Real Estate Investment

Lecture 1: Introduction to Real Estate Investment

1. Intro to Real Estate & RE Leases
What is RE?
Residential | Office | Retail | Industrial | Operational | Land

Land: • Agricultural, Forestry, etc. • For Development

Residential: • Owner occupied • Buy to let
Commercial: • Office (Prime inner city, out of town, single user buildings, etc.)
• Retail (High Street, Inner city, out of town, retail boxes, shopping centres,
supermarkets)
• Industrial, logistics, etc. • Student accommodation, Hotels, Nursing
• Cinemas, etc. homes etc.
Special Use: • Production facilities • Fire stations

Each of these subclasses has specific characteristics and may require

different analytical approaches.
Real Estate as an Asset Class
The Asset Classes: • Bonds • Equity • Real Estate (and other Alternatives)

Real Estate Characteristics (perception):

(1) Physical asset
(2) Long-term hedge against inflation (like equity), but with
(3) Stable returns (like bonds)
(4) Comparatively illiquid (i.e., takes time to buy and sell and is lumpy)

The perception is that real estate is somewhere between equity and bonds.
Reality is more complex.

i. RE is relatively illiquid and lumpy

a) Direct form: Illiquid by nature -> may take months or yrs to buy or sell in volume
-> This is what generally puts it in the “Alternatives” bucket
b) Indirect form: RE is liquid in its indirect form (shares in REITS, listed property companies or
open-ended funds, etc.)
• However, indirect RE can have very different portfolio characteristics compared
to direct real estate (i.e., tends to behave + like equity)

ii. Buildings depreciate, Land does not

• Buildings are physical assets -> they depreciate
• The analysis of physical depreciation in RE is still in its infancy (partially due to the lack of
good data)
• RE therefore has a permanent and a depreciating components

iii. Comparatively Poor Data Quality

• Poor data availability compared to stocks or bonds
• Real Estate indices for commercial real estate are mostly valuation-based and not price- based.
There are significant differences in valuation methodologies across countries and sectors. In
Europe, the UK RE market is the most transparent.
• Significant private information asymmetries continue to exist which provides for the
opportunity of superior returns and arbitrage

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iv. Optionality
• Real Estate contains inherent optionality, especially land

1.2 Relative Size of Real Estate Markets Vs Stock Markets

The data would indicate that the actual size of the investible real estate space is similar to that of the stock market.
Approx. Aggregate Value of Asset Classes, USA, early 2000s (in tn$), (Geltner, 2014) Chapter 7

* Excludes value of mortgages and corporate real estate

(including them would mean RE would value $27 trillion. The
data includes residential real estate (commercial real estate
makes up around $8 trillion). Corporate Real Estate is implicitly
included in Stocks and Bonds

UK Example: Real Estate by sector

European Yields & Rents

European Property Prime Rents and Yields (Q4 2022)

E.g., prime rent is + expensive in West Ldn than City due to (a) lack of supply as opposed to City (taller building,
more supply). (b) tricky to develop in West, you can’t dev so high, less supply. (c) govt offices will go where it’s
cheaper. (d) proximity to clients (e) your yield, and also your rent is a little bit determined. What's your alternative?
What's your best use? E.g., office or turn it into Ritz, high end residential building?
- This is a space market: where the unit of exchange is rent
Prime = ideal building = best in office; Prime rent divided by prime yield
Yield is the opposite of the property value (it’s the multiple)
Why is the yield higher in the City of Ldn than West End?
(a) Its return expectations  expectation of the development of the value of the property and the yield. So
maybe in the way people expect the values of the properties to go up more. So they demand a lower yield.
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 (b) The associated risk  yield is just an infinite Discounted cash flow
- Why wld your DR be different City vs West?
- Higher risk in City, expect higher return -> you think there might be more volatility.
- CFs are riskier: larger buildings: when you buy a building and it becomes vacant, it takes longer
to lease -> more supply shock risks

Budapest’s higher yield: currency in Hungary -> it’s a non-euro country in Europe -> currency risk -> IR are higher
-> benchmark is higher (financing risk) -> that inflliences the whole thing
- Country risk, government, views on that markets
- All countries have some issues in real estate market. All of them. There's no clean system.

- Y/Y shift:
as IR go up, prices of RE hasn’t moved down as much, why?
Residential RE is sticky, ppl tend to want to keep their house…
Offices: it’s the LT IR expectations that truly matter, not the ST IR.
- logistics has been a huge beneficiary of Covid huge because it accelerated this whole of transition into
online.

Global Investments
 Yields are driven by liquidity & transaction volumes.

Example: Historic UK Yields & Rents

Beware of crisis, real estate goes hand in hand with it. Rise in prime yields, drops in rents.

Global Real Estate Rental

Markets
Prime Office Yields across 21 major office markets

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EMEA Office Rental Clock

Who Invests in Real Estate?

