Part One Real Estate as an Investment: An Introduction
Chapter 1 Real Estate - The Global Asset 3
1.1 The Global Property Investment Universe 3
1.2 Market Players 6
1.2.1 Investors 6
1.2.2 Fund Managers 9
1.2.3 Advisors 9
1.3 Property - Its Character as an Asset Class 11
1.3.1 Property Depreciates 12
1.3.2 Lease Contracts Control Cash Flows 13
1.3.3 The Supply Side is Inelastic 13
1.3.4 Valuations Influence Performance 14
1.3.5 Property is Not Liquid 15
1.3.6 Large Lot Sizes Produce Specific Risk 16
1.3.7 Leverage is Commonly Used in Real Estate Investment 18
1.3.8 Property Appears to be an Inflation Hedge 19
1.3.9 Property is a Medium-Risk Asset 21
1.3.10 Real Estate Cycles Control Returns 22
1.3.11 Property Appears to be a Diversifying Asset 24
Specific Risk 27
Leverage 27
Illiquidity 28
Taxes, Currency, and Fees 28
1.4 Conclusion 28
Chapter 2 Global Property Markets and Real Estate Cycles, 1950-2020 33
2.1 Introduction and Background 33
2.1.1 The Property Cycle 33
2.2 A Performance History 34
2.2.1 Before 1970: Real Estate Becomes a Medium-Return Asset 34
2.2.2 The 1970s: Inflation, Boom, and Bust 36
The USA 36
The UK 37
2.2.3 The 1980s: New Investors Flood the Real Estate Capital Market 38
The USA 38
The UK 42
2.2.4 The 1990s: The Rise of REITs 43
The USA 43
The UK: Deep Recession, Low Inflation, and Globalization 45
2.2.5 2002-7: A Rising Tide Lifts All Boats 47
The USA 47
The UK 59
2.2.6 The Global Real Estate Credit Crisis Hits 60
The USA 60
The UK 67
2.2.7 The Markets Recover Post-crisis 70
2.3 The Global Market 72
2.3.1 The European Market Develops 72
2.3.2 Asia Emerges 75
2.4 Real Estate Cycles: Conclusion 80
Lesson 1: Too Much Lending to Property is Dangerous 80
Lesson 2: Yields are Mean-Reverting - Unless Real Risk-Free Rates Change 81
Lesson 3: Look at Yields on Index-Linked 81
Chapter 3 Market Fundamentals and Rent 83
3.1 Introduction: The Global Property Cycle and Rent 83
3.2 The Economics of Rent 84
3.2.1 Rent and Operational Profits 84
3.2.2 Theories of Rent 86
Ricardo 86
von Thünen 87
Fisher 89
3.2.3 Rent as the Price of Space 90
3.2.4 Supply 91
3.2.5 Demand 93
The Cyclical Demand for Space 93
The Structural Demand for Space 94
Variations in Locational Demand by Use 95
3.2.6 The Relationship Between Rental Value and Rental Income 97
3.2.7 The Impact of Currency Movements on Rent 99
3.2.8 Property Rents and Inflation 99
3.3 Forecasting Rents 101
3.3.1 Forecasting National Rents 101
Model Types 101
Price 102
Demand 102
Supply 102
Building the Model 104
An Historical Model 104
A Forecasting Model 105
3.3.2 Forecasting at the Local Level 105
Conceptual and Modelling Problems 106
Data Issues 106
3.4 Conclusion 107
Chapter 4 Asset Pricing, Portfolio Theory, and Real Estate 109
4.1 Risk, Return, and Portfolio Theory 109
4.1.1 Introduction 109
4.1.2 Risk and Return 110
4.1.3 Portfolio Theory 111
The Efficient Frontier 111
4.1.4 Risk and Competitors 112
4.1.5 Risk and Liabilities 113
4.1.6 Property Portfolio Management in Practice 113
The Investment Strategy 114
4.2 A Property Appraisal Model 115
4.2.1 Introduction: The Excess Return 115
4.2.2 The Cap Rate or Initial Yield - A Simple Price Indicator 116
UK Terminology 116
US Terminology 117
How are Cap Rates Estimated in Practice? 118
