Urban Real Estate Financing and Investment (Mgt 278A)
Lecture Modules – Professor Habibi
MODULE 1: Real Estate Finance Fundamentals
Why Study Real Estate?
 Tangible products that affect our daily lives in meaningful ways
It is easy to relate to real estate, and all of us have experiences living, working,
eating, shopping and visiting places. The success of many real estate projects is
largely dependent on a concept called placemaking, which strengthens the
connections between people and place, and as an industry, real estate is relatively
straightforward and easy to understand. That said, the relative simplicity of the
industry can sometimes be deceptive, lulling investors into a state of
overconfidence and resulting in overly aggressive acquisition/financing strategies
 Rapid growth through leverage/tax benefits
Real estate investors have access to a few powerful tools that enable rapid wealth
creation, such as the ability to perform tax-deferred exchanges, syndicate outside
capital and make optimum use of financial leverage. While these tools are not
without attendant risks, they nevertheless facilitate the growth of equity capital at
rates that can potentially outperform many other asset classes.
 Rewards common sense, wisdom and relationship building
Real estate is a very mature industry, with proven rules that determine the success
of its participants. As such, those who know what to look for and how to maximize
the benefits and exploit inefficiencies in the marketplace tend to outperform those
who don’t. Moreover, two of the most formidable hurdles to investment success
are access to deals and capital, both of which are heavily dependent on
relationships.
At the same time, the industry tends to be somewhat slow moving relative to others,
and there are still myriad opportunities for technological disruption. We have seen
some of these over the past few years, though it is still very early in the innovation
lifecycle. Firms like Amazon have led to online sales growth that has been a leading
cause of the closure of multiple national and local retailers. Similarly, we are also
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seeing the disruption of real estate sales and brokerage through newer entrants such
as Zillow/Trulia, Redfin, Opendoor, Knock and OfferPad, to name a few. Even the
flow of capital has expanded to individual investors through new laws allowing for
the proliferation of crowdfunding.
 Different types of jobs for all types of people
The real estate industry crosses myriad disciplines, and participants vary widely in
their backgrounds, skills, and duties. For example, brokers rely heavily on sales
and marketing skills to buy and sell property; financial analysts build financial
models that predict the returns on capital investments; and, civil engineers may
consider the condition of the soils upon which to construct an office tower. There
are many more such examples of professions that encompass the industry.
 Local community knowledge yields competitive advantage; each property is a “minibusiness”
Real estate is a local game. Each parcel of property is unique not only in a physical
sense, but also with respect to its situation within a country, metropolitan area, city,
community and sub-community. Outsiders to a specific geographic area rarely
have a grasp of the nuances of local markets in the way that locals do, and typically
lack the relationships to source investment opportunities before locals do.
Outsiders to a specific market area rarely get the “first look” at choice properties
and tend not to have the deep relationships with brokers and sellers that provide an
attractive stream of deal flow.
 Can work virtually anywhere on earth; full-time or hobby
The real estate industry allows participation in a variety of capacities, whether
you’re planning to grow your nest egg through the purchase of a single-family
home, or grow a portfolio of investment properties as part of a large scale corporate
structure. There are opportunities at all levels of the industry, from passive to active
involvement, as we will discuss in future modules. And of course, since real estate
is ubiquitous, you can work anywhere in the world so long as you understand the
specific drivers and risks of each market.
Real Estate Product Types
 Residential (single-family)
o
o
o
o
o
o
Detached – no shared walls, separated living spaces
Attached – shared walls, connected
Condo/townhouse – one grant deed per unit, individual ownership interests
Co-op – one grant deed for the whole property, undivided ownership interests
Modular/pre-fab – increasingly popular with escalation of labor costs
Mobile home
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 Commercial: The 5 ‘Core’ Property Types
o Multifamily
Types: Duplex/triplex, garden style, podium, high-rise
Typically full service gross (FSG) leases – FSG consists of tenant paying a
base rental rate, and the landlord paying for operating expenses, such as
property taxes, insurance and common area utilities
Lowest on risk curve, lowest yields – because multifamily is needs-based,
and people always need a place to live
o Industrial
Types: Warehouse/Distribution, Manufacturing, Flex
Simple construction, often tilt-up (“four walls and a roof”), but note that
warehouse/distribution facilities are becoming more advanced to suit the
growing needs of e-commerce fulfillment
Usually triple net (NNN) leases – tenant pays base rent plus operating
expenses
Typically requires unique considerations:
Size, clear heights, column widths, access/loading docks,
environmental, technology, roof, HVAC (heating, ventilation, air
conditioning), surrounding infrastructure (i.e., access to freeways,
ports, etc.)
Single-tenant leasing risk, as opposed to multiple tenant diversity
Relative ease of management (fewer users per square foot compared to other
product types)
Success largely driven by functionality and commercial viability, rather
than whether properties are appealing to people (unlike the other product
types)
o Retail
Types: Street retail, strip, neighborhood anchor/power centers, regional
malls etc.
Anchors drive traffic and typically pay lower rents than in-line tenants
Combination of location and collection of brands drives traffic
Visibility is key
Less complicated leases
Percentage rent clauses – base rental payment up to a “break point,” usually
defined as X% of tenant’s sales revenue
Use clauses and radius restrictions
“National tenants” and anchors (i.e. Wal-Mart, Bloomingdale’s) tend to
have most of the power and pay low rents and obtain higher Tenant
Improvement (TI) allowances relative to in-line retailers
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o Office
Types: office campus, low-rise, high-rise
Classifications based on age, amenities and tenant quality (A, B, C)
Location is key – near transit corridors and housing
Leasing risk high, especially as tenants get larger
Stacking/planning tenants can be tough – think of the video game Tetris
Modified gross leases get complicated with CAM (common area
maintenance) charges and base year expense stops
o Hospitality
Types: Limited service, full service, extended stay
Really an operating/service business
Tenants turn rapidly, high vacancy, F&B (food and beverage) is large
component of income
Very sensitive to economic conditions, typically high along risk curve
 Commercial: ‘Non-Core’ Property Types
Over the past 20 years investors have gradually broadened their scope for what they
constitute as ‘real estate’. As of today non-core property types represent roughly half
the value of the U.S. publicly listed real estate market. These property types include:
o Healthcare
o Self Storage
o Manufactured Housing
o Student Housing
o Data Centers
o Cell Towers
Real Estate Direct Investment Cycle (jobs in parentheses)
Deal Sourcing: Listed or off-mkt
(Principals, Brokers, Sales/Mktg)
Offer and due diligence
(Principals, Brokers, Consultants, Market Research, Inspectors)
Financing
(Equity and debt finance, appraiser, mortgage broker/banker, M&A)
Closing: Transaction Support
(Escrow, title, legal, insurance, acctg, etc)
Asset Management
(Property mgmt, leasing, construction/maintenance, tax/acctg, etc)
Reversion/Exit
(return to top)
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The Players: Principals and Agents
Seller (Principal), typically represented by Listing Agent (Licensed Broker or Salesperson)
Buyer (Principal), typically represented by “Selling Agent” (Licensed Broker or Salesperson)
Upon execution of a Listing Agreement between the Seller and Listing Agent, there will be a specified
commission that is paid upon close of escrow (completion of sale) by the Seller to the Agents
representing the Principals. For residential transactions, this commission is typically about 5-6%. If
there are two agents (Listing Agent and Selling Agent) working on the deal, then they typically split the
commission. If there is only one Agent representing both sides (called a “dual agency”), then that
Agent typically keep the whole commission to himself (more on this below). As you can imagine, dual
agency can be very attractive, yet is riddled with conflicts, as it is nearly impossible for an Agent to
truly represent and maintain fiduciary duties to both sides of a transaction. For this reason, some states
outside California have outlawed dual agency in residential transactions.
Types of Listings
Public (Marketed) Listing: advertised for sale through one or many of the public networks, accessible
by brokers, agents and principals. These public networks include LoopNet (commercial properties) and
the Multiple Listing Service, or MLS (residential properties). As you can imagine, these deals gain
large exposure and create a bidding war between buyers, which often results in high offers to the seller.
It is the listing agent’s responsibility to “qualify” each buyer and ensure that they have the financial
capacity to close the deal, as well as the desire to purchase the property and not lead the seller on, only
to back out of the deal after tying it up in escrow.
Pocket (Off-Market) Listing: not advertised for sale through the public networks. Instead, in a pocket
listing, the Listing Agent typically calls upon his network of known buyers and “shops” the deal across
this network, telling prospective buyers that they have the opportunity to make an offer on a deal to
which the public does not have access. The catch, however, is that the Listing Agent will often times
request to act as a Dual Agent, which means he will write the offer on behalf of the buyer, and thus act
as the Agent of both the seller and buyer. As such, he will keep all of the commission from sale rather
than splitting it with another Agent. The benefit to the buyer is that he can avoid a bidding war, which
may otherwise result in an unattractively high purchase price. The benefit to the seller is that the Agent
usually knows the buyer well, and can “vouch” for his intent and financial capacity to close the deal.
The big downside, however, is that the seller will likely not gain as much exposure to his property and
may not yield the highest possible price. Pocket listings work best for the seller who knows the true
value of his property and can refuse to accept offers that seem too low.
