CRE Technicals

Question 1

What are the different types of real estate firms?

Answer 1

REPE (RE Priv Equity)
REIT (RE Investment Trust)
RE Development Firm
RE Investment Management
REOCs (RE Operating Companies)
RE Brokerage Firms

Question 2

Real Estate Private Equity

Answer 2

-Raise capital from investors
-Acquiring and developing commercial properties (buildings), managing the properties, and selling the improved properties to realize a profit

Question 3

Real Estate Investment Trust

Answer 3

-Own a portfolio of income-generating real estate assets over various sectors
-Exempt from corporate-level income taxes
-Ex. the obligation to issue 90% of their taxable income as shareholder dividends
-Most are publicly traded & must follow SEC guidelines

Question 4

Real Estate Development Firm

Answer 4

-Build properties from scratch

Question 5

Real Estate Investment Management

Answer 5

-Raise funding from limited partners to acquire, develop, and manage commercial properties to sell them at a profit later
-Different from REPE because REIMs usually have no end date (open-end funds)

Question 6

Real Estate Operating Companies

Answer 6

-Purchase and manage real estate, like REITs, but REOCs re-invest their earnings rather than the mandatory distribution to shareholders
-“Double taxation”: income taxation occurs at the entity and shareholder levels – contrary to REITs.

Question 7

Real Estate Brokerage Firms

Answer 7

-Intermediaries to facilitate transactions on both sides
*Protect the interests of their clients in transactions involving the purchase, sale, or leasing of real estate assets
*Help clients identify a new property to purchase or market and sell a property on behalf of the client or even negotiate the terms of a lease

Question 8

Property Classes in RE investing

Answer 8

Class A: Class A premium properties in prime locations with top-of-the-line amenities. Low risk, low reward investing

Class B: More outdated, yet are built and renovated with high-quality construction material and maintained well. Offer higher yields with upside potential from the value-add opportunities

Class C: more outdated in infrastructure and located in bad areas regarding the outlook on rent pricing and market demand. More upside in returns on Class C properties to compensate investors

Class D: distressed assets because of their poor condition. Class D properties are located in areas with collapsing market demand. Investors tend to avoid Class D properties

Question 9

What are the four main real estate investment strategies?

Answer 9

Core: Lowest risk. Modern properties in prime locations occupied by creditworthy people

Core-plus: Necessity for capital improvements, marginally riskier (low-to-moderate risk)

Value-add: growth-oriented and carry a moderate-to-high risk profile

Opportunistic: involve the most complicated, time-consuming projects – such as new development or redevelopment. No CFs on date of acquisition though has potential to have large returns in the future.

Question 10

What is the real estate capital stack?

Answer 10

Common Equity: highest risk/reward. Equity claims are last in priority in the event of default.

Preferred Equity: blends features of debt and common equity but is only senior to common equity and subordinate to all debt.

Junior (mezzanine) debt: Bridges gap between equity + senior debt. The interest rate is higher than senior debt because it’s unsecured and of lower priority. Possess the right to take control of a property in the event of default.

Senior Debt: Highest priority. It can be the standard mortgage loan. Return is lowest as the borrower pledges collateral as part of the financing arrangement.
Senior debt lenders, such as banks, are first in priority of repayment

Question 11

What are the four stages of the real estate cycle?

Answer 11

Recovery: Market coming out of the trough, low occupancy rates with no demand, construction, etc.

Expansion: the economy and real estate market show improvements (ex. unemployment rate)

Hyper-supply: prices of properties initially retain their upward momentum before starting to descend downward from the oversupply in inventory. Buyers have power.

Recession: Ex. high unemployment

Question 12

What influences the real estate cycle?

Answer 12

Interest rates, economy, government intervention, consumer income, etc.

Question 13

What are vacancy and credit losses?

Answer 13

Vacancy loss: percentage of units available for rent that were left unoccupied in a given period (opportunity cost)

Credit loss: inability to collect rent from tenants

Question 14

How do you calculate Effective Gross Income?

Answer 14

Effective Gross Income (EGI) = Potential Gross Income (PGI) – Vacancy and Credit Losses

Question 15

How do you calculate vacancy rate?

Answer 15

Vacancy Rate (%) = Number of Vacant Units/Total Number of Units

Question 16

What is NOI in real estate?

Answer 16

Profit potential of income-generating properties before subtracting non-operating costs.

Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses

Ancillary Income: parking passes, ammenities, etc.

Direct Operating Expenses: property management fees, property taxes, property insurance, utilities, and maintenance work.

Question 17

How is the cap rate used to value a property?

Answer 17

Expected rate of return on an income-generating investment property.

Cap Rate (%) = Net Operating Income (NOI) + Property Value

Income is the Forward NOI which is subject to error (projected 12 months).

Question 18

Income Approach (appraisal)

Answer 18

Property Value = Net Operating Income (NOI) ÷ Market Cap Rate

Cap rate is estimated through research of similar properties/transactions

Question 19

Why is the cap rate the inverse of a multiple?