Insurers & Pension Funds | Sovereign Wealth Funds |Property Companies, REITS, Specialised
Real Estate Funds | End users, owner occupiers (e.g., retailers)| Discretionary Allocation Funds |
Hedge Funds, Opportunity Funds… | Family offices, Estates & Private Indivs | The State

 # investors aim to achieved # things, so approaches to value & analysis

differ significantly, as does pricing.
 Importance of players varies across countries, sectors & cycles.

Largest Instit. RE Investment Managers

Blackstone, Brookfield A/M, PGIM R/E, Nuveen, MetLife I/M, JP A/M, AXA I/M RE, CBRE
I/M, UBS A/M, CapitaLand, Allianz R/E, Principal R/E Investors, ARA A/M

Fund Investment Clusters

CORE (low risk, low return, stability…)
• Target return: initial yield and third-party valuation driven (IRR is not used universally)
• Leverage: 0%-50% (restrictions and definitions vary)
• Investment in prime, high-quality real estate in liquid markets with stable income profile
CORE PLUS (do sthing to a building, w/ leverage)
• Target Return: Around 8%-13% IRR,
• Leverage: 35-65% (restrictions vary)
• Investment in good quality buildings that require some work and limited risk (generally some
re-gearing of leases or limited physical changes to a building)

VALUE-ADD (heavier work)

• Target Return: Around 13% -17%+ IRR,
• Leverage: 50-75% (restrictions vary)
• Significant value enhancement strategies (e.g. lease up, refurbishments, major re-gearing of
leases)
OPPORTUNISTIC
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• Target Return: 17%+ IRR,
• Leverage: no restrictions (generally)
• Broad array of strategies or special situations approach

Decision Criteria used by RE Investors

- Property Fundamentals (micro/macro location, age and size of building, access…)
- Relative or Absolute Risk
- Risk/Return Profile
- Multiple on Investment
- Price/Sqm & Replacement Cost
- Initial Yield, Reversionary yield, yield on cost, cash-on-cash yield
- Intended Hold Period vs Fund Life
- Strategic Reasons
- Control of Optionality
- ESG…

Value
# Defs of Value. The Market Value of RE in UK (& Europe)

Market Value: Est. Amnt for which a property should exchange on date of valuation btw a
willing buyer & a willing seller in an arm’s-length transaction after property marketing wherein
the parties had each acted knowledgeably, prudently, and w/o compulsion (RICS UK)
 Not necessarily “worth”, or “cost”. It’s foremost a comparative/subjective concept.
 The example of the tacky/golden swimming pool that nobody wld want to pay for.
 MV is the estimate of the highest IV. Usually, it’s a noisy guess.
 So sometimes that your most aggressive buyer to find share market value.
 And that's a read, because the public markets are really bubbly.
 Sometimes it's private equity, because they're the only ones around.

Investment Value: Value of the property to a particular owner, investor or class of investor for
identified investment objectives. This subjective concept relates specific property to a specified
investor, grp of investors or entity w/ identifiable inv. objectives and/or criteria
 In the UK, was referred to as worth

RE can be very untransparent -> hence can have arbitrage opportunities

- Definitions of MV & IV differ but major difference in all defs is that MV is the
expectation of what a property should trade for whereas IV emphasises what it is worth
to a particular investor. The 2 concepts can give very different results!
- The purpose of this elective is to introduce investment techniques. Investment analysis
uses and relies on concepts of value but is ultimately driven by what someone wants to
achieve through investing.

Real Estate Leases

- Why RE is similar to bonds is bc of LEASES. Gives RE a Fixed Income/Coupon characteristic.
- Lease = contract btw a tenant & a landlord/owner in which the owner provides the tenant with
a right to occupy and use space at pre-agreed terms for specified period of time.
(a) Leases, in most contexts, survive the sale of a property and as such, influence the
performance of a property for the duration of the lease
(b) In many contexts & countries, leases also survive the insolvency of a property
owner

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N.B: Leases # Leasehold Interests, which can be thought of as providing ownership over a
period of time, often against payment and over extended periods, with the freeholder having
perpetual ownership. Whilst leasehold rights and conventions differ significantly across
countries the easiest way is to think of leasehold ownership is as temporary ownership with
similar but slightly more restrictive rights as freeholders over the leasehold period (e.g. leasehold
interests can typically be mortgaged)

• Laws and conventions determining the content of leases differ significantly across Europe and
across asset classes.
• Different market lease conventions and laws can have a significant impact on the long run
performance and characteristics of a specific market segment (many countries for example have
restrictions on increasing residential rents)
• Lease law and tenant rights for commercial properties are often strongly influenced by
residential lease law (at least in some countries)
• Leases contain specific agreements between a tenant and an owner. E.g., a landlord can
force a tenant to operate a retail unit, even if operating the unit is unprofitable. Another
example can be found in non-compete clauses, in which a landlord’s ability to lease space to a
competing tenant in the same building is restricted.