Direct Solicitation: direct transaction between two willing Principals (Buyer and Seller). Usually
results from a prospective buyer locating an attractive piece of property and approaching the seller
directly and making an offer. These types of deals can be completed using no brokers, or else by
bringing brokers or attorneys into the transaction to assist in working through various issues. The idea
here is that in a direct solicitation, the deal is never marketed, and the buyer and seller basically find
each other and strike a deal between themselves. These types of deals are typically beneficial for both
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parties, as commissions are either non-existent or else very low, resulting in higher net proceeds to the
seller and a lower net cost to the buyer.
Offer and Due Diligence: Terms of a Well-Constructed Purchase Agreement
1.
2.
3.
4.
5.
6.
7.
8.
Identity of Buyer (and/or Assignee clause)
Legal Description of Property
Purchase Price
Earnest Money Deposit
Escrow Period
Contingency Periods – Physical and Financing
Liquidated Damages Provision
Disclosures (Various)
Elements of the Operating Statement
The operating (income) statement for an investment property looks very similar to any other income
statement, with some exceptions to reflect the uniqueness of this asset class. The basic premise is that
we begin with Gross Potential Rent, and then make adjustments to account for Vacancies and
Delinquencies/Concessions to arrive at Effective Gross Income (EGI). After we have EGI, we subtract
Operating Expenses to arrive at Net Operating Income (NOI). Operating expense ratios vary by
property type, and can range from 20%-50% or more, depending on various factors. Also remember
that Operating Expenses are stated as a percentage of Gross Potential Rents due to the fact that even an
empty building incurs some operating costs. Thus:
Gross Potential Rent
(Less: Vacancies)
(Less: Delinquencies/Concessions)
=Effective Gross Income
(Less: Operating Expenses)
=Net Operating Income (NOI)
Operating expenses include items such as: property taxes, utilities, insurance, management, repairs and
maintenance, and other costs associated with operating the property. If the expense is associated with
the day-to-day operations of the physical property itself, it’s most likely an operating expense.
You may notice that there are certain items missing from this operating statement, namely: depreciation
expense, interest expense, and income taxes. These are not part of operating expenses, and are instead
referred to as “below the line” items. There reason these are not part of NOI is because these costs are
attributable to the investor, not the property. In other words:
Depreciation expense changes depending on ownership, as each investor has her own cost basis
and annual depreciation charge (if any, as a property could be fully depreciated for tax
purposes).
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Interest expense depends on how the property is financed (i.e., how much debt is used to buy
the property) and thus changes depending on the ownership.
Income tax expense rates depend on ownership, as each individual and entity have different tax
rates.
As you can see, if the expense changes with ownership, it is likely a “below the line” item and not part
of NOI. Because of this, NOI is a very useful way to look at the cash flow from a property independent
of the ownership and financing structure. And if you’re buying a building, this is exactly what you
want to know.
A Note on Capital Expenditures (“Cap-Ex”)
Although depreciation is intended to reflect the rate at which a building’s improvements
decrease over time, there is often a divergence between a standard deprecation schedule and the
actual cap-ex costs needed for a building. Cap-ex costs occur infrequently and are ad-hoc in
nature, which is why they are “below the line” items. That being said, when underwriting a
potential investment opportunity it is important to factor-in the expected cap-ex costs that will
be necessary to achieve the projected rents. Cap-ex needs vary by property type, but each cap-ex
item is typically grouped into one of three categories:
1. Maintenance Requirements – Costs paid to keep a property competing at the same level
(e.g. replacing an old roof, fixing damaged plumbing/electrical, etc.).
2. Tenant Improvements – For office and retail properties, the allowance given by a
landlord to tenants to build-out their leased space is amortized over the life of the lease.
3. Leasing Commissions – For office, retail and industrial properties, the cost paid to the
leasing broker is typically amortized over the life of the lease.
Capitalization Rates (“Cap Rates”)
The cap rate is a valuation metric used by real estate investors to apply a measure of value to each
dollar of NOI. It is defined as:
Cap Rate = Annual NOI / Property Value
This is effectively the unlevered yield on a piece of real estate, and very similar to an inverted version
of the common Price/Earnings ratio you may have seen in securities analysis. While on the surface it
may seem like a very simple metric, it is very powerful, as modest changes to the cap rate can have
very large-scale effects on a property’s value.
Another useful way to understand the cap rate is to compare it to the Dividend Growth Model,
whereby:
Price of Stock = c / (r - g)
Both “Property Value” and “Price of Stock” signify asset value. Thus:
Annual NOI / Cap rate = c / (r – g)
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Next, we can equate “Annual NOI” to “c,” or cash flow. Thus:
Cap rate = (r – g)
The cap rate therefore equates to the discount rate less the NOI growth rate. This relationship is
referred to as the Gordon Growth Model.
Risk/Return Tradeoffs (Cap Rate Continuum)
Source: Ziman Center AREA 101 featuring Professors Paul Habibi and Eric Sussman
Leasing
1. Full Service Gross Leases – tenant primarily pays base rent amount (with some potential addons), and operating expenses paid by landlord
2. Triple Net Leases (NNN) – tenant pays base rent plus operating expenses (property tax,
insurance, utilities). As such, base rent charged to tenant is usually equal to net operating
income to landlord
3. Modified Gross Leases – Somewhere in between the above two configurations, subject to
negotiation and can be complex, depending on the situation
The Yield Curve and Mortgage Rates
Interest rates on loans, also called mortgage rates, are primarily derived from the yield curve, a tool
widely used by analysts and forecasters in assessing the state of the economy. Put simply, the yield
curve depicts yield-to-maturity (YTM) of risk-free U.S. Treasury securities along different time
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horizons. To come up with the mortgage rates, lenders add a risk premium (also called a “spread”) to
the YTM to come up with the interest rate on a loan with a specific time horizon. The yield curve:
 Reflects expectations regarding future rates. It is typically increasing with maturity since
long-term bonds have more rate risk and because of expectations for increasing rates
 Is considered “normal” when it is upward sloping, though it may also slope downwards
(“inverted”), implying expectations of economic contraction. Or, it can be flat, implying
future uncertainty
 Is one of the most important metrics to watch as you proceed in your investment careers,
regardless of asset class
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How does the yield curve tie into Real Estate Asset Valuation?
Recall the yield curve is for risk-free investments. Real estate investments are not riskfree, so we need to make adjustments for the risks inherent in owning this type of asset.
 We must add a “risk premium” (also called the “spread”) to the chart above to adjust
for the risks (and thus returns) of owning RE vs. Treasury securities. The spread for
real estate debt is naturally lower than that of real estate equities given the higher
priority of debt in the capital stack and increased volatility expected with equity cash
flows
 Investors cannot compare two different types of investments without adjusting for the
differences in risk profile of each (discount rate is used – more on this later). Within
real estate investing, risk premium can differ due to property type, MSA/sub-market,
property quality (class A, B, C), and other factors
 Capitalization rates (referred to as “cap rates” for short) measure the unlevered yield
on real estate investments. (Unlevered yield refers to the return on assets generated by
the property—in year 1—assuming we buy the property “all cash” and with no
borrowed funds)
o Cap rate equals the risk-free rate plus the risk premium
o Cap rate also equals the expected return to equity holders (r) minus the expected
growth rate of net operating income (g). Recall the Gordon Growth Model
o Cap rates on various property types can be mapped as a continuum ranging from
low to high based on risk levels (see Risk/Return Tradeoffs (Cap Rate
Continuum above as example)
 In an asset bubble, such as the one we experienced leading up to the Great Recession
of 2007-2009, risk premiums typically compress to unreasonable, unsustainable levels,
causing prices of real estate to rise faster than its underlying cash flows:
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Forms of Investment in Real Estate
Basic Types of Investment are Debt and Equity, plus their various permutations
What is the difference between debt and equity? Well, there are a few differences:
Debt holders (lenders) have priority of claims on cash flow of a property. As such,
debt holders are paid before equity holders. This makes debt “senior” to equity,
and equity “subordinated” to debt. As cash flows from a property are allocated to
first to debt holders, this makes equity riskier than debt, and thus the equity holders
will require a higher rate of return on money invested to compensate them for their
inherently heightened risk or volatility.
Within the category of debt, there can be “senior” debt and “subordinated” (also
called “junior”) debt. Senior debt has the very highest priority on the cash flows
from a property. It is usually secured by a “first trust deed” (more on this later).
Because of the security interest, senior debt is sometimes referred to as being in
“first place” or in “first position.” Junior debt is usually secured by something
called a “second trust deed” (again, more on this later.) Because of this, junior debt
is also called “a second.” For the same reasons described above, junior debt will
require a higher rate of return than senior debt.
Equity and debt are treated differently from a tax perspective. The interest expense
on debt is generally tax deductible to the borrower; thus, true cost of debt is lower
than stated interest rate. The “actual” cost = Interest rate x (1 – tax rate)
Now that we are familiarized with the basic differences between debt and equity, let’s
examine the four basic ways to invest in real estate:
Active debt – loan origination (making loans), loan purchases on secondary market
(also sometimes referred to as “trust deed investing”)
Passive debt – pass through certificates, mortgage REITs
Active equity – ownership of rental property, development