Answer 19

The net income multiplier (NIM) is the reciprocal of the cap rate.

Property Value = Net Operating Income (NOI) × Net Income Multiplier (NIM)

Question 20

Why is the cap rate the inverse of a multiple? (Part 2)

Answer 20

Estimate the value of a commercial building expected to generate $200k in NOI at stabilization.

Given a market cap rate of 10.0%:
Implied Property Value = $200k ÷ 10.0% = $2 million

Given the NOI and net income multiplier (NIM):
Implied Property Value = 10.0x × $200k = $2 million

Question 21

Compare the cap rates for the main property types?

Answer 21

Hospitality (hotels): highest cap rates because demand fluctuates based on external factors (state of the economy and the income of consumers). Bookings are on a short-term basis.

Retail: risky because of the shifts disrupting the broader market (eCommerce)

Industrial: top performer in the CRE market because trends such as eCommerce, cloud computing, and big data

Multifamily: the most stable in terms of consistent demand (i.e., consumers will always need a home to live in), but economy still has an effect on occupancy rates

Office: Exhibits cyclicality based on the conditions of the broader economy. Crucial to establish long-term leases

Question 22

What is the relationship between the cap rate and risk?

Answer 22

Higher cap rate = higher risk, but higher potential returns

Lower cap rate = lower risk

Ideal scenario is the mispricing of property values relative to their income potential.

Question 23

What is cash-on-cash or “cash yield” return?

Answer 23

measures the annual pre-tax cash flow received per dollar of equity invested.

Suppose the return on a property investment is centered around value appreciation instead of income generation (e.g., lease-up, renovations). In that case, the cash-on-cash returns should be expected to be on the lower end.

Question 24

What is the difference between the cap rate and cash-on-cash return?

Answer 24

The cap rate measures the return expected on a rental property investment. (Formula in another flash card)

The cash-on-cash return, or “cash yield,” measures the annual pre-tax cash flow received per dollar of equity invested. It’s a levered metric because the numerator is the annual pre-tax cash flow.

Cash-on-Cash Return (%) = Annual Pre-Tax Cash Flow ÷ Equity Contribution

Question 25

How are property values and NOI multiples affected if the market cap rate rises?

Answer 25

Higher Cap Rate: Lower Property Value + Lower NOI Multiple Lower Cap Rate: Higher Property Value + Higher NOI Multiple

Question 26

What does funds from operations (FFO) measure?

Answer 26

Measures the operating performance of REITs by estimating its capacity to continue generating sufficient cash. Funds from Operations (FFO) = Net Income + Depreciation – Gain on Sale (net)

Question 27

What is the difference between NOI and EBITDA?

Answer 27

NOI: measures the operating profitability of properties in the real estate industry EBITDA = Net Income + Taxes + Interest Expense, net + Depreciation + Amortization. EBITDA reflects the operating profitability of an entire corporation. NOI measures a property's profit potential.

Question 28

What are the three methods of appraising a property?

Answer 28

Income approach: divide a property’s pro forma, NOI, by the market cap rate Cost approach: based on the total cost of replacing the property (reconstructing the property from scratch) Sales comparison approach: recent historical sales data of comparable properties to estimate the valuation of a property

Question 29

Walk me through the income approach to real estate valuation?

Answer 29

Capacity to generate income, most often projected on a twelve-month time horizon. 1) Project forward NOI 2) Determine market cap rate (research on recent comp sales) 3) Estimate property value Property Value = Forward NOI ÷ Market Cap Rate

Question 30

What does the cash-on-cash return measure?

Answer 30

The percentage of an investment expected to be distributed in cash before income taxes. Cash on Cash Return (%) = Annual Pre-Tax Cash Flow ÷ Initial Equity Invested

Question 31

What is the intuition behind the cost approach?

Answer 31

Pricing of a property should be determined by the cost of the land and cost of construction, minus depreciation. Estimated Property Value = Land Value + (Cost New – Accumulated Depreciation) Replacement Cost < Asking Price =reasonable Replacement Cost > Asking Price =not reasonable

Question 32

What is the difference between the yield on cost (YoC) and cap rate?

Answer 32

YOC: measures the risk-return of a property at its core Yield on Cost (%) = NOI ÷ Total Project Cost

Question 33

Explain how to calculate NOI from EGI?

Answer 33

1) EGI = Potential Gross Income (PGI) – Vacancy and Credit Losses 2) NOI = EGI – Direct Operating Expenses

Question 34

What is the loan-to-value ratio (LTV)?

Answer 34

the risk of a real estate lending proposal by comparing the requested loan amount to the appraised fair value of the property securing the financing. LTV = Loan Amount ÷ Appraised Property Value Higher LTV = Greater Credit Risk + Higher Interest Rate Lower LTV = Less Credit Risk + Lower Interest Rate

Question 35

What does the loan to cost ratio (LTC) measure?

