% of A$50m) Capital Value & Rental Only

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The University of Hong Kong Real Estate Index Series – HKU-REIS In Hong Kong, the capital increase or decrease of the secondary residential property market is tracked by The University of Hong Kong Real Estate Index Series or HKU-REIS (see Figure 4). The HKU-REIS is a timely, reliable, robust and transparent series of property indices published monthly by the Department of Real Estate and Construction at The University of Hong Kong. The level of the index is expressed as a percentage of an absolute base level at the date of conception (i.e. January 2000 = 100). This base level always equates to 100 percent.

For example, the level of The University of Hong Kong Island Residential Price Index (HKU-HRPI) was 161.8 as of 31st May 2008. This means the present value of residential property on HK Island at that moment was 61.8% higher than the base level in January 2000.

The HKU-REIS consists of: The University of Hong Kong All Residential Price Index – HKU-ARPI, a weighted average of the following three sub-indices: I.

The University of Hong Kong Hong Kong Island Residential Price Index – HKU-HRPI

II.

The University of Hong Kong Kowloon Residential Price Index – HKU-KRPI

III. The University of Hong Kong New Territories Residential Price Index – HKU-NRPI Please refer to http://hkureis.versitech.hku.hk/ for more information on the HKU-REIS, including a technical paper detailing the methodology and computation.

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Property Derivative Pricing A Hong Kong Example The following example shows how the property derivative market is quoted in Hong Kong. A 12-month contract (31st December 2007 – 31st December 2008), with a notional amount of HK$100 million (or HK$100mm), referencing the HKU-HRPI: Index

Maturity

Bid (buyer)

Offer (seller)

HKU – HRPI

31 Dec 08 (12 months)

108%

110%

In the example below, you will notice a difference in price between the bid (buyer) and the offer (seller). This is called the „spread‟.

The spread reflects the buyer‟s and seller‟s expectation of future market performance. In this case, the buyer believes the market and hence the index will rise by 8% (108%) or more, from 31st December 2007 until 31st December 2008.

The seller (offer) in this example believes the market may rise by less than 10% (110%) or even fall in value over the next 12 months. The seller wishes to receive 10% (fixed rate) of HK$100mm from the buyer, and in return, will pay the floating index percentage return from 31st December 2007 to 31st December 2008.

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Trading Scenarios The following example further explains the mechanisms of an index linked property derivative and its potential application for institutional investors.

Figure 8.2: Swap Trade on HKU-HRPI Index

Index Level

Tenure (31st Dec, 07 to 31st Dec, 08)

Agreed Premium

Notional

HKU - HRPI

100

12 months

107%

HK$200mm

In December 2007, a buyer, US Fund Ltd., believes the Hong Kong Island residential property market will rise at least 7% (e.g. 8-15%) by the end of 2008. Assessing the various costs of buying and eventually selling the „physical‟ real estate asset (stamp duty, agency‟s fees, legal fees, etc.) as well as the cost of funding, US Fund Ltd. decides that a property derivative is an attractive investment tool to gain exposure to the Hong Kong Island residential market.

Therefore, US Fund Ltd. is willing to pay 7% fixed per annum (on HK$200mm), to receive the positive percentage appreciation of the HKU-HRPI. Conversely, a seller, HK Corp. Ltd., being a real estate portfolio manager and owner of many residential units on Hong Kong Island, believes the Hong Kong Island residential property market will rise less than 7% (e.g. 2-4%) or even fall in value over the next 12 months. The investment manager at HK Corp. Ltd. wishes to hedge part of its residential portfolio, by receiving a fixed rate of 7% (on HK$200m) and in return pay away the market return or beta.

The trade is brokered: US Fund Ltd. and HK Corp. Ltd. agree the fixed rate at 7% (107%) in HK$200m for a 12-month period (31st December 2007 – 31st December 2008); US Fund Ltd. is now legally contracted to pay HK Corp. Ltd. HK$14m (7% of HK$200m), and I.

in return receive the positive index percentage appreciation from HK Corp.

Ltd. (e.g. Index moves from 100 to 115 = 15%, HK$30m); or

II.

Pay the index depreciation (e.g. Index moves from 100 to 90 = 10%, HK$20m) to HK Corp. Ltd. if the market falls as well as the pre-agreed fixed rate.

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Settlement Scenario 1 – HKU-HRPI rises from 100 to 117 (Hong Kong Island residential prices rise by 17% in value) US Fund Ltd (Buyer)

KHD Fund Ltd (Seller)

fixed rate

Receives

 7%  17%

Profit

+10%

10% of notional = +HK$20mm

receives

fixed rate

pays away

 7%  17%

Loss

-10%

10% of notional = -HK$20mm

pays away receives

floating index % return

floating index % return

On 31st December 2008, the index level has risen to 117 posting a positive return and hence a rise in Hong Kong Island residential house prices.

Therefore HK Corp. Ltd. has to pay 17% of the notional amount to US Fund Ltd. (i.e. 17% x HK$200m = HK$34m). US Fund Ltd. has captured the price appreciation of Hong Kong residential property market through a property derivative rather than through purchasing a physical asset and has a net profit of HK$20m ( –HK$14m + HK$34m = HK$20m ).