Passive equity – equity REIT, Limited Partnership (LP) shares
Who invests in real estate aside from individuals?
A.
Institutional Investors
REITs (Real Estate Investment Trusts)
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REITs are tax-advantaged entities that trade like stocks, meaning that they
raise equity capital through public share issuances
Established by Congress in 1960 to help smaller investors make investments
in large-scale income producing real estate
90% of taxable income must be distributed to shareholders as dividends. –
because of this REITs function similar to fixed income securities. REITs
must distribute this sizable percentage of their income so as not to “hoard”
earnings. This ensures that even though REITs are tax advantaged, that they
are still paying a healthy tax bill each year
The requirement to distribute 90% of earnings means that REITs have to
fund new acquisitions primarily through equity and debt offerings
Private Equity Funds
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Pools of capital raised from investors to make debt and equity investments
Typically have fixed life span and exit strategy, investments “illiquid”
Types of funds include: core, value-add, and opportunity.
o “Core” (and “Core-Plus”) assets include properties that are already
stabilized, with tenants and steady income streams in place. These
are typically fairly lower risk
o “Value-add” assets include properties that are in need or
repositioning, re-tenanting, or change of use. They are often
moderately risky, based on the less-than-certain likelihood of
achieving expected results
o “Opportunity” assets include ground-up development, distressed
deals, and properties that exhibit a high level of risk and uncertainty.
These investors require high returns to compensate themselves for
the inherently higher level of risk and uncertainty
Pension funds
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ERISA (Employee Retirement Income Security Act) of 1974 required asset
diversification for pension funds
Pension funds own approximately 1/3 of the real estate equities market
Foreign Investment (largest presence are Sovereign Wealth Funds). What factors
drive international investment activity?
(1)
(2)
(3)
(4)
Need for diversification
Hedge against political risk
Exchange rates – when US dollar is weak, US real estate is less costly
Relative interest rates – Higher rates abroad tend to create investment
outflows, as prices abroad are depressed and thus more attractive
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RE Performance
A.
Difficult to compare against other asset classes. Why?
(1) Sparse, contradictory data (although getting better with institutionalization)
Note: Securitization of real estate loans and entrance of Wall Street has
created greater demand and liquidity.
(2) Fewer reporting periods, quarterly appraisal estimates, smoothing of trends
makes RE seem less volatile
B.
Real Estate Compared to Other Asset Classes:
Returns on real estate tend to parallel that of common stocks more closely than
most other major asset classes, but usually outperforms the stock market during
periods of inflation – thus real estate is commonly thought of as a good hedge
against inflation
Market Efficiency
Market efficiency theory refers to the idea that all relevant information is reflected in market prices,
rendering the current price of any asset to reflect its true intrinsic value. As you can imagine, this
is a hotly contested area of finance, given the market bubbles and volatility that have persisted in
financial markets. In any case, there are two forms of market efficiency, and different people
believe in various forms of efficiency in the marketplace, if at all:
Semi-strong form: all publicly known info is reflected in market prices
Strong form: all publicly and privately known info is reflected in market prices
Regardless of what you may believe, there are certain variables that tend to increase market
efficiency. That said, real estate markets tend to be much less efficient than other markets, such
as the stock, bond and commodities markets. And the greater the inefficiency in a marketplace, the
easier it is to purchase assets at a discount to intrinsic value and earn above-market returns So why
is the real estate market less efficient? Here are some of the reasons:
(1) Fundamental analysis is often times very weak. Many transactions occur at prices that
reflect little more info than past prices of similar properties. Whereas investors in other
asset classes run complex models to make investment decisions, real estate investors often
perform little, if any, financial analysis before making decisions. This creates the
opportunity for asset mispricing.
(2) Transactions are infrequent in real estate related to other asset classes, typically because
larger amounts of capital are required to make an investment. This “lumpiness” factor
tends to decrease the frequency of real estate transactions relative to stocks, bonds,
commodities and other markets.
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(3) There is a substantial lag between the time comparable transactions occur and the time
when information is recorded and available for viewing in public records databases. Recall
that a typical escrow period can last several months, which means that there can be a
substantial time interval between when a deal is consummated and when its details are
made available to the public. In contrast, stock transactions on the public exchanges, such
as the NYSE and NASDAQ, for example, settle within three days.
(4) Transaction costs high compared to securities markets, which inhibits frequent portfolio
adjustments and increases time for info to be reflected in market prices. Sales commissions
for publicly traded stocks can be as low as $8, but in real estate, they are a few percentage
points (typically 2 - 6%) of the purchase price; this can be millions of dollars for sizeable
deals.
(5) Product is always differentiated. Each parcel unique, so that there is always some
monopolistic control. Real estate is not a pure commodity. Building upon the comparison
to publicly traded stocks, for example, all common shares of Microsoft and American
Airlines are homogenous, whereas every piece of real estate is a unique asset with its own
idiosyncrasies.
Module 2: Market Cycles and Drivers of Supply and Demand
Cyclical Change and Real Estate Activity
At a macroeconomic level, the expanding and contracting of economic output over time is referred
to as ‘the economic cycle’. The economic cycle is typically categorized into four stages—
expansion, peak, contraction, trough. As the economy moves through a full business cycle, similar
characteristics occur at each stage.
As the economic cycle enters different stages, monetary and fiscal policy changes are enacted by
government to counteract the macroeconomic distortions. Government will then enact policies that
curb the over/undersupply affecting various parts of the economy.
Like the macroeconomy, real estate values also generally move in a cyclical manner, and this is
commonly referred to as ‘the real estate cycle’. Although the real estate cycle and the economic
cycle follow a similar general pattern, a distinction is made between the two because they do not
move through the cycle stages in unison. Further, the real estate cycle typically refers to changes
occurring in rents and occupancy, a byproduct of the economic cycle’s expansions and
contractions.
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Understanding the progression of each phase within the cycle is critical in being able to identify
investment opportunities, as different risks become more prevalent when the cycle transitions
between stages. There are some important considerations to note when analyzing cycle stage. First,
the stages do not necessarily occur over equivalent time periods. Historically there have been
recoveries that are brief and quickly transition to expansion, but other cycles where the recovery
may drag on for years. It is also difficult to project the duration of phases. Just because there was
general consensus that a previous cycle spanned a decade does not imply that the next cycle will
approximate the same total duration.
A unique aspect of real estate investing is that investors can create a successful allocation strategy
for all stages of the cycle. However, understanding whether fundamentals indicate the cycle is
entering a new stage can affect how investors approach a number of factors such as: property type
allocation and return expectations, hold period/exit strategy, heavier focus on annual income
versus property appreciation, appropriate timing of capex improvements.
Current Market Conditions
Please refer to in-class PowerPoint presentation for color on the current macroeconomic
observations of the macroeconomy and U.S. real estate market
Module 3: Financial Underwriting and Forecasting
Let us start by defining our goal for this module: Forecasting the benefits (cash flows) from a
proposed real estate investment. These benefits appear on the property’s operating statement.
Recall the Elements of the Operating Statement:
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Gross Potential Rent: amount of revenue generated with no vacancies or uncollectibles
Effective Gross Income (EGI): potential gross rent adjusted for vacancies and
uncollectibles; includes other income (the total is considered actual gross revenues)
Operating Expenses (OpEx): expenditures needed to maintain and operate the property;
costs required in order to generate rent; these include any costs specific to the property.
Measured as a percentage of Gross Potential Rent, as this best captures the fixed costs of
real estate operations.
NOI = difference between EGI and Op Ex
Due Diligence (Some Basic Steps – there are many more)
Legal, title and survey
Preliminary title report
Zoning restrictions
Easements, property lines, topography, etc
Physical inspection
Land, environmental, soil, seismic
Structural, foundation, grading/drainage issues
Roof, water heater, laundry, mechanical/electrical/plumbing (MEP) systems
Tenancy and leases
Review rent rolls (collections, delinquencies, vacancies)
Review leases for rates and concessions
Review Certificate of Occupancy
Review building permits
Financial and operational
Model expected operating results
Develop an exit strategy
Assess optimal operational, capital and tax structures
Collect data from the subject property:
Review past Statements of Operations
Audit past operating expenses (utility bills, invoices, check copies, contracts, etc.)
Market research
Compare with peer group properties
Look for substitutability and comparability, same segments
Equally desirable, similar amenities
Establish the market area
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7th Street Santa Monica Apartments Case Study: Multi-Family Financial Forecast
Subject property: 1809 - 1833 7th Street, Santa Monica, CA
Refer to Lee & Associates Marketing Brochure
Construction of operating statements
Revenues
Confirmation of rents
 Inspect rent rolls
 Review leases
 Estoppels: confirms to tenants
Adjust for vacancies, uncollectibles, concessions, write-offs and delinquencies
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