What’s in a Lease: Some Key Items

 Space: What exactly is rented (e.g. are common areas rented too, what about staircases, lift
shafts, areas below heaters or even walls)
 Term: Duration of the lease (e.g., there may be special termination rights or options to
extend a lease by a tenant)
 Rent: Price at which space is rented. In retail property this sometimes takes the form of
turnover rents
 Rent over time: How does the rental income behave over time (e.g. many leases in the UK
contain so called “upwards only” market rent review provisions which state that every five
years the rent is reviewed and will move to the higher of the current rent and the market
rent. In other countries rents are regularly adjusted to changes in the cost-of-living index or
there are pre-agreed stepped rental increases or rent- free periods
 VAT: Does the tenant pay VAT?
 Service Charges: Who pays for service charges (e.g. insurance), that is, does the tenant or
the landlord have to pay
 Repairs: Who pays for common repairs. Who pays for repairs to structure and roof
 Failure to perform contract: What happens if one party does not perform or default
 Guarantees: How does one back a default (e.g. recourse, tenant deposits, etc.)

SQM Rented
Especially for cross-border investors or occupiers the answer to ‘What exactly is rented?’ can
be puzzling:
 # markets, even within the same country, can have # conventions of what contains rented
space (the # can be 5-20% of space).
o In some markets one leases gross leases gross lettable area (consisting of the area
measured from the outside wall to the outside wall).
o In other markets one uses Net Lettable Area, which may exclude structural walls.
o Other differentiating elements are for example lift shafts, staircases, certain
common areas…
 Some leases allow a tenant of landlord to re-measure the rented space after the tenant
moved in and adjust the rent if material # are found

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  Individual leases can also overrule convention and contain specific provisions or
definitions of what constitutes leased area

There have been various initiatives to harmonise rental space definitions but there is
still a long way to go and significantly # approaches.

More on Leases
Beware, even if a lease contract says something specific, a country’s laws may overrule a
specific provision. Examples of provisions that tend to be affected in certain countries include:

• Special termination rights may exist: e.g., case law provides for special termination
rights for both tenants and landlords when leases contain certain “defects” (e.g. “written
form” requirement in German lease law)

• Right of tenure: In some countries a tenant may have the first right to lease the space
when a lease finishes; in other countries it is difficult to expel a tenant or a tenant may have
special termination rights (all this is often deriving from residential tenancies)
• Who needs to pay for repairs: Again, case law may overrule specific provisions

Lease conventions, laws regulating leases, or the specifics of a particular lease can have a very
significant effect on:

 Performance of a building over time

 Quality of an investment to an institution
 Specific performance of an asset (e.g. gross to net rental effects)
 Value & pricing of a building

UK Average new lease length weighted UK Average Commercial lease length

- Increased trend towards flexible space and shorter leases (usually more expensive, and
more inclusive).
- Generally, leases are much shorter companies need + flexibility.
- leasehold tends to be much longer than RE lease, and you have ownership rights.

What’s included in the Rental Area?

You define a primary rented area, which is all this stuff which you have exclusive use.
Vs. common area
but then we also allocated the proportion of which of the floor to the toilets for the kitchen, the common
kitchen, and so on.
Common rule - lift shafts, stairs, or vertical - No, we can't allocate this. Just maybe the platform.
Ground floor – Lobby area. In some countries, you can allocate.

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As a Landlord, You Would Like To Maximise The Space Area.

Gross area (wall. To wall) VS. Net area.

In general, professional leases, partitioning leases are included in the area, but not the fixed walls…

2. Direct Capitalisation Approaches

Simple Capitalisation approaches used in the analysis of commercial RE.

Example 1: London apartment Buy-to-let

 2023 and a friend from Imperial told you that she recently bought an apartment in London as a
long-term investment. She plans to let it to third party tenants (i.e. it is a buy-to-let). You think
this is interesting and you start researching. On Saturday, you visit a high street brokers to see
what is available and then consider the following investment

 Ground Floor apartment in London, Islington N1

 3 bedrooms, ca. 1,500 SQ FT
 Price of £1,350.000
 Broker says you can get rent of £1,050 pw and you can finance at 50% LTV. But depending on
your banking relationships you may get up to 65%

(a) Which factors would you want to analyse?

The typical high-level analysis focuses on:

Affordability
• Have you got the cash, can you pay interest and amortisation with the rent you expect to get
Comparison
 Is the price justified compared to other properties that sold (“comparables”) or that are on the
market
 Do you think the property is “good value”
Financing
• How much debt can you get based on rental expectations after management costs and reserves and
given your financial situation and earnings potential
Expectations
 Do you expect the market to go up or down
 Interest rate expectations
 How did prices grow during the last 20-30 years and why?
Tax
 Unfortunately, for many private investors tax tends to be a massive driver in decision making
 Acquisition costs, stamp duty, interest deductibility, etc.

- Location, supermarkets nearby, transport, amenities, drugpoint, neighbourhood, busy high street?
Ground floor?
- Does it give you good return?
- How does it compare in terms of yields (rent/cost), rent/sqm?