Cap Rates are the Inverse of Price/Earnings Ratios 118
What Drives the Cap Rate? 119
4.2.3 The Fisher Equation 121
4.2.4 A Simple Cash Flow Model 121
4.2.5 Gordons Growth Model (Constant Income Growth) 122
4.2.6 A Property Valuation Model Including Depreciation 122
4.3 The Model Components 123
4.3.1 The Risk-Free Rate 123
4.3.2 The Risk Premium 124
What is Risk? 124
The Capital Asset Pricing Model 125
4.3.3 Inflation 127
4.3.4 Real Rental Growth 128
4.3.5 Depreciation 128
4.3.6 'Correct Yields 129
4.3.7 An Analysis in Real Terms 129
4.4 The Required Return for Property Assets 130
4.4.1 The Sector Premium 130
4.4.2 The City Premium 131
4.4.3 The Property Premium 131
4.4.4 Example 131
Tenant 131
Tenure 132
Leases 132
Building 132
Location 132
4.5 Forecasting Real Estate Returns 135
4.5.1 The Origin and Uses of Property Forecasts 135
4.5.2 Forecasting Cap Rates 136
4.5.3 Forecasting Property Cash Flows 138
4.5.4 The Portfolio Model 138
4.5.5 Example 139
4.5.6 Fair Value Analysis 141
4.6 Conclusion: A Simple Way to Think About Real Estate Returns 141
Part Two Making Investment Decisions at the Property Level
Chapter 5 Basic Valuation and Investment Analysis 145
5.1 Introduction 145
5.1.1 Cash Flow 146
5.1.2 Risk and the Discount Rate 147
5.1.3 Determining Price 147
5.1.4 Determining Return 148
5.2 Estimating Future Cash Flows 148
5.2.1 Introduction 148
5.2.2 Holding Period 149
5.2.3 Lease Rent 149
5.2.4 Resale Price 149
Estimated Rental Value at Resale 150
Going-Out Capitalisation Rate 150
5.2.5 Depreciation 150
5.2.6 Expenses 152
Fees 152
Taxes 152
Debt Finance (Interest) 153
5.3 The Discount Rate 153
5.4 Conclusion 156
Chapter 6 Leasing 159
6.1 Introduction 159
6.2 Legal Characteristics of Leases 160
6.3 The Leasing Process 161
6.4 Important Economic Elements of a Lease 161
6.4.1 The Term of the Lease 162
6.4.2 Base Rent and Rent Escalation Provisions 162
6.4.3 Options 163
Renewal Options 163
Expansion, Contraction, and Termination Options 163
6.4.4 Measurement of Space 164
6.4.5 Expense Treatment 165
Gross Lease 165
Triple Net Lease 168
6.4.6 Concessions: Tenant Improvement Allowance and Rental Abatement 170
Tenant Improvement Allowance or Tenant Upfit/Fitout 170
Rental Abatement (Rent-Free Periods) 171
6.4.7 Brokerage Commissions 172
6.4.8 Other Key Elements of a Lease 174
6.4.9 Leasing Differences Across Property Types 175
6.5 Lease Economics and Effective Rent 177
6.5.1 Comparing Leases with Different Expense Treatment 177
The Landlords Perspective 177
The Tenants Perspective 178
6.5.2 Comparing Leases with Different Concession Allowances 179
Landlords Perspective 180
Tenants Perspective 181
6.6 Conclusions 183
Appendix: Modeling Lease Flexibility In The Uk 183
Example 185
Assumptions 185
Result 185
Explanation 186
Chapter 7 Techniques for Valuing Commercial Real Estate and Determining Feasibility: The Unleveraged Case 187
7.1 Introduction 187
7.2 Background on the Investment Opportunity 188
7.2.1 Project Details 188
7.2.2 Where Do You Find Information About Income and Expenses? 189
7.3 Developing a Pro Forma Income Statement 190
7.3.1 Calculating Total Revenues 191
7.3.2 Estimating Vacancy Loss 191
7.3.3 Estimating Operating Expenses 192
7.3.4 Calculating Net Operating Income 193