Vacancy factor in strong markets is typically low, say 3%
Vacancy factor in weaker markets is higher, say 10%
Write off/delinquency factor is typically about 0.5%
Vacancies represent units that are unoccupied, whereas write-offs/delinquencies represent
occupied units with non-paying tenants who do not pay rent and must be evicted.
Expenses
Property taxes and Insurance

Property tax: Proposition 13 (1978) placed property tax cap of 1% of assessed
value, with value to be reassessed only upon legal transfer of title

Unless a property is reassessed through transfer of title or other such trigger, tax
increases are capped at 2% annually to keep up with inflation; counties have some
discretion to add additional assessments to property taxes to cover local services.
(typical City of LA tax is around 1.125%)

Insurance: The lender requires insurance to protect its interest in the underlying
loan collateral. If the borrower does not maintain adequate insurance, the lender
will purchase a “force policy” and charge the borrower for insurance premiums
that are often several times higher than traditional coverage.
Fees and Commissions

Property management fee: this is added by the lender to account for the costs it
would have to incur if they foreclosed on the property. Covers the costs of offsite
management, and is typically about 4%
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Payroll



Resident manager compensation per door per month; resident manager is required
by California state law if building contains 16 or more units
Payroll tax of 12% of the payroll
Workers compensation of 9% of the payroll
Maintenance/repairs: this is a wildcard, depends largely on the condition of the property,
as well as the type of property (e.g., hotel, office, apartment, etc.)

Repairs and maintenance covers plumbers and electricians (1099 employees)

Painting and decoration covers painting of common areas only; painting expense
doesn’t include “clean and show” costs as they wash out against security deposits
retained. Deposits that are kept cover cleaning, painting and getting unit ready. If
tenant has been there more than 3 years you cannot deduct for painting the units.
Refer to specific landlord/tenant laws for the state in which you plan to operate
Utilities

Gas bill is typically for water heater only, unless property is master metered
(meaning landlord pays for tenants’ gas)

Electricity is for common areas and hallways, unless property is master metered
(meaning landlord pays for tenants’ electricity); total cost depends largely on
whether common areas and hallways are open or enclosed, as enclosed common
areas require 24-hour lighting; typically less for open common areas, and more
for enclosed

Water and sewer typically incurred by landlord
Other expenses

Legal fees are based on one Unlawful Detainer action per year
Unlawful Detainer (UD) Action:
If rent is not submitted by due date, landlord can give three-day notice, in which case tenant
has three days to pay, not counting Sundays and holidays. At the end of three days, owner
can refuse to accept rent and file UD. Once UD is filed and served to tenant, tenant has
Urban RE Financing and Investment - Habibi
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five days to respond. If tenant responds, they have to go pay a fee to the court and a hearing
date is then set for three weeks from then.
If the tenant does not respond, lawyer can take a “default” and get a judgment. Judgment
goes to the Sheriff’s office and Sheriff posts a note, giving the tenant five days to vacate.
If at the end of this time the tenant has not moved out, Sheriff comes to give possession of
unit to owner. At this time, owner should have a locksmith present in case locks need to
be opened or changed.
Construction of Operating Forecast and Valuation
Every analysis requires an exit strategy, whether it is operation of the property into perpetuity or
obsolescence, or a quick flip. In this analysis we will assume three years of operations prior to a
sale, or “reversion.”
Some new terms used in the forecast and valuation
 Exit cap: cap rate to be used in the year of sale or exit; a future estimation using all







available macroeconomic and other data
NOI growth: compounded annual rate of growth in NOI, to be forecasted based on
revenue and expense trends
Reversion value (sale price): what we will sell the property for at the end of the holding
period; calculated by dividing the final year’s NOI by the exit cap
Adjusted basis: the depreciated value of the property, used to calculate the taxes
payable upon sale of the property
Cash flow to equity holders: cash they receive as residual claimants on the property’s
cash flows; they are paid after debt holders are paid
Cash on cash return: cash generated divided by cash invested in property (although
widely used, this measure does not properly account for the time value of money and
risk of the investment)
Equity Multiple: Measure of money returned to equity investors versus money
contributed by those investors = (total profit + equity invested) / equity invested
Debt yield: NOI divided by Loan Amount. Higher yield implies less risk to lender, as
there is more NOI available to service debt. In a volatile market, lenders will seek
higher debt yields (i.e., will lend less relative to the underlying income)
Financing: Calculating the Maximum Loan Amount
Income approach/NOI margin method:
NOI/Margin = Maximum annual loan payment
Loan-to-Value (LTV) method:
Urban RE Financing and Investment - Habibi
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Take percentage of value of property, typically somewhere between 50-90%, but this depends on
property type and other factors
For adjustable rate loans, interest rate is priced with a spread above the T-Bill rate, and thus
fluctuates over time. As a rise in interest rates may adversely affect a borrower’s ability to
service the debt, most adjustable rate loan programs provide for a lower LTV ratio and thus
protect both the borrower as well as the lender.
After all this is done, use the LTV test and compare how much you can borrow under this cap.
Compare what you can borrow under both the income approach and the LTV approach, and use
the prevailing (lesser, more restrictive) loan amount.
MODULE 4: Financial Leverage and the Capital Stack
Let’s begin this module with a little review of how interest rates work.
Compounding Intervals:
Thus far when referring to interest rates, we have made the basic assumption that we are dealing
with “nominal” or “stated” rates in our calculations. When compounding on a periodic basis, we
need to change our general formula:
From
FV = PV (1+r)n
To
FV = PV [1 + (r/m)]nm, where m=intervals per year
Effective Annual Yield Illustration
Let’s examine the following scenarios and see how the effective interest rate is
altered by compounding frequency:
FV of $10k, annual rate of 6% compounded annually for one year = $10,600
EAY = (FV-PV)/PV = 6%
FV of $10k, annual rate of 6%, compounded monthly for one year =
$10,616.78
EAY = 6.1678%
FV of $10k, annual rate of 6%, compounded daily for one year = $10,618.31
EAY = 6.1831%
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More frequent compounding gives higher EAY. However, even with infinitesimal compounding
intervals, the EAY will reach a limit, expressed as en. Thus, using r=6%, the limit is 6.1877%.
Now, we’re ready to tackle financial leverage…
In this module, we will:

Introduce the concept of leverage

Show why it can be valuable and also dangerous

Show how lenders price loans via the interest rate and illustrate the risks they incur every
time they underwrite a loan

Illustrate types of loans and ways lenders charge interest

Run through some basic calculations for each type of loan
Lenders make loans in exchange for compensation. What’s their compensation?
Interest – compensation for the use of funds; driven by market and risk
What are they being compensated for? What are their risks?
Default risk – borrower defaults on the loan
Interest rate risk – unanticipated inflation
Prepayment risk – risk that loan will be prepaid when rates fall below contract rate
o
Prepayment penalties
 Stepdown
 Yield maintenance
 Defeasance
Liquidity risk – risk that loan cannot be sold in secondary market
Legislative risk – tax status of mortgages, rent controls, etc.
Interest rate must provide for fair and adequate compensation for these risks.
Positive vs. negative leverage:
ROA must exceed debt constant (debt service/loan amount)
ROA less this borrowing cost is the “spread”
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Financial leverage also effectively increases the depreciation deduction. Recall that you depreciate
real property using some portion of total cost basis, not just the equity invested. As such, financial
leverage allows the investor to benefit from a depreciable basis that can be much larger than the
total amount of equity in the deal. Similarly, financial leverage amplifies tax benefits derived via
favorable capital gains rates
Assume loans below are 9% interest, compounded monthly, with 20-year amortization:
Illustration: Cash Flow Consequences of Financing Alternatives
Net Operating Income
Less: Annual Debt Service
Before Tax Cash Flow
No Loan
$
210,000
$
$
210,000
$1,000,000
Loan
$
210,000
$
107,964
$
102,036
$1,200,000
Loan
$
210,000
$
129,564
$
80,436
Purchase Price
Less: Loan Amount
Equity Invested
$
$
$
$
$
$
$
$
$
Ratios:
Debt Service / Loan Amount
Net Operating Income / Cost
Return on Equity
1,500,000
1,500,000
N/A
14%
14%
1,500,000
1,000,000
500,000
1,500,000
1,200,000
300,000
11%
14%
20%
11%
14%
27%
Net Operating Income
Less: Annual Debt Service
Before Tax Cash Flow
No Loan
$
150,000
$
$
150,000
$1,000,000
Loan
$
150,000
$
107,964
$
42,036
$1,200,000
Loan
$
150,000
$
129,564
$
20,436
Purchase Price
Less: Loan Amount
Equity Invested
$
$
$
$
$
$
$
$
$
Less-Than-Expected NOI
Ratios:
Debt Service / Loan Amount
Net Operating Income / Cost
Return on Equity
Urban RE Financing and Investment - Habibi
1,500,000
1,500,000
N/A
10%
10%
1,500,000
1,000,000
500,000
11%
10%
8%
1,500,000
1,200,000
300,000
11%
10%
7%
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Key points:

Yield to equity increases w/ positive operating leverage

Spread affects whether leverage is positive or negative

Debt cheaper than equity b/c senior, less risk, and interest is tax deductible
o “True” cost of debt =[interest rate x (1-tax rate)]

Too much debt squeezes NOI, which is static; this can amplify bankruptcy risk

Capital structure refers to debt/equity mix; balance low cost of capital with tolerable
bankruptcy risk (decreasing cost of capital vs. increasing bankruptcy risk).
Keep in mind that both senior and subordinated debt are included in this calculation. Debt
of any type will increase the debt/equity ratio and will increase bankruptcy risk.