Scenario 2 – HKU-HRPI falls from 100 to 92 (Hong Kong Island residential prices fall by 8% in value) US Fund Ltd (Buyer)

KHD Fund Ltd (Seller)

fixed rate

pays away

 7%  8%

Loss

-15%

15% of notional = -HK$20mm

receives

fixed rate

Receives

 7%  8%

Profit

+15%

10% of notional = +HK$20mm

pays away

floating index % return

floating index % return

On 31st December 2008, the index has fallen to 92, posting a negative return of 8% and hence a fall in Hong Kong Island residential house prices.

HK Corp. Ltd., the owner of residential units on Hong Kong Island and the seller of the property derivative contract, receives the pre-agreed fixed percentage of 7% of the notional amount (i.e. HK$14mm) from US Fund Ltd., as well as the 8% fall of the index (i.e. HK$16mm); HK Corp. Ltd. is obliged to pay the positive return on the index and receives any negative return.

This is a good example of using a property derivative as a way to hedge a physical real estate portfolio.

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The physical assets that HK Corp. Ltd. owns on Hong Kong Island have depreciated in value (HKU-HRPI declined from 100 to 92). By selling a property derivative contract, the company has generated a profit by hedging this market risk while maintaining ownership of their real estate assets. Furthermore, HK Corp. Ltd. property portfolio may outperform the HKU-HRPI and only decline by 5% in value over the contract period. By selling a property derivative contract, HK Corp. Ltd. has profited from the market fall (beta) of 8% while their assets are worth 3% more than the market rate (alpha isolation).

Figure 3: OVERVIEW â&#x20AC;&#x201C; Asia Pacific Indices: A Basis for Property Derivatives Trading

HONG KONG With a total value of sale transactions averaging HK$340Bn per annum and an average residential holding period of 3.4 years, this highly liquid Hong Kong residential market is ideally suited to property derivatives.

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Unit 8: Introduction to Property Derivatives

AUSTRALIA The PCA/IPD index (see Figure 5) is published quarterly and is a valuation based, direct property index measuring total returns for all directly held real estate assets in the main market sectors - composite, retail, office and industrial. The Index represents an estimated 37% of the investment market in Australia, including more than 900 properties with an estimated value of A$78Bn. The Australian residential property derivative market references monthly RP Data-Rismark Hedonic Indices (see Figure 7). These indices highlight the change in capital value of residential property, at the national and state capital city level. A separate accumulation figure is also published, with both capital value and rental yield incorporated. Residential property derivatives in Australia will likely mimic those in Hong Kong, with fixed percentage swaps being traded to capture or hedge residential risk.

JAPAN July 2007 witnessed the first commercial property derivative transaction in Asia between RBS and Grosvenor referencing the IPD Japan Monthly Indicator (see Figure 6). This index is based on the performances of the Japanese assets that are managed by all J-REITs. It should not be confused with the returns received by investors in J-REITs, which are based on their share price and distribution.

The indices represent the total return of various market sectors including office, retail and residential.

KOREA In Korea, IPD officially launched its IPD Korean Property Index on April 1st 2008. The index measures the total returns of directly held standing property investments from one open market valuation to the next.

For more details on this and any other IPD indices please see www.ipdglobal.com.

SINGAPORE A number of organisations are working together with industry to bring residential and commercial property derivatives to the Singaporean market. This is an exciting addition to the property derivative market in Asia Pacific.

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Useful Property Derivative Web Sites Company Websites http://www.g.group.com/markets/commodities/property-asia.aspx%20 http://www.colliers.com/Markets/HongKong/Services/ServiceGroups/PropertyDe rivatives/ http://www.colliers.com/Markets/HongKong/Services/ServiceGroups/PropertyDe rivatives/ Indices http://hkureis.versitech.hku.hk/ http://hkureis.versitech.hku.hk/ http://www.ipd.com http://www.ipd.com%20 http://www.rpdata.com/indices http://www.rpdata.com/indices%20 Organisations http://www.ipf.org.uk/ http://www.ipf.org.uk/ http://www.red-sig.org/ http://www.red-sig.org/ http://www.afmaservices.com http://www.afmaservices.com Bloomberg PDER <go> PDER <go> HKRE <go> 9 <go> or GCPD <go> HKRE <go> 9 <go> or GCPD <go> INVP <go> INVP <go> Reuters 3000Xtra 0#HKUREIS or HKUREIS/INFO

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Figure 8.4: The University of Hong Kong Real Estate Index Series

Figure 8.5: PCA/IPD Australia Property Index

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Figure 8.6: IPD Japan Monthly Indicator

Figure 8.7: RP Data – Rismark Property Indices

RECAP: At the end of this subject you should be able to understand the following concepts:  The various types of property derivatives and how they are used in markets  The pricing mechanism model for property derivatives  Property derivatives trading strategies and settlement process  How property derivatives are used as a hedging tool

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Addendum

Assessment Research Task

PS03 ď&#x20AC;ź Real Estate Finance & Investment

Addendum: Assessment Research Task

Assessment Research Task To be advised.

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