7.4 Valuation Using Net Operating Income: Single-Year Cash Flow 193
7.4.1 An Aside on Capitalization Rates 194
Estimating the Market Cap Rate 194
Cap Rates are the Inverse of Price/Earnings Ratios 195
Using Cap Rates to Value the Apartment Project 195
Calculating the Implied Cap Rate for the Apartment Investment Opportunity 196
7.5 Investment Analysis Using Operating Income: Multiple-Year Cash Flows 197
7.5.1 Operating Cash Flows from Leasing 197
7.5.2 Cash Flows from Disposition 198
7.6 Applying Discounted Cash Flow to Analyze Investment Feasibility 200
7.6.1 Determining Feasibility 200
7.6.2 Equity Multiple 200
7.6.3 Partitioning the Internal Rate of Return 201
7.6.4 Calculating the Maximum Price to Pay 202
7.7 Sensitivity Analysis 202
7.8 Conclusion 203
Chapter 8 Mortgages: An Introduction 205
8.1 Introduction 205
8.2 What is a Mortgage? 206
8.2.1 Promissory Note 206
8.2.2 Mortgage Instrument 206
8.3 The Risks and Returns of Mortgage Investment 207
8.4 The Financial Components of a Mortgage 208
8.4.1 The Bond Component 208
8.4.2 The Call Option Component 208
8.4.3 The Put Option Component 209
8.5 The Mortgage Menu 210
8.5.1 Fixed or Floating-Rate Loans 210
8.5.2 Fully or Partially Amortizing Loans 211
8.6 An Introduction to Mortgage Math 212
8.6.1 Calculating the Monthly Payment 212
8.6.2 The Mortgage Loan Constant 213
8.6.3 The Amortization Schedule 213
8.6.4 Converting from the Contract Rate to the Compounded Rate 217
8.6.5 Determining the Cost of Borrowing 217
Borrowing Cost without Up-front Fees 217
Borrowing Costs when the Lender Charges Fees 219
Borrowing Costs when the Loan is Prepaid Prior to Maturity 220
8.7 Calculating Prepayment Penalties 220
8.7.1 Lockout Periods 221
8.7.2 Step-down Prepayment Penalties 221
8.7.3 Yield Maintenance Penalties and Yield Calculations 222
8.7.4 Treasury Flat Prepayment Penalty 225
8.7.5 Defeasance 228
8.8 Conclusion 228
Chapter 9 Commercial Mortgage Underwriting and Leveraged Feasibility Analysis 229
9.1 Introduction 229
9.2 Mortgage Underwriting and the Underwriting Process 229
9.2.1 Ratios and Rules of Thumb 230
Loan-to-Value Ratio 230
Debt Coverage Ratio 230
Debt Yield 232
9.2.2 Determining the Maximum Loan Amount 232
Operating Expense Ratio 236
Breakeven Ratio 236
Debt Yield 237
9.3 Investment Feasibility with Leverage: Before-Tax Analysis 238
9.3.1 The Two-Part Nature of Cash Flows: Operating Income and Disposition Income 238
9.3.2 Financing Impact on Investor Income Statements: Adding Debt Service Cash Flows 238
Income from Disposition 239
9.3.3 Determining Investment Feasibility: The Leveraged Before-Tax Case 240
Static or Single-Year Measures of Investment Performance 240
Determining Investment Feasibility Using Multiple Year Cash Flows 242
Equity Multiple 242
Partitioning the IRR and NPV 242
Determining the Maximum Price to Pay with Leverage 243
9.4 Sensitivity Analysis 244
9.5 Conclusion 245
Chapter 10 Real Estate Development 247
10.1 Introduction 247
10.2 The Development Process 248
10.3 Preliminary Analysis of 'The Station' Development 250
10.3.1 'Back-of-the-Envelope' Analysis 250
Estimating Construction Costs 251
Estimating Market Value 251
10.3.2 Adding Construction Financing 253
10.3.3 Sensitivity Analysis 254
10.4 Formal Analysis of Development of 'The Station' 257