Banks implement measures to protect us from over-leveraging: NOI cushion (Debt Service
Coverage Ratio), LTV maximums, debt yield (NOI/loan amount), et al.
Additional Benefits of Leverage
Amplify tax shelter - even when properties purchased w/ borrowed funds, while equity outlay is
reduced, you can deduct full depreciation
Amplify gain on disposal - realize appreciation benefit on less cash. To the extent that you can
take depreciation deductions, they offset ordinary income, but when you reduce your tax basis,
you only pay unrecaptured depreciation rate (25%) on those basis reductions. Gain is also
amplified when appreciation rate on property exceeds borrowing costs
Illustration:
A parcel of land that is well situated to benefit from rapid urban growth can be acquired for
$600,000. A prospective investor expects that the land will double in value during the next five
years, after which she plans to sell. During the interim, the land can be leased to a turnip farmer
for an annual rental that just covers the property tax liability, so there will be zero annual cash
flow before debt service and income taxes (because there are no improvements on or to the land
– just raw farm land – there is no cost recover allowance to consider.
The land can be purchased for $600,000 cash, or the present owner will agree to accept a
$150,000 down payment accompanied by a note and purchase-money mortgage for $450,000.
Both the principal and the accumulated interest on the note will be due and payable at the end of
the fifth year, with interest accumulating at a compound annual rate of 9 percent (9%).
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Calculation of CAGR/IRR
Proceeds from Sale after 5 Years
Less: Balance due on loan
Net Sales prodeeds, before tax
$
$
$
Initial Cash Outlay
Approximate annual pretax rate of return
$
With
Leverage
1,200,000
692,381
507,619
Without
Leverage
$
1,200,000
$
$
1,200,000
150,000 $
27.60%
600,000
14.90%
FV of $450k loan ($450k*(1.09)^5) = $692,381
Terminology
Note: A note is a contract that says “I owe you money.” For a commercial real estate loan,
the note typically will include a more complicated version of the following language:
“Bank of America (the “Lender”) agrees to provide a $1,000,000 loan to
Cornell, LLC (the “Borrower”). Borrower agrees to make payments to
Lender on the first of the month, every month, in the amount of $5,995.51
(calculated as follows: 6% interest rate, 30 year amortization.) Borrower
agrees to pay the loan back in full to Lender by January 1, 2015 (the
“Maturity”).
Deed of Trust: A deed of trust is a security instrument that secures the note to the real
property. If the Borrower does not pay back the debt, the Lender has the legal ability to
foreclose on the property, sell the property, and use the proceeds to pay back the debt.
Loans that are not secured by a deed of trust do not have this ability and hence are called
unsecured loans.
The deed of trust is a deed wherein legal title to the property gets transferred to an
independent third party (a trustee), which holds it as security between the borrower and
the lender. The borrower is the trustor, and the lender is the beneficiary. If the debt is
paid off as indicated in the note, the trustee transfers title back to the trustor in what is
known as a reconveyance. If, however, the debt is not paid off according to the
specifications in the note, the trustee has the power to foreclose on the property by a clause
in the deed of trust known as the power of sale clause.
Deeds of trust can be secured by a 1st priority lien, a 2nd priority lien, a 3rd priority lien, etc.
(See next section.)
Mortgage: A mortgage is another kind of document that pledges real estate as collateral
for a loan, much like a deed of trust does. The main difference between a mortgage and a
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deed of trust has to do with the foreclosure process. A foreclosure under a deed of trust
can take place outside of the court system in a process known as “non-judicial
foreclosure”. A foreclosure under a mortgage can only take place via the court system in
a process known as “judicial foreclosure”. Mortgages are not used frequently in
California.
Seniority of Loan Instruments
Senior loan – also called a first deed of trust, or first mortgage, or sometimes just a “first”
for short. This is the highest “rung on the ladder” of debt, and first in line as compared to
other loans. As a result, these loans usually have the lowest interest rate, and comprise the
largest piece of a property’s capitalization.
Junior loan – also called subordinated debt, or a second mortgage, or sometimes just a
“second” for short. These instruments are lower (junior) to in collection priority. Because
of this, they have a higher rate. No one wants to be behind a big first mortgage unless it
is priced accordingly. Here is why:
Say you have an apartment building worth $1,000,000. There is a senior loan in first place
for $750,000 and a 2nd for $100,000. That means that there is $150,000 of equity in the
building. Now let’s assume that the owner of the building stops paying his mortgage for
whatever reason. The first has the right to accelerate the loan (call all $750,000 due at
once, not just the missing interest payments) and foreclose on the property. This means
that the second will get totally wiped out, unless it comes up with the $750,000 of fresh
cash out of pocket to cure the first. (This is in addition to the $100,000 that they already
loaned.) This is not a happy day for the holder of the 2nd mortgage! Keep in mind that
there was (and still is) equity in the property when they made their loan in 2nd place.
Therefore, one important aspect of being a lender in second position is your ability to come
out of pocket with fresh cash to cure the first. This is necessary in order to protect your
security interest as we saw in the example above.
This situation is made even more precarious if we consider a scenario in which values are
declining. Let’s assume that due to the recent “Great Recession”, the apartment building
is now only worth $800,000. Therefore, the second lender now can only hope to recover
$50,000 of the $100,000 loan he originally made. Because they are higher up in the capital
stack that the first, they will only achieve a partial recovery.
Amortization Alternatives
Interest only
Fully-amortizing (amortization = maturity)
Partially amortizing – balloon payment (amortization > maturity)
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Sample Calculations (Calculator and Tables)
Ex: 1810 Cherokee apartment building: $2.4M @ 6.1% annual interest rate, monthly payments
and monthly compounding intervals
Interest only – simple monthly calculations; principal paid at end.
Fully amortizing – constant payments calculated such that monthly interest is paid yet
principal paydown is big enough such that the loan reaches zero balance at end of term.
The amortization period is the length of time it takes for the principal balance to reach zero.
Partially amortizing – same as above, but maturity hits a wall; value of the balloon
payment can be calculated at any point in time; it’s the PV of all the remaining annuities
discounted at the note rate.
Alternative Interest Rate Provisions
Fixed rate loans – lock and pay for longer term (recall yield curve)
Adjustable rate loans (ARM) – Index rate + spread based on Yield-to-Maturity (YTM)
on Treasuries, average cost of funds, average mortgage rates, or LIBOR; adjustment period
frequency determines risk to lender
Negative ARM – limits interest payment, but interest unpaid gets added to principal
balance; these loans are no longer common as they can tend to create problems for
borrowers who only make minimum payments. Usually, these loans get “recast” every 5
years, meaning payments are recalculated using remaining term and prevailing rate. Some
banks will recast anytime principal balance reaches 110% of initial balance. Thus, this
type of loan only protects you in the short term until you are recast.
Additional topics
Recordation: Deeds of trust and mortgages are recorded on real property. Recordation is
a process of filing a document at the county recorder’s office so it becomes “of record” and
allows the public notice that a claim on the property exists. Although unrecorded
documents are fully effective and binding under common law, as a best-practice, all deeds
are always recorded. Here’s why:
The law assumes that once something is recorded, it provides constructive notice to the
public that such a claim exists on the property at a certain point in time. For example, let’s
assume that A sells a property to B, and B does not record the sale. One year later, A turns
around and sells the same property to C, who immediately records the sale. The law says
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that C now owns the property. (C would have had no way to know that B had a claim on
the property, since B did not record.)
California has what is known as the race-notice recording statute, which states that the first
party to record without notice of conflicting claims has priority. “Race” refers to the idea
of a “race” between two parties to the recorder’s office. (Each wants to be first to record.)
Senior loans are “senior” to junior loans because they were recorded first in time.
Chain of Title: The term chain of title refers to a chronological history of all documents
affecting title to a certain property. To be included in the chain of title, a document must
be properly recorded so that it may be discovered in a search of the property records at the
county recorder’s office. (In practice, this is all done electronically via a title company.
Title companies have digital copies of each document in a chain of title.)
Title Insurance: As you can imagine, there are massive amounts of records in a chain of
title, dating back to the first person who originally owned a piece of land. Because the risk
of missing a record could be catastrophic, title companies will offer insurance policies
stating that they guarantee a particular claim (for example, a loan) is in a given position in
the chain of title. No lender will make a loan without a title insurance policy insuring that
the lender is in (for example) first position.
Foreclosure: Foreclosure refers to the process by which a trustee conveys the title of a
property to a lender due to non-performance of a secured debt. For example, let’s assume
you get a loan on your house for $500,000 from Bank of America, and your monthly
payment is $3,000 per month. Let’s further assume that you lose your job and can’t pay
your monthly mortgage. Three months go by (and so, therefore, you are behind $9,000 in
your mortgage payments.) Bank of America will likely begin foreclosure proceedings.
Here are the steps that this entails:
First, the lender files a Notice of Default (also called an “NOD”.) This is a
formal document that gets recorded by Bank of America that says that you’ve
missed several payments on your loan, and therefore are in default under the terms
of the note. (Remember, the note is not recorded, but the deed of trust is recorded.)
The NOD basically says if you don’t cure the default immediately, BofA will sell
your house at a public auction. Sometimes, but not always, the NOD also includes
a clause whereby the debt is accelerated, meaning that not only do you have to pay
off the $9,000 immediately, but you also have to pay off all $500,000 immediately.
(If you have lost your job and can’t pay off the $9,000, the likelihood of you being
able to pay off the $500,000 is zero.)
Second, the lender files a Notice of Sale (also called a “NOS”). This is another
formal document that gets recorded by Bank of America. It basically says that if
you don’t pay off the entire loan ($500,000), it will instruct the trustee to conduct a
public auction of your deed of trust securing the house. The notice of sale always
gives the location and date of the auction (called a trustee’s auction.)
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Third, the trustee conducts the auction. Assuming the auction does not get
delayed (which can happen for a variety of reasons), the trustee will auction off the
deed of trust. If the deed of trust is in first position, the buyer of the deed will get
the house. If the deed of trust is in second position, the buyer of the deed will get
the house subject to the loan which is in first place (i.e., senior to him.) There are
a variety of other conditions and idiosyncrasies of trustee auctions which are
beyond the scope of this module. The important part is understanding that a secured
lender has the power to foreclose on a deed of trust and wind up owning the
property.
Trust Deed Investing: This is a type of real estate investing that involves purchasing
loans and holding them for interest. It is analogous to somebody who purchases a corporate
bond, only in this case you are getting the additional protection of a security interest.
Although as individuals we don’t usually think of being a real estate lender (typically
individuals are borrowers and banks are lenders), trust deed investing allows individuals to
be lenders.
Like anything else in life, there are certain trust deed investments which are excellent
investments and others which are not. The trick is figuring out (a) what position the loan
is in, (b) what the value of the property is, and (c) who your borrower is and why they have
procured a loan in this fashion, and (d) if the interest rate being offered if adequate to
compensate you for the risk you’re taking on.
Nominal Rate vs. APR vs. Effective Annual Yield
Differences:
(1) Nominal rate is simply the stated note rate
(2) Building on the nominal rate, APR also includes points/origination fees that deduct from
proceeds and makes APR > nominal rate
(3) Building on APR, EAY includes compounding frequency, which makes EAY > APR
Example:
A borrower signs a $100,000 mortgage note payable in equal monthly installments over 25 years,
with interest at 9 percent per annum on the unpaid balance. The lender charges a loan origination
fee equal
to 2 percent
(2%)
the face
amount of the
loan.
Loan
proceeds
= Face
ofofnote
– Origination
fee
Loan proceeds = Face value less origination fee
= $100,000 – (.02 x $100,000) = $98,000
But…
Loan PMT is based on the full $100k, so loan PMT is: $839.20/month
HP12C: 9 Enter 12 Divide =i; 300=n; 100,000=PV; PMT
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Now, if we want to find out the effective interest that is charged based on the actual $98,000
received…
HP12C: 839.20(CHS)=PMT; 98,000=PV; 300=n; I
This is monthly rate. Multiply by 12 to get the effective annual rate.
Comparing Effective Rates
Exercise
An investor is offered three alternative $1 million loan proposals. All the loans are fully amortizing
and require monthly payments.
a. There is a 2.5% origination fee for Loan A. The interest rate is 7.5% per annum. The
amortization period is 20 years, and there is no prepayment penalty.
b. Loan B requires a one-half percent loan origination fee. The contract interest rate is 8%
and the amortization period is 25 years. There is no prepayment penalty.
c. Loan C requires no loan origination fee. The interest rate is 8% and the amortization
period is 25 years. There is a prepayment penalty of 2% of the prepaid amount.
Effective Interest Rate with Three Borrowing Alernatives
When Loan Runs Full Term
Face Amount of Note
Less: Front-End Charges
Loan Proceeds
$
$
$
Monthly Payment
Effective Pre-tax Rate
$
A
1,000,000
25,000
975,000
8,055.93
7.84%
Loan Proposal
B
$ 1,000,000
$
5,000
$
995,000
$
$
$
$
C
1,000,000
1,000,000
7,718.16
8.06%
$
7,718.16
8.00%
922,739
922,739
$
$
$
922,739
18,455
941,194
Prepayment After Five Years
Remaining Balance after Five Years
Add: Prepayment Penalty
Payoff amount
Effective Pre-Tax Rate
$
$
$
869,021
869,021
8.15%
$
$
$
8.13%
8.31%
Refer to the 3 alternatives presented above. Goal is to find best possible EAY available. To do
this, find the EAY of each given the payoff assumptions (i.e., loan outstanding for whole term vs.
5-year prepay)
Find EAY for each alternative, assuming loan held for entire term. Alternative “A” looks best.
However, assuming a 5-year prepay, things change. Look at annuity plus balloon plus prepay
penalty (if any) to determine EAY of alternatives. Alternative “B” is now most appealing.
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You really need a computer to perform these calculations, but two points to note:
(1) Front-end fees give us higher EAY over short term because fee must be amortized over
short period. Thus, opt to pay points only if you’re holding the loan over the long haul.
(Lenders assume 3-4 year hold nowadays and add about 0.25 to the rate if you don’t pay
points; thus, this time period is the breakeven point to make this decision).
(2) Prepayment penalties (and yield maintenance) can radically affect an otherwise appealing
loan, so if you’re going to sell in the short-term or refinance, avoid these situations.
Incremental Cost of Borrowing
Say we can take a loan of:
(A)
(B)
$80k for 25 years, compounded monthly @ 12% or
$90k for 25 years, compounded monthly @ 13%
At first glance you may think that the incremental cost of extra $10k is 13%. To get the extra $10k
you must pay an additional 1% on the first $80k also. Increases the cost of the additional $10k
considerably. But how much?
(A)
(B)
Payment $842.58
Payment $1,015.05
Difference of PMT is $172.47
Want to find the annual rate of interest, compounded monthly, that makes the PV of the differences
in the payments ($172.47) equal to $10,000
Calculator solution:
n=300
PV=(10,000)
PMT=172.47
FV=0
Solve for I =20.57% ANNUAL (must multiply by 12)
Proof:
[($80k/$90k) x 12%] + [($10k/$90k) x 20.57%] = 13%
Key Takeaway: Unless you can earn more than this with an investment of equal risk, you are better
off using your $10k as down payment.
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Other Important Considerations
Aside from the effective interest rate or cost of borrowing, we must consider other factors that
differentiate various loan alternatives. These include factors that have both quantitative and
qualitative implications. Here are a few additional things to consider:
Recourse: allows the lender to pursue assets of individual guarantors in the event of a loan default.
Full recourse allows for a full guaranty of the loan amount, 50% allows for half, and so forth. Nonrecourse loans are also available from certain lenders; however these are priced slightly higher
(typically about half a point) to reflect the additional cost to the lender. In a non-recourse loan,
the lender can only pursue the assets of the borrowing entity with few exceptions.
Covenants: requirements placed on the borrower for the loan to remain in good standing. Often
times, a violation or non-performance of a covenant can lead to acceleration of the loan, requiring
immediate payoff. Common examples of loan covenants include:





Compliance with certain debt coverage ratios during the life of the loan
Periodic submission of borrower financial statements showing compliance with minimum
liquidity requirements
Requirements for no secondary financing to be placed on property (i.e., second mortgages)
Requirements to maintain adequate levels of insurance on the property
Requirements to remain current on property tax payments and any special assessments
Partitioning the IRR
When assessing the total returns on a project, it is useful to know how much of the total return is
dependent on cash flows from operations and how much is dependent on property appreciation.
Generally speaking, the overall undertaking becomes inherently riskier when a larger part of the
return is dependent on appreciation. To determine how the total IRR is distributed, or
“partitioned,” we must perform the following steps:
(1)
(2)
(3)
(4)
Compute the IRR
Discount cash flows from operations using the IRR
Discount cash flow from sale using the IRR
Compute the percentages
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Example:
Equity invested = $600,000
BTOCF1 = $40,000
BTOCF2 = $42,000
BTOCF3 = $45,000 + $800,000 from sale
IRR = 16.48%
Where BTOCF = Before-tax operating cash flow
PV of BTOCF = $93,773 (using 16.48% as discount rate)
PV of BTCF (sale) = $506,229 (discounting $800,000 at 16.48% for 3 years)
Percent from Operations = 15.63% ($93,773/$600,000)
Percent from Sale = 84.37% ($506,229/$600,000)
Usefulness of this Method:


This is useful for comparing alternative similar investments
For example, an alternative property may have the same IRR, but if the percentage of
return from sale relative to percentage of return from operations is higher, there may
be significantly higher risk associated with this property (dependence on future leases
not yet in place, rent growth, exit cap rate, etc)
MODULE 5: Risk/Reward Tradeoffs and Deal Structuring
Legal Ownership Entity Types
Below is a summary of the various legal ownership entity types used for real estate investing
(NOTE: this section only offers a high-level summary of ownership entities and their differences.
Please speak with a qualified legal professional before pursuing the establishment of an ownership
entity):
Sole Proprietorship: Real estate ownership is structured so that it is held by a single
individual. There are no formalities to create a sole proprietorship, and all economic
gains/losses are reported on the individual’s personal tax return. The sole proprietor has
unlimited liability, meaning that real estate losses can both wipe out equity invested and
courts could go after the individual’s personal assets to satisfy a judgement. Sole
proprietorships are not a common structure used to hold real estate because they do not
limit liability.
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Partnerships: Ownership entity where two or more entities share ownership. Partnerships
are pass through tax entities structured so partners own interest in the partnership, not in
the invested property. The two main types of partnerships are General Partnerships and
Limited Partnerships:
General Partnership is a structure where each partner has unlimited liability,
meaning one partner’s dealings with third parties can impact the remaining
partners. Because of this liability exposure, general partnerships are used in
combination with other legal ownership structures to help limit liability.
Limited Partnership (LP) is a legal entity that separates members into two separate
classes—general partner(s) and limited partner(s). An LP must have at least one
general partner and one limited partner. A partnership agreement outlines LP
agreement, explaining how the responsibilities differ between the two classes, and
how profits are split between general partners and limited partners. General partners
handle the details of asset investment and management decisions and have
unlimited liability exposure. The limited partner(s) risk is limited to only their
equity invested in the LP, and they do not participate in the day-to-day operations.
LP’s have a finite life that is specified in the partnership agreement.
Limited Liability Company (LLC): Ownership entity consisting of one or more members
where the liability is limited to only the financial stake committed by each member. LLCs
are structured so members own interest in the LLC, not in the property itself. LLCs are
very flexible in how they can be structured allowing members to distribute managerial and
financial responsibilities disproportionately, if desired. The two common types of LLC
structures are member-managed and manager-managed:
Member-Managed gives all members an equal say in business operations and
management decisions
Manager-Managed established a two-tier structure where the managers handle all
day-to-day operations (and do not necessarily have to be members of the LLC),
whereas members are owners who take a more passive role. This structure is similar
to a corporation.
Corporation: Legal entity owned by one or more shareholders and often managed by
directors. They will be registered at a state level via an article of incorporation, which is a
costly process. The main benefit offered by corporations is the limit on the liability they
give shareholders, who can only lose the equity invested in the corporation. Furthermore,
they are fairly liquid ownership entities because they are organized to operate in perpetuity.
C Corporations and S Corporations are the two types of corporations used for real estate
investment, they key difference between the two is taxation:
C-Corporation is a legal taxable entity that is owned by shareholders and managed
by directors. A c-corp is that it cannot operate as a pass-through tax entity, so
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investment returns will be “double-taxed” first at a corporate level, then at the
shareholder income level.
S-Corporation can elect to be taxed as a partnership, and thus avoiding “doubletaxation”. To elect s-corp status the shareholders must adhere to the following
conditions at the time of incorporation: Less than 100 shareholders, all of which
must be individual persons who are residents of the United States. Also, shares must
all be a single class of stock.
Joint Ventures (JV)
JV’s are a form of business agreement commonly used for large real estate investments. JV’s allow
parties to jointly pursue an investment, but distribute the economic benefits/burdens unevenly
between the parties. Typically a JV will be formed to bring together 1) a party with a high degree
of operational skill (e.g., a developer) with 2) a party with access to a deep pool of equity capital
(e.g., an institutional investor). The JV structure allows the two parties to share the investment
risks accordingly and structure the profits to align with each party’s risk tolerance.
JV’s are not a legal ownership entity in themselves, so will be organized as some combination of
sole proprietors, partnerships, corporations or trusts. These parties will come together an outline
terms using a JV agreement which outline the benefits and burdens of each party involved.
Common Deal Structure Terms and Example
Refer to in-class PowerPoint presentation
MODULE 6: Real Estate Taxation
Note: Our discussion of income taxes in intended only as a general overview of how taxes affect
real estate investments. Tax laws change very frequently, and many complexities in the Internal
Revenue Code area beyond the scope of this class. When considering the impact of taxes in real
estate investment, it is a good idea to consult a qualified tax professional.
For those of you who wish to learn more about taxation, pick up a copy of the Commerce Clearing
House U.S. Master Tax Guide, which is published annually and available through
www.amazon.com or www.tax.cchgroup.com
Important Distinctions
Personal Use
 Personal residence is not depreciable
 Gain on sale is tax exempt if primary residence for 2 out of the last 5 years
$250k individual; $500k married filing jointly; anything in excess of this exclusion
is considered capital gain
 Loss on sale has no tax consequences
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



Mortgage interest on the first $750,000 of home loan deductible
Property taxes deductible, but when combined with SALT, capped at $10k/year
Loan points deductible
Closing costs typically capitalized and added to cost basis
Investors: property “held for use in a trade or business”
 Most income producing real estate is included in this category
 Includes investors holding title as corporations, partnerships, LLCs and trusts
 Homes held for investment or rental purposes are included in this category, as well
as most income property within the various product types.
Dealers: those who intend to flip, or immediately resell; includes developers and those who
subdivide land for resale; refers to those who hold real estate as inventory available for sale
 Cannot take depreciation deductions
 Cannot enter into Section 1031 tax-deferred exchanges
 Must pay taxes at ordinary income tax rates, not capital gains rates
Entity Taxation: treatment of “C” corps (entity is taxed) differs from that of individuals,
partnerships, “S” corps and LLCs (entity not taxed; income passes through)
Definitions
Taxable income = NOI – interest expense – depreciation allowance
Depreciation: in theory, investors should only be taxed on income net of an economic allowance
for decreases in physical value
Historically, Congress has provided for allowances in excess of economic depreciation to stimulate
investment activity and increase the supply of available space (e.g., accelerated depreciation)