Answer 35

Analyze credit risk by comparing the total size of a loan to the total development cost of a real estate project. Loan-to-Cost Ratio (LTC) = Total Loan ÷ Total Development Cost The lower the LTC ratio, the less risk for borrowing (vice versa for a higher LTC ratio).

Question 36

From the perspective of a lender, is a higher or lower debt yield preferred?

Answer 36

Debt yield measures the riskiness of a RE loan based on the estimated return on investment for a CRE loan. Higher debt yield = higher potential return on investment on the loan (and vice versa). Debt Yield (%) = Net Operating Income (NOI) ÷ Total Loan Amount

Question 37

What is the operating expense ratio (OER)?

Answer 37

The percentage of a property investment’s gross income allocated to pay off its operating expenses. LOW = GOOD OER = Total Operating Expenses ÷ EGI

Question 38

What is the difference between a capital lease and operating lease?

Answer 38

Capital lease: functions like purchasing a long-term fixed asset, in which the accounting treatment “spreads” the recognition of the acquisition cost across its useful life. Operating Lease: a rental agreement in which the right to use the leased asset is transferred to the lessee for a set period, and the lessee must return the property at the end of the lease term.

Question 39

What is the difference between operating and non-operating expenses in real estate?

Answer 39

Operating expenses: the recurring costs that are part of the day-to-day core operations of the property itself (ex. property management fees, utilities, taxes, insurance, repairs and maintenance) Non-operating expenses: capital expenditures (Capex), tenant improvements, leasing commissions (broker fee), mortgage payments

Question 39

What is the equity multiple?

Answer 39

The ratio between the total cash distributions collected from a property and the initial equity contribution (ex. cash investment) Equity multiple = 1.0 - break-even Equity multiple < 1.0 - unfavorable Equity multiple > 1.0 - favorable

Question 40

What is the difference between levered IRR and unlevered IRR in real estate investing?

Answer 40

IRR: measures the % yield received on a property investment across a pre-defined period. Neglects effects of financing Levered IRR: expected rate of return after factoring in the leverage used to fund the investment.

Question 41

What is the difference between the going-in and terminal cap rate?

Answer 41

Going-in cap rate is pre-calculated on day of purchase, terminal is at exit year & final sale price. The cap rate on the exit date can deviate substantially from the estimated terminal cap rate. Going-in cap rate > Terminal cap rate is the most ideal

Question 42

How does the interest rate environment impact property values?

Answer 42

Low interest rates: low cost of financing, increase in demand High interest rates: high cost of financing, reduction in demand If interest rates rise, the cost of borrowing increases, reducing the purchasing power of consumers and the affordability of properties.

Question 43

What are the three common commercial lease structures?

Answer 43

Triple-Net (NNN) Lease: tenant is responsible for all property operating expenses on top of the base rent (taxes, maintenence, etc.) *most common CRE* Full-Service Lease (FS): landlord pays all operating expenses of the property (usually higher base rent) Modified Gross Lease (MG): mix of both, split responsibilities

Question 44

What does the term “stabilization” refer to in property development?

Answer 44

Occupancy rate & Rent pricing are each on/around market occupancy & rate

Question 45

What is a good debt service coverage ratio (DSCR) in commercial real estate?

Answer 45

DSCR measures the riskiness of a loan. DSCR = NOI ÷ Annual Debt Service = 1.0 - breakeven < 1.0 - insufficient income > 1.0 - sufficient income Lenders prefer a higher DSCR because a greater margin of safety and affirms that the property generates enough income to handle the current debt burden without the risk of defaulting on the loan.

Question 46

What is the net absorption rate?

Answer 46

Net absorption reflects the change in tenant demand relative to the supply available in the market. Net Absorption = Total Space Leased – Vacated Space – Net Space Higher net absorption rate: implies strong demand for CRE properties Lower net absorption rate: indicates a surplus of available properties in the market.

Question 47

What is the development spread used to determine?

Answer 47

The profitability that could potentially be earned on a real estate development project. The greater the development spread, the more economically better a proposed development project likely is.

Question 48

What is breakeven occupancy in commercial real estate?

Answer 48

The percentage of occupied units needed to cover its total costs, including fixed and variable costs. Breakeven Occupancy Ratio (%) = (Total Operating Expenses + Debt Service) ÷ Potential Gross Income (PGI)

Question 49

What are the step to calculate the unlevered free cash flow of a property?

Answer 49

The cash flow before deducting debt payments, such as interest or mortgage payments. Unlevered Cash Flow = NOI – Capital Reserves – Capex – Tenant Improvements – Leasing Commissions

Question 50

What are the step to calculate the levered cash flow of a property?

Answer 50

Reflects net cash flow (NCF) post-financing, contrary to the unlevered cash flow metric. Levered Cash Flow = Unlevered Cash Flow – Debt Service Debt service = annual mortgage pmt, interest expenses