10.5 Budget for 'The Station' Office Project 258
10.6 Financing Development 259
10.6.1 Stage One: Pre-construction 260
10.6.2 Stage Two: Construction 260
Construction Loan Calculations 260
10.6.3 Stage Three: Lease-Up 263
10.6.4 Stage Four: Operations 264
Lender Yield Calculation for the Construction Loan 264
10.7 Developer Profit and Return 265
10.8 Comparison to 'Back-of-the-Envelope' Analysis 266
10.9 A London Office Development Through the Cycle 267
10.10 Conclusion 274
Part Three Real Estate Investment Structures
Chapter 11 Unlisted Real Estate Funds 277
11.1 Introduction to Unlisted Real Estate Funds 277
11.1.1 The US Market 278
11.1.2 The Global Market 278
11.2 The Growth of the Unlisted Real Estate Fund Market 280
11.2.1 The Global Unlisted Property Market Universe 281
11.2.2 How Much Global Real Estate is in Unlisted Funds? 283
11.3 Unlisted Fund Structures 284
11.3.1 Open-Ended Funds 285
11.3.2 Closed-Ended Funds 286
11.3.3 Funds of Funds 287
11.4 Characteristics of Unlisted Real Estate Funds 288
11.4.1 Style 288
11.4.2 Investment Restrictions 289
11.4.3 Property Sector and Geographic Focus 290
11.5 Liquidity and Valuation Issues 291
11.5.1 Liquidity 291
11.5.2 Valuation 294
11.6 The Case for and Against Unlisted Real Estate Funds 294
11.6.1 The Case for Unlisted Real Estate Funds 294
Unlisted Real Estate Funds can Diversify Real Estate-Specific Risk 294
Unlisted Funds are Priced by Reference to NAV 294
Unlisted Funds Provide Access to Specialist Managers 295
11.6.2 The Case Against Unlisted Real Estate Funds 295
The Drawdown Profile 295
Gearing and the J-curve Effect 296
Fees and Performance Persistence 297
Do Trading Prices Track NAV? 297
11.7 Conclusion 300
Chapter 12 Real Estate Private Equity: Fund Structure and Cash Flow Distribution 301
12.1 Introduction: The Four Quadrants and Private Equity 301
12.2 Private Equity Fund Background 303
12.3 The Lifecycle of a Private Equity Fund 304
12.3.1 Initial Fundraising 304
12.3.2 Acquisition Stage 305
12.3.3 Asset Management 306
12.3.4 Portfolio Management 306
12.3.5 End of Fund Life 307
12.4 Fund Economics 307
12.4.1 Management Fees 307
12.4.2 Limited Partner Distributions 307
Return of Initial Capital 308
Preferred Return 308
Carried Interest 308
Promoted Interest 309
12.5 Waterfall Structures 310
12.5.1 Introduction 310
12.5.2 Pro-rata Investment and Distribution 311
12.5.3 All Equity Provided by Limited Partner, 80%/20% Carried Interest 311
12.5.4 Adding a Preferred Return 312
12.5.5 Return of Capital, Simple Interest Preferred Return, Carried Interest 314
Adding Management Fees 316
12.5.6 Return of Capital, Compounded Interest Preferred Return, Carried Interest 317
12.6 Private Equity Structures in the Credit Crisis 319
12.7 Conclusion 321
Chapter 13 Listed Equity Real Estate 323
13.1 Introduction 323
13.2 REITs and REOCS 324
13.3 Listed Funds and Mutual Funds 324
13.4 Exchange-Traded Funds 325
13.5 The US REIT Experience 325
13.5.1 Introduction 325
13.5.2 Distributions 326
13.5.3 Measuring REIT Net Income 327
Defining Net Income 327
Funds from Operations 329
13.5.4 Performance 332
Summary 335
13.6 The Global Market 335
13.6.1 The Global Property Company Universe 335
13.6.2 The Global REIT Universe 335
13.6.3 The UK REIT 338
13.7 REIT Pricing 339