Residential real property depreciated straight-line over 27.5 years. To qualify as
residential real property, 80% or more of gross rental income must be from dwelling
units; otherwise it’s considered non-residential real property
Non-residential real property depreciated straight-line over 39 years
Under the Tax Cuts and Jobs Act of 2017, depreciable lives extend to 30 and 40 years for
residential and non-residential, respectively, when election is made to deduct all interest expense
past the allowable limits.
Depreciable basis: the amount that can be depreciated, which is usually equal to acquisition cost
plus capital improvements plus costs associated with placing property into service, such as legal
work, title insurance, et al. Costs associated with financing or costs incidental to purchase are not
included. Land has no depreciable basis, as it is not a depreciable asset
Allocating value between land and buildings: there are three generally accepted ways to do this
(1) Specify in the purchase and sale agreement
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(2) Order an appraisal
(3) Use the Tax Assessor’s ratio of land-to-improvements
Adjusted basis: depreciable basis less accumulated depreciation
Mid-month convention: during the month a property is placed into, or removed from, service, the
taxpayer can only claim half of the monthly allowance (e.g., property purchased or sold on
November 1st is treated as if sold on November 15th, and half month of depreciation is taken)
Disposal of Depreciable Real Property: tax is determined by subtracting adjusted basis from net
sales proceeds, which is gross sales price (cash or property received in payment for property sold,
plus liabilities against the property assumed by the buyer) less selling expenses (e.g., legal,
recording, brokerage fees).
Tax is paid on the difference between the net sales proceeds and adjusted basis, and divided into
two parts:
Capital Gains, which represents the “true” appreciation on the property (net sales proceeds less
cost basis). The Federal tax rate is currently 15-20% on capital gains and applies only if the
property has been held for investment purposes for at least one year.
Unrecaptured Depreciation, which represents the total accumulated depreciation taken form
acquisition through date of sale. The Federal tax rate is currently 25% on unrecaptured
depreciation.
Interest expense: generally deductible, principal is not
Loan points: deductible ratably over the term of the loan
Example: investor secures loan for $1 million to buy a building. The loan is partially
amortizing, with a 10-year maturity and 30-year amortization. Two points, or $20k,
are paid on the loan. For tax purposes, the $20k is deductible over 10 years, at a rate
of $2k per year. If the property is sold before all points are amortized, the balance can
be expensed in the year of sale. As such, if the building is sold and the loan is repaid
in year 5, the remaining $10k can be immediately expensed
Construction period interest and taxes: capitalized if incurred during the time of construction
Leasing commissions: capitalized and amortized over life of the lease
Income Classifications
Arose from 1986 Tax Reform Act
Passive income (or loss) is where investor does not materially participate in the management or
operation of property. Investment in rental property is considered passive
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Material participation requires satisfaction of both of the following criteria:
(1) More than half of all services individual performs during the year are for RE
trades/businesses; and
(2) Individual performs more than 750 hours of service per year on those activities
Active income (or loss) is where investor materially participates on a “regular, continuous and
substantial basis.” Salaries, wages and fees for service are active income. However, even if
taxpayer materially participates, income or loss from rental activity is not considered active income
(exceptions for hotels, nursing homes, et al.)
Passive Loss Limitations
Passive losses can only be used to offset passive income, with unused losses carried forward
indefinitely. When an investment producing passive income is sold and capital gain occurs, any
unused or suspended losses from that activity are:
(1) First used to offset any capital gain from sale;
(2) Next, used to offset any other passive income from that year;
(3) Next, used to offset any income from that year
Any excess is carried forward as a capital loss, not subject to passive loss rules
When an investment producing passive income is sold and capital loss occurs, and unused losses
from prior years remain, unused losses may be used to offset any sources of income. Of the capital
loss portion, $3k of the loss can be used to offset any other source of income for the year. Any
excess is carried forward indefinitely as a capital loss, not subject to passive loss rules
Special Passive Loss Exceptions
Individual rental property owners are allowed to offset active income with up to $25k of passive
losses (to the extent that passive losses exceed passive income) from rental activities in which
individual actively participates. Active participation is less stringent than material participation.
In general, the individual must own 10% or greater interest in the activity and be involved in
management decisions. This exception phases out for individuals at Adjusted Gross Income (AGI)
levels between $100k and $150k. The phase out reduces the $25k by 50% of every AGI dollar
above $100k.
Example: If AGI is $130k, limitation is reduced by $15k (50% of the difference between
$130k and $100k). The maximum allowable deduction is then $10k ($25k less the $15k
reduction)
For “material participation,” individuals can deduct unlimited real estate losses (Tax Act of 1993).
Section 1031 Tax Deferred Exchanges
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Refer to posted handout on course website for definitions and requirements.
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In-Class Case Study
Curtis Jackson purchased an apartment building in Queens, NY on December 9, 2019, at a cost of
$8M. According to the Tax Assessor, the building has an assessed value of $6M and the land has
an assessed value of $2M. As of May 31, 2022, the date on which he plans to sell, the property
has a value of $12M. Curtis has a loan of $6M on the property and no other liabilities.
Question 1: As of May 31, 2022, what was Curtis’ adjusted basis in the property?
Monthly dep. = $18,182 [use $6M over 330 per. (27.5 yrs. X 12)]
Use ½ month convention for Dec. 2019 and May 2022 (total 29 mos.)
Accumulated depreciation = $18,182 x 29 months = $527,278
Adjusted basis = $8M – $527,278 = $7,472,722
Later on that day Curtis decides to enter into a like-kind exchange with Shawn Carter, an unrelated
party. The new property, an apartment building in Brooklyn, has a fair market value of $17M, and
Curtis is going to assume a loan of $9M on the new property. This transaction requires Curtis to
contribute $2M cash for the purchase of the new property. Shawn’s adjusted basis in his property
before exchange is $10.5M.
New adjusted basis (after exchange) is a function of:
(1) Carryover basis
(2) Net loan assumption/relief
(3) Cash conveyed/received (“boot”)
To compute new adjusted basis, we start with carryover basis, then make the following
adjustments:
(1) If there is net loan assumption and cash conveyed, add the two to old basis to get new basis.
There is no taxable gain in this case;
(2) If there is net loan relief and cash received, both are considered taxable income and basis
doesn’t change;
(3) If there is net loan assumption and cash received, the cash received is taxable and the net
loan assumption is added to old basis to arrive at new basis;
(4) If there is net loan relief that is partially offset by cash conveyed, the excess of net loan
relief over cash conveyed is taxable, and the basis does not change
(5) If there is net loan relief that is fully offset by cash conveyed, the excess of cash conveyed
over net loan relief is added to basis, and there is no taxable gain
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Question 2:
What are Curtis’s and Shawn’s adjusted bases, realized and recognized gains after the exchange?
FMV
Loan
Equity
Adjusted Basis
Cash Received (Conveyed)
Loan Relief (Assumed)
Basis after Exchange
Realized Gain
Recognized (taxable) gain
Shawn (in millions)
17
9
8
10.5
2
3
10.5
6.5
5
Curtis (in millions)
12
6
6
7.47
(2)
(3)
7.47 + 2 + 3 = 12.47
12 – 7.47 = 4.53
0
One year later, Sean Combs makes an offer of $20M on the Brooklyn property, resulting in an
immediate sale. Curtis must pay a 6% commission on the sale.
Question 3:
What are the Federal tax consequences to Curtis upon sale, assuming the land allocation is 30%?
Curtis’ Brooklyn building depreciation schedule
Depreciable basis = [$12,472,722 x 70% (land @ 30%)] = $8,730,905
Depreciation expense/month = $8,730,905/330 periods = $26,457
Accum. dep. for Curtis’ holding per. = $26,457 x 12 mos. (1/2 mo. conv.)= $317,487
Adjusted basis @ sale = $12,472,722 – $317,487 = $12,155,235
Net sales proceeds = $20M x (100% – 6%) = $18.8M
Total gain on sale = $18.8M – $12,155,235 = $6,644,765
Unrecaptured dep. = $527,278 + $317,487 = $844,765
Capital gain = total gain – unrecaptured dep. = $5.8M
Intuition: The $5.8M makes sense if you consider that we “gained” $4M (or $12M – $8M) from
the first transaction and $1.8M (or $18.8M – $17M) from the second transaction
Tax liability = (25% x $844,765) + (20% x $5.8M) = $1,371,191
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MODULE 7: Disruption and Structural Shifts in Real Estate
Structural Change vs. Cyclical Change
Cyclical factors (see Module 2) only partially drive real estate values. Structural changes also drive
value. Structural shifts—i.e. technological advances, demographic shifts, political regime
changes—fundamentally change the way physical space is utilized. Unlike cyclical changes, where
trends usually revert back to the historical mean, structural shifts cause changes that have little
resemblance with past performance.
Recall that the “fair value” of a property is the present value of all future cash flows, and to
establish a baseline understanding an investor typically begins by analyzing past performance.
When a property type is in the midst of structural shift, past performance may be a poor indicator
of future growth, and may not help with determining future cash flows.
Generally structural shifts have dramatic impacts on real estate at a property type level and the
timing and magnitude of a their impact can be heavily debated among investors.
A current example: There is disagreement among investors regarding the extent to which
e-commerce’s growth impacts brick-and-mortar retail sales. Some investors argue we are
at the beginning of storefront obsolescence, while other investors believe that storefronts
still serve an essential purpose, and are in the process of adapting to digital consumers’
preferences. Regardless of which argument is ultimately true, the future cash flow
performance of brick-and-mortar retail will not resemble the past, making the estimate of
current “fair value” an extremely difficult exercise.
Finally, it is important to note that when a property type is undergoing structural changes, this does
not mean it has ceased to be impacted by the cyclical changes as well. Instead an investor must
carefully incorporate analysis that overlays both cyclical and structural factors simultaneously
impacting future growth expectations when estimating a property’s value.
Current Structural Changes Impacting Real Estate
Please refer to in-class PowerPoint presentation for observations on current disruptors causing
structural shifts impacting various real estate property types.
Deal Sourcing: Listed or off-mkt
(Principals, Brokers, Sales/Mktg)
Offer and due diligence
(Principals, Brokers, Consultants, Market Research, Inspectors)
Financing
(Equity and debt finance, appraiser, mortgage broker/banker, M&A)
Closing: Transaction Support
(Escrow, title, legal, insurance, acctg, etc)
Asset Management
(Property mgmt, leasing, construction/maintenance, tax/acctg, etc)
Reversion/Exit
(return to top)
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