(b) Which additional information would you want to consider?

Location
 Micro- location analysis - transport, local demographics, trends
 How does the yield and SQM price compare to other recent transactions
Rent
 Rental Market analysis – how realistic is the rent the broker quotes
 Competing developments
 What is your average expected rent over 1 year including turnover vacancy
State of Repair
 Deferred Maintenance
 Future expected capital expenditure
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Legal Due Diligence
 Clean title
 Encumbrances
 Party wall issues
 Is it freehold, leasehold? What do you actually own?
 Who owns the wall? Who owns the garden? Rights or water company etc?

Example 2: Would you buy?

Part 1: Assume:
• 6 weeks vacancy per year (52 weeks)
• 15% management costs of expected yearly rental income
• 5% sinking fund for repairs
• Broker rent is correct but we ignore rental letting fees
• Assuming you are a first time buyer, Stamp Duty of £76,250
• Other costs are £1,500 (legal due diligence and contract, valuation)

Part 2: Assume you:

get financing at 1) 65% loan to value at a total interest cost of 5.15% fixed for 5 years
or 2) 50% loan to value at a total interest cost of 4.90% fixed for 5 years

Example 3: Supermarket
You work for a family office and look for interesting investment opportunities in RE across Europe
Your Problem
• A broker offers you a supermarket in an East German town
• The supermarket pays €12/sqm/month on a lease that has another 5 years to run (plus tenant
prolongation options) and comprises 20,000 sqm of retail space
• There were two recent supermarket lettings close by, that saw rents of €10/sqm/month and one of these
supermarkets recently sold for an 8.5% yield
• The broker says you can buy this for 9% and that this represents an excellent deal. Is he right?

How do you approach such a problem?

1. “Quick-check”/”Direct Capitalisation” approaches – Session 1

(a) Check what others paid based on some comparable metric like yield, price/sqm, etc.
(b) Make adjustments, that the comparison holds
- Separate what you think is permanent, which is market, and what is temporary?
Visual Depiction

Approach distinguishes between sustainable, “Perpetual” income and the “Temporary” income
component (generally referred to as the “Core and Froth” approach)
• The perpetual part is the comparable part
• The temporary part is the adjustment to the comparable

2. DCF approach – Sessions 2-3

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Alternative Visual Depiction
An alternative way to think about the same cash flow is in terms of the “Term” (cash flow until lease
ends) and “reversion” (new lease at market rent)

“QUICK-CHECK APPROACH”

Value = Perpetual Value + Adjustment,

where:
• Perpetual Value = Market Rent p.a./Market Yield
• Adjustment = Discounted cash flow stream of temporary income components (or income
shortfalls)

The Direct Capitalisation Approach is really just a special case of the DCF method when CF(i) = k for
all i, and the market yield is the discount rate d. This can be seen as follows:

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So, in cases where the market rent is identical to k and the market yield is d then:

Is the broker right (is a 9% yield a good deal)?

Some lessons:
• Quick-Check approach can be very useful as a first/rough check, if you include the main value drivers
• Quick-Check approach ignores cost of capital and only implicitly deals with expectations of rental
inflation and market rental growth
• Quick-Check approach quickly becomes cumbersome if many variables seem important
• Elements of Quick-Check approach are basis of more complicated models
• DCF approach is dominant in fund management/PE world and we will study it in detail in the next few
sessions
• DCF approach explicitly deals with cost of capital
• DCF approach allows you to explore issues/variables in detail (e.g. consequences of reversion and
sensitivity of results)
• DCF is a dynamic method in the sense that it can look and analyse how certain variable change over
time
All said, it is important that you sense check all your work and take a step back after you run a model to
see whether it makes sense. We will emphasise this point throughout this course.

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Lecture 2: DCF of Income Producing Real Estate
1. Pro-Forma Analysis of Income Producing Real Estate
DCF analysis is used in most professional environments, especially by core plus, value add and
opportunistic investors.

Example 1: Office Investment Opportunity

You: It is early ‘16 and you work for a US Value-add (target 13-15-17%
IRR) fund with a pan-European mandate
Your Problem:
• Through a conversation with a friend who works at another international
fund that is winding down you hear that they will market a building in
Frankfurt through an agent. Many alternative buyers are active in the market
and you try to convince her to let you pre-empt the sales process
• She says that she would provide you with the information and that you would have to make an
indicative offer within one week
• She sends you the tenancy schedule, some plans and the non-recoverables and service charge
reconciliation of the last few years
• The property is in Niederrad, a decentral office submarket in Frankfurt
• You fly to Frankfurt, briefly inspect the building, speak to some brokers, do some research about rents
and yields and then go to run your cash flow before you brief your investment committee

Pro-forma analysis
-> Detailed line by line cash flow projection (for this example).

-> Note:
• Major difference btw company analysis and real estate analysis is that the actual operating
cash flow in real estate can be forecast with a comparatively high level of precision. The
starting point is a detailed lease by lease analysis.