13.7.1 Using Earnings to Value REITs 339
13.7.2 Market Capitalization and Net Asset Value 340
13.7.3 Premium or Discount to NAV? 340
Instant Exposure 341
Liquidity/Divisibility 342
Asset Values are Higher than the Reported NAV 342
Projected Asset Values are Expected to Exceed the Reported NAV 342
Management Skills 342
Tax 343
Debt 343
13.8 Conclusion 343
Chapter 14 Real Estate Debt Markets 345
14.1 Introduction 345
14.2 A Brief History Lesson 347
14.2.1 Banking in the 1960s and 1970s 347
14.2.2 The Volcker Era of High and Volatile Interest Rates 349
14.3 Wall Street Act I: The Early Residential
Mortgage-Backed Securities Market 349
14.3.1 The Securitization Process Explained 350
14.3.2 Lender Profitability from Securitization 353
14.4 Wall Street Act II: Senior-Subordinated Securities, the Advent of Structured Finance 354
14.4.1 The Coast Federal Savings and Loan Deal 354
14.4.2 Risk and Return Characteristics of the Senior-Subordinated Structures 358
14.5 Wall Street Act III: The Evolution of Structured Finance 359
14.5.1 An Updated Look at the Senior-Subordinated Security 359
14.5.2 Who Profits from these Transactions? 362
14.6 Collateralized Debt Obligations 363
14.7 Mezzanine Debt 365
14.7.1 Mezzanine: The Background 365
14.7.2 Mezzanine Structures 366
14.7.3 A UK Example 368
14.8 Whole Loans and Synthetic Mezzanine 368
14.9 Income Strips 369
14.10 Cash-out Refinancing 371
14.11 All Good Things Must Come to an End 373
14.11.1 The Cash-out Refinancing Example Extended 374
14.12 Post-crisis Recovery 381
14.12.1 A Final Update to the Cash-out Refinancing Example 382
14.13 Conclusion 383
Part Four Creating a Property Investment Portfolio
Chapter 15 Building the Portfolio 387
15.1 The Top-Down Portfolio Construction Process 387
15.1.1 Introduction 387
15.1.2 Risk and Return Objectives 390
The Relative Return Target 392
The Absolute Return Target 393
15.1.3 Benchmarks 394
15.2 Strengths, Weaknesses, Constraints: Portfolio Analysis 394
15.2.1 Current Portfolio Structure 394
15.2.2 Strengths, Weaknesses, Constraints 395
15.2.3 Structure and Stock Selection 395
15.3 Portfolio Construction 397
15.3.1 Top-Down or Bottom-Up? 397
15.3.2 Mixing Listed and Unlisted Real Estate 398
15.3.3 Can Real Estate Investors Build Efficient Portfolios? 400
15.3.4 Possible Approaches 403
Case 1: Large US Endowment Fund 403
Case 2: UK Family Office 406
15.4 Conclusion 409
Chapter 16 International Real Estate Investment: Issues 411
16.1 Introduction: The Growth of Cross-Border Real Estate Capital 411
16.2 The Global Real Estate Market 413
16.2.1 The Global Universe 413
16.2.2 Core, Developing, Emerging 413
16.2.3 Transparency 414
16.2.4 The Limits to Globalisation 414
16.3 The Case for International Real Estate Investment 415
16.3.1 The Case for International Real Estate Investment: Diversification 415
16.3.2 The Case for International Real Estate Investment: Enhanced Return 417
16.3.3 Other Drivers of International Property Investment 418
16.4 The Problems 419
16.4.1 Introduction 419
16.4.2 Index Replication and Tracking Error 419
16.4.3 Leverage 420
16.4.4 Global Cycles, Converging Markets 420
16.4.5 Execution Challenges 421
16.4.6 Loss of Focus and Specialisation 421
16.5 Formal Barriers 421
16.5.1 Legal Barriers 421
