Acknowledgements xxi About the Authors xxiii Preface xxv 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 Thunen 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 Gordon's 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 Landlord's Perspective 177 The Tenant's Perspective 178 6.5.2 Comparing Leases with Different Concession Allowances 179 Landlord's Perspective 180 Tenant's 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
