# Real Estate Equity Investments Flashcards

## Practice questions

- What is the complement option type to financial options?

• A real option. A real option is an option on a real asset rather than a financial security. The real option may be a call option to purchase a real asset, a put option to sell a real asset, or an exchange option involving exchange of nonfinancial assets.

- What is the name of the point in a decision tree at which new information arrives?

• An information node denotes a point in a decision tree at which new information arrives.

- List the two major approaches to valuing private commercial real estate equity.

• The income approach and valuations based on comparable sale prices

- Define effective gross income.

• The effective gross income is the potential gross income reduced for the vacancy loss rate.

- How does the numerator of a pretax discounting approach differ from the numerator of an after-tax discounting approach?

• In the pretax discounting approach, pre-tax cash flows are used in the numerator. In the after-tax discounting approach the estimated after-tax cash flows are used in the numerator.

- How does the equity residual approach to real estate valuation differ from a discounted cash flow approach applied to the assets of a real estate project?

• The equity residual approach focuses on the perspective of the equity investor by subtracting the interest expense and other financing outflows due to mortgage holders (in the numerators) and by discounting the remaining cash flows using an interest rate reflective of the required rate of return on the equity of a leveraged real estate investment (in the denominator). The discounted cash flow approach discounts all cash flows from assets using a rate commensurate with the risk of the assets, not the equity.

- What are the characteristics that distinguish syndications from other real estate investment vehicles?

- Syndications are formed by a group of investors

* Syndications are usually formed to undertake a particular real estate project.

- A real estate project is estimated to offer a 10% after-tax rate of return when the depreciation allowed for tax purposes is equal to the true economic depreciation. In what direction would the expected rate of return change if the depreciation allowed for tax purposes were accelerated relative to the true economic depreciation, and why?

• When depreciation for tax accounting purposes is accelerated in time relative to true economic depreciation, the after-tax return generally increases and exceeds the pretax return reduced by the stated income tax rate.

- What is the effect of using appraised prices of real estate values to estimate risk when the appraisals are based on lagged information (of varying lengths of time lag)?

• In the case of real estate returns, if appraisals are used in place of true market values, and if the appraisals provide dampened price changes, then the resulting return series consistently underestimates the volatility of the true return series, as well as understates the correlation of the returns of the real estate to the returns of other assets in the investor’s portfolio.

- What data (i.e., information) are required to construct a hedonic price index for real estate?

• Hedonic approaches use prices from real estate transactions along with the characteristics (e.g., size, location, construction) of those properties to attribute price changes to property characteristics.

after-tax discounting approach

the estimated after-tax

cash flows (e.g., after-tax bond payments) are discounted using

a rate that has been reduced to reflect the net rate received by

an investor with a specified marginal tax rate.

appraisals

are professional opinions with regard to the value

of an asset, such as a real estate property.

backward induction

is the process of solving a decision tree

by working from the final nodes toward the first node, based

on valuation analysis at each node.

closed-end real estate mutual fund

is an investment pool

that has real estate as its underlying asset and a relatively

fixed number of outstanding shares.

commingled real estate funds (CREFs)

are a type of private

equity real estate fund that is a pool of investment capital

raised from private placements that are commingled to

purchase commercial properties.

comparable sale prices approach

values real estate based

on transaction values of similar real estate, with adjustments

made for differences in characteristics.

data smoothing

occurs in a return series when the prices

used in computing the return series have been dampened

relative to the volatility of the true but unobservable underlying

prices.

decision node

is a point in a decision tree at which the

holder of the option must make a decision.

decision tree

shows the various pathways that a decision

maker can select as well as the points at which uncertainty is

resolved.

depreciation

is a noncash expense that is deducted from

revenues in computing accounting income to indicate the

decline of an asset’s value.