• Detailed analysis, research and due diligence can also remove significant risk/uncertainty
• This said, there remain a range of key assumptions/unknowns that can nonetheless significantly
change predicted results

Before you spend much time compiling a detailed cash flow model, you should always use your
calculator and do a back-of-the-envelope analysis of an investment.

Permanent Features of every investment

(1) LOCATION: micro, macro, trends, demand/supply
(2) PHYSICAL SPACE: age, quality, layout, features (e.g. A/C, EPC rating, ESG, Net
zero…, embedded carbon in buildings, gas heater…)
 Phenomenal change £bns of R.E that will need to be remodelled, or
repurposed or restructured. That needs regulation.
Location
- Before much time is spent on modelling an investment you should always check a number of key
knock-out criteria of which the most important is location followed by age/state/type of
building.
- Never underestimate the importance of location as a value driver. The location component
determines how susceptible your building is to competition and how ‘unique’ it is.
- The land component of your total value can be anything between 15-100% of what you are
buying - we will spend a significant time on this aspect in later sessions.

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3 key elements:
- Rent; Yield; Development Costs
- Depends also on the cycle.

Dark blue: below development costs. You can’t build and get rent below 10. Reasons: old crappy
building, badly designed buildings.
Look at. Vacancy rate? In vs. outside the city.
In certain area, trade tax rate, lower than in Frankfurt.
Subway & public transportation? From ESG point of view.

a. look at the building, area etc.. b. then, look at the tenancy structure, what is the stacking plan
(schematic view of the building where each of the tenant is, what is vacant?
- Fire escape – always need 2 fire escapes
- maximum distance between the furthest corner and the closest fire escape.
- puts limitations on how to split the building amongst tenants
- firewalls?
- the more units you can create (even if it costs $$, the more flexibility/optionality you have).

Description Space
(a) Space characteristics
When considering investing in a building you should always carefully analyse the structure, composition
and quality of space. The tenancy schedule does not always provide this information.

• You should always ask for what is called a stacking plan, a schematic layout of the building showing
where exactly each tenant/vacant space is located on a floor by floor basis. This will be very useful in
assessing the actual rent paid by tenants and the likely market rent you will get should a tenant leave.
This analysis sometimes also throws up interesting aspects such as vacant space that is in fact dead space
or space that cannot be rented or is of lower quality.

(b) Space Quality

 Does the space configuration conform with what tenants demand/require
 Is the space efficiently laid out (efficiency of space)
 How deep is the space, are there windows (is closeness to windows required by tenants or law?)
 How attractive is the space, etc.
 ESG requirements?
Your answers feed into your assessment of the expected rental value “ERV” of the space, i.e. the rent at
which the space could be re-let if empty. It also influences the risk assessment of your rental income
stream.
(c) Fit out Quality

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Probably less important for retail tenants (as opposed to office tenants) - as retail tenants generally fit out
the space they rent), but very important for office buildings. Examples of important questions are:
 Is there air conditioning?
 What needs to be spent to refurbish the space once a tenant leaves?
The answers to these questions feed into your estimate of “ERV” and of the refurbishment and fit out
costs (called “TI”s, short for tenant improvements) required to achieve this ERV, when the space will
need to be re-let at the end of a lease

(d) How is the rented space measured

- When running your analysis, you also need to understand the standard, according to which your
building is leased (gross lettable area, net lettable area or some other measure). As mentioned in the
previous session, each market tends to follow different leasing conventions. In addition, the basis of
space measurements for your existing tenants tents to be described in the existing leases

- Ultimately when investing in a building you buy a certain quantity of space and you need to be certain
about:
1) how this is measured (to be checked in due diligence), and
2) that it actually conforms with reality (to be checked in due diligence)

Unlevered Cashflow Analysis

1. Key Stages of analysis: Stage 1

Reversion is the point in time

when a lease expires and the space needs
to be re-let

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Simplified Tenancy Schedule

 Tenant name, space rented (sqm), parking number, rent/month and p.a., rent psm/month, and what’s
the earliest break.
 You also want your stacking plan i.e., who is where in the building, to see the vacancy.
 Tenants pay different rent: different areas in the building (ground v. upper; light; better spaces;
timing of the rent e.g., in financial crisis; length of the lease; reputation of the lessor; (lessor #
leaseholder- leasehold is like 200 years).
 Fact: rule of thumb, you need 12.5 sqm to build a Parkhouse
 In some countries, you are forced to build a parking.
 Who determines what is office vs. storage: it’s tricky, not usually declared. the seller. The buyer
should check.
 Definition of space is subjective. Has to spot-check for discrepancies
 Earliest break vs. options to break or extend (generally one-sided options)

Tenancy Schedule
The description of the rental income and its composition are contained in what is called a
tenancy schedule or rent roll. Larger, multi-tenanted buildings or large shopping centres can
easily have rent rolls with 500+ lines. The basic information should, at a minimum, include:
 Tenant details
 Detailed location of space within building
 Designation of space (e.g., office, storage, canteen, etc.)
 SQM or N* of parking spaces
 Rent paid for spavr
 Contract date & break or extension options by tenant
 Whether tenant pays VAT (usually +20%)
 Indexing
 Service charge details

Rental Income
The rent roll on a previous slide showed the net rent. In addition, tenants generally also pay:
• Service charges (either directly) or as pre-payments to the owner (if the owner has to pay them)
• VAT – unless they do not pay VAT (e.g. governmental tenants)
• Both the level and treatment of service charges as well as VAT can differ significantly from
country to country – we will analyse service charges later

When is rent paid?