16.5.2 Capital Controls 422
16.5.3 Tax 422
16.6 Informal Barriers 425
16.6.1 Introduction 425
16.6.2 Currency Risk 425
16.6.3 Legal and Title Risk 426
16.6.4 Liquidity Risk 427
16.6.5 Geographical Barriers 427
16.6.6 Political Risk 428
16.6.7 Cultural Barriers 428
16.6.8 Information Asymmetry 429
16.7 A Pricing Approach for International Property 429
16.7.1 Example 429
16.7.2 Theories of Interest Rates and Exchange Rates 431
The Law of One Price 431
Absolute Purchasing Power Parity 431
Relative Purchasing Power Parity 432
The Monetary Model of Exchange Rates 432
The Fisher Equation 432
Interest Rate Parity 432
Putting Relative Purchasing Power Parity and Interest Rate Parity Together with the Fisher Equation 432
16.7.3 Putting Theory into Practice 433
16.7.4 Using Local Excess Returns 438
16.8 Managing Currency Exposure and Currency Risk 441
16.8.1 Diversifying 442
16.8.2 Using a 'Currency Overlay 442
16.8.3 Using Local Debt 443
16.8.4 Hedging Equity 444
16.8.5 Leverage, Tax, and Fees 446
16.9 Building a Portfolio 447
16.10 Conclusion 450
Chapter 17 Performance Measurement and Attribution 451
17.1 Performance Measurement: An Introduction 451
17.2 Return Measures 452
17.2.1 Introduction 452
Income Return 453
Capital Return 453
Total Return 453
Time-Weighted Return 454
Internal Rate of Return 454
17.2.2 Example: IRR, TWRR, or Total Return? 454
IRR or TWRR? 456
IRR or Total Return? 456
17.2.3 Required and Delivered Returns 456
The Required Return 456
The Delivered Return 458
17.2.4 Capital Expenditure 459
Timing of Expenditure 460
17.2.5 Risk-Adjusted Measures of Performance 460
17.3 Attribution Analysis: Sources of Return 462
17.3.1 Changes in Initial Yields 462
17.3.2 The Combined Impact 464
17.4 Attribution Analysis: The Property Level 465
17.5 Attribution Analysis: The Portfolio Level 467
17.5.1 Introduction 467
17.5.2 The Choice of Segmentation 468
17.5.3 Style 469
17.5.4 Themes 470
17.5.5 City or Metropolitan Statistical Area Selection 471
17.5.6 Two or Three Terms? 471
17.5.7 The Formulae 472
17.5.8 Results from Different Attribution Methods 473
Case 1 474
Case 2 474
17.6 Attribution and Portfolio Management: Alpha and Beta 474
17.6.1 Alpha and Beta Attribution: An Introduction 474
17.6.2 Sources of Alpha and Beta 476
17.7 Performance Measurement and Return Attribution for Property Funds 477
17.7.1 Introduction 477
17.7.2 The Asymmetry of Performance Fees 478
17.7.3 An Attribution System for Funds 480
17.7.4 Alpha and Beta in Property Funds: A Case Study 482
17.7.5 Unlisted Fund Performance: Empirical Evidence 485
The Data 485
Relative Returns 486
Alpha and Beta 486
Timing: IRR and TWRR 488
IRRs and Vintage Year 488
17.8 Conclusion 489
Chapter 18 Conclusions 491
18.1 Why Property? 491
18.2 Lessons Learned 493
18.2.1 Liquid Structures 493
18.2.2 Unlisted Funds 494
18.2.3 International Investing 495
18.2.4 Best-Practice Real Estate Investing 495
18.2.5 Pricing 496
18.3 The Future 496
18.3.1 The PropTech Explosion 496
18.3.2 Smart Buildings and ESG 499
18.3.3 Occupier Markets: Space as a Service 499
18.3.4 Fractionalization and Liquidity 500
Liquidity and Faster Transactions 500
Tokenization and Fractionalization 502
18.3.5 Derivatives 502
18.4 Conclusion 504
References 509
Glossary 515
Index 527