• Almost all commercial leases reference a net rent that needs to be paid every month or
quarter. In some jurisdictions rent is paid in advance, in others in arrears.
• In Germany, where our example is based, rent is paid monthly in advance

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Indexation
Rental income, in most leases and countries, is adjusted by inflation or market rental
movements. The way it is adjusted can however differ significantly from country to country and
from lease to lease. Indexation or rental adjustment is an important aspect tenants and landlords
tend to negotiate.
Examples of adjustments to rent one tends to see:
1. Pre-agreed stepped rental increases or fixed agreed rental increases every x years
2. % adjustment to cost of living index (or to some other index) every x years or
whenever the respective index changes by y%
3. Open market rent review every x years
• An important and unique special case is given in the UK, where one has
‘upwards only’ rent reviews, typically every 5 years.

Indexation assumptions tend to have a much larger influence on the IRR

than one might expect.

Lease Term & Options to Break

 Standard lease terms vary widely across Europe and internationally. Lease terms tend to be
anything between short term (e.g. one year) to 30 years.
 Common lease terms in Europe tend to be between 3, 5 and 10 years and for newly built
properties 10, 15, 20 or sometimes even 30 years. In the UK one still often finds rather long
leases.
 N.B. even if leases are long, tenants may have options to break a lease, and this can
significantly affect value/certainty of income.
 In this case -> need to consider whether to assume the worst case = a tenant uses his option
to break a lease whenever this action results in lower returns. Alternatively, in some
instances it may make sense to use a probabilistic approach – more on this later.

Vacancy
Existing vacancy at acquisition
• Implies that operating costs and service charges cannot be recovered for this space
• You will need to decide whether you can lease the vacancy up and at what terms
Roll-over vacancy
• Potential vacancy when a lease expires (TBD when discussing reversion)
Stabilised vacancy
• Many models contain a variable which automatically categorises a certain % of each lease
renewal as stabilised vacancy (i.e. % will not be leased for ever). The One Reversion Model
does not include such a variable, primarily because I generally consider it better to model
vacancy explicitly and categorise certain space to be perpetually vacant or never to be re-let
when it becomes vacant
Key Questions
• What is the quality of the vacancy one is buying
• Can the vacant space be rented (is it leasable or should it be categorised permanently
vacant)
• How much money does one need to spend to lease up the vacant space
• How long will it take you to lease it and what is the achievable rent
• Is currently leased space specific to a tenant and can it be leased to other tenants

- Vacancy is like an illness with double cost (pay vacancy costs without making any money e.g. electricity
bills allocated and loss of rent)
- when there’s a building, if gives you an idea abt what’s wrong w/ the building

16
- when you buy a building, seller wants you to pay the vacancy as if it’s fully rented and they allocate the
rent. Seller gets away with that but generally depends on D/S dynamics.
- if it’s a buyer’s market (not so good), you generally tend to get the vacancy for free (allocate a little bit
of value to the cashflow).
- In general, in the UK, the vacancy rate is 12%. 10% usually is a structural problem (too much space) –
4-5% is the norm. if higher, it becomes a tenants market.
- Look out for structural vacancy (e.g., space hard to access e.g. only thru fire escape, unfitted…)

Tenant Quality
2 Common Ways to model risk of rental loss:
1. If one’s investment rationale is based on a long lease to a specific tenant then tenant quality is
essential. If one is not convinced that a tenant will pay rent then one should either not buy or when
buying one needs to have a plan B in case the tenant fails. This risk may also need to be reflected in
one’s analysis by applying a much higher discount rate or by explicitly including a scenario for tenant
failure

2. One assumes a provision (%) for rental loss. This approach may make sense if there is no dominant
tenant, i.e. there are many small tenants and risk is granular

However,
remember that this 2nd approach only makes sense if tenant risk is distributed across many tenants
(#1-2), so that a statistical approach makes sense. With few tenants the default risk of each tenant
should be assessed on a case-by-case basis.

Operating Costs
Recoverable and non-recoverable operating expenses
- In many countries and sectors, operating costs are largely (but sometimes not
completely) recoverable from tenants (pre-payments, then reconciliation at y/e).
E.g., in the UK, everything pushed to tenant, your rent = NOI.
- In some countries, tenants tend to negotiate which operating costs they will pay for. In
other countries convention or law dictates what is recoverable from tenants. Especially in
contexts or countries where operating costs are not completely recoverable by default,
detailed analysis needs to be carried out to assess this group of costs.
- Operating costs are items such as:
• Utility costs of building • Ground/land tax
• Rubbish collection • Cleaning
• Care taker • Maintenance
• Repairs to exclusive or common area • Facility management costs….

One can analyse/model operating expenses in 2 different ways:

1. Gross analysis: Shows all inflows & outflows (residential companies often show gross flows)
2. Net analysis: Only shows net effects (i.e., what is non-recoverable) – the “One Reversion”
model uses this approach

- Both ways of looking at the effect of operating costs are correct and should lead to the same
result. In practice the “net” analysis is more frequent when undertaking commercial real estate
analysis and the “gross” method when analysing residential real estate companies, but both can
be applied in either case.
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- Operating costs can be between 10% and 50% of potential rental income. It is therefore very
important to get the analysis right, especially in situations when vacancy is expected.

Cashflow Structure: Gross Analysis

Data splitting up the income components or costs components in great detail are often not
provided for large residential companies. Reporting may thus consist of 3 lines only:
Gross Income, Operating Costs, Operating Cash Flow.

Cashflow Structure: Net Analysis

Remember the ORM Model assumes the Net Analysis of Operating Costs
“Net” analysis
The best way to estimate non-recoverable operating costs (i.e. costs that cannot be recovered
from tenants) is to explicitly model them.
However, especially in early phases of analysis, typically does not have enough info*, or too
time consuming to carry out this type of analysis. In practice, in commercial RE analysis, tend to
approximate non-recoverable operating costs.

Operating Cost Assumptions Base Case (“Net Analysis”)

- Table here from the ORM
lists some operating
assumptions that’d occur
in Net Analysis.
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 - Table also lists the likely source for assumption (i.e., whether can verify the assumption through DD
or whether simply an assumption).

Collection Loss: ratio of uncollected rent to potential rental income (measures amount of income
lost due to unpaid or uncollectible rents)
Service charges:
Facility Mg. (fully tenant-recovered) v. Property Mg. v. Asset Mg. v. Fund Mg. (see defs)
Maintenance costs (sinking fund) v. Capex: Maintenance is small or unpredictable. Sometimes
sinking funds turn into Capex.
Capex: one-time things (eg., roof is 35 y/o, will have to be replaced at some pt)
Void costs: gross service charges for the vacant space. e.g., generally allocate the PM costs to
the vacant space (you pay it as the landlord)
General O/H: SPV costs, Accting, Audit, Tax, Valuation costs…
Asset Mngt: non-allocable to tenants – straight cost to you.

Recurring Operating Costs (cont’d)

1. Non-recoverable service charge assumptions
• Based on past non-recoverable expenditure or based on the analysis of the in-place leases –
expressed as a % of leased space

• + operating costs for vacant space – expressed as a cost/sqm vacant space

2. Sinking fund for maintenance expenditure

• Regulation about what constitutes maintenance expenditure and/or repairs and whether this is
recoverable varies widely across countries. Maintenance often tends to be recoverable from
tenants through the service charge reconciliation. This said repairs or replacements are often not
recoverable. A sinking fund should be used when expenditure is not yet certain. In a number of
jurisdictions (e.g. UK and Ireland) one can have ‘full repairing & insuring’ lease (FRI lease). An
FRI lease prescribes that absolutely everything (incl. roof repairs / replacements) must be paid
by a tenant.
• The size of a sinking fund for maintenance expenditure is best based on the sqms of
lettable space in a building. The provision should be higher for older buildings than for new
buildings (where there may also still be guarantees against the company that constructed the
building). The assumption should be based on a detailed analysis of historical costs and costs in
comparable buildings.

3. Non-recoverable Property Management

• The cost of Property Management (PM) tends to be between 2-4% of rent for commercial buildings of a
certain minimum size, with a minimum payment in case of vacancy. Costs can vary across countries and
also depend on the particulars – e.g. single tenant buildings can be much less time consuming to manage
than multi-tenant buildings

• Whether the cost of property management is recoverable depends on country/sector conventions and the
particulars of a lease. Information can often only be obtained by reading an in-place lease or receiving an
analysis from the seller.

• Fees for PM are generally expressed as a % of rent, with a minimum threshold

4. Other non-recoverable operating costs

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1. Under this heading one should only include non-investor specific non-recoverable operating costs
(investor specific costs should best be treated as overheads or other costs – i.e., below NOI II).
Other non-recoverable operating costs may e.g., include:
1. Centre management fees in the case of a shopping centre
2. Required asset management fees (that are not specific to any particular owner)
3. Non-recoverable VAT on operating costs….

Non-Recurring Operating Costs: Capex & Leasing Expenditure

Deriving NOI II:
In CF, we also needs to take account of the following non-recurring items (one-offs):
- important as you may capitalise them in # ways, so you apply # yields to them
- you wouldn’t want to to capitalise them / apply your multiple on them
- In bigger multi-tenant buildings (100+ eg. Rocjefeller, this would be recurring)

1. “TI”: Tenant improvements/tenant fit out costs for each space

1. Expressed in terms of costs/sqm
2. Level of Tis depends on the fit out required by a tenant (this needs to be sensible and in line
with market practice and with the rents (ERV) you are trying to achieve)
(e.g., tenant leaves & you have to refurbish space, broker fees…)

2. “LC”: Leasing commissions

1. Based on rent achieved by broker
2. Level depends on market practice

3. “Capex”: capital expenditure/deferred maintenance –

1. Identified and non-recoverable costs for deferred maintenance or expected major repairs
during hold period – this would generally not be covered by your sinking fund
(e.g., make building ESG-conform, as it’s big costs)

In ORM, Tis and LCs would occur once only per space. Specified Capex would also only occur once per
item. Regular maintenance or capital expenditure should be reflected in NOI I within the sinking fund.

N.B. some modelling approaches would include Tis & LCs within NOI I, especially in large multi-tenant
buildings when shorter leases are assumed and more than one reversion is modelled – more on this later.

Overheads
Examples of general overheads or investor/structure specific costs:
• Annual valuation costs – not all investors carry out valuations
• Auditing & corporate accounting fees –costs depend on the type of investor and structure
• Costs of maintaining a particular corporate structure (e.g. costs of “maintaining substance” in
Cayman Islands, Luxembourg or Guernsey/Jersey)

N.B. one of the most important investor-specific aspects of the analysis is tax – (next session)

2. Key Stage of Analysis - Stage 2: Reversion

What Happens When a Lease Expires?
- The point in time when a lease expires and the space needs to be re-let is called the “Reversion”
- The assumption of whether a tenant stays or not can either be:
• Deterministic (determine a specific outcome 0|1): i.e., a tenant is either assumed to stay or to
leave
• Probabilistic: one assigns a certain probability to the chance that a tenant stays – i.e. the
reversion is then modelled in terms of expected probability
- The expected probability approach is best suited for portfolio/diversified tenant risk and can be
misleading when considering lumpy tenant retention risk (i.e., a few, large tenants) – we will discuss this
later in more detail

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- Whilst the expected probability approach is almost universally used in RE when one works with this
type of uncertainty, other approaches are possible.

Reversion (will tenant stay?)

Use the market rent when market rent < current rent.
Use current rent when market rent > current rent

When using expected probability, Reversion can be modelled as follows:

Assume a probability x% that tenant stays, where x either [0,1]:

• Tenant stays or renews but may receive some rent-free period for extending – the rent free period will
be reflected as a reduction in rental income, service charges will typically be paid when rent free
concession is given. What the rent will be when someone stays/renews is often not explicitly shown in
many models and can be ERV or current rent or something else

Assume a probability (1-x%) that tenant leaves:

• Space will be vacant for several months – reflected in loss of rent and occurrence of vacancy costs

• Space needs to be refurbished for a new tenant - fit out cost reflected as Tis

• Attracting new tenants may imply having to pay leasing commissions (LCs)

• New tenant pays ERV (possibly indexed) and may receive rent free period – tenants tend to pay service
charges during free periods

The renewal probability, Tis, LCs, ERVs and rent-free periods are all input assumptions in the
ORM. You should play around with these variables to get a feeling for their effect on cash flows
and returns

Important comments on modelling ‘reversion’:

1. Ex-post the world is deterministic, that is, each tenant either stays or goes (not both). The expected
probability approach can only ever be an ex-ante approximation and is ideally suited to situations with
many tenants (and no dominant tenant). Care needs to be applied when using this approach in models
with few tenants.

2. The traditional approach and the one used in the ORM provides for one reversion – this approach is
often justified in contexts where the average lease length is shorter than the expected/assumed hold
period (e.g. 5-10 year leases assuming a 5 year cash flow analysis so that there will only ever be one
reversion during the hold period). But in some contexts it may be important and may make a significant
difference to use multi reversion models

3. To assume that everything is let upon reversion is often not realistic – more on this later

REVERSION ASSUMPTIONS BASE CASE – ONE REVERSION MODEL

General Model Assumptions: Reversion

-Table contains the variables determining what

happens upon reversion in terms of renewal
probability, vacancy periods and leasing
commissions when a lease expires.
-These are general modelling assumptions that are
applied to each tenant and that can be adjusted on
a tenant per tenant basis, as required.
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N.B.: - All timing assumptions ‘Leaves’ in the table above also apply to vacant space
- The model automatically sets the ‘General Renewal Probably’ for vacant space to , that is, the
vacancy does not prolong

Table shows the assumed market rents (ERVs) as

well as the likely tenant fit out costs/sqm.

Again, these are general assumptions to be

adjusted on a tenant-by-tenant basis in the model

Specific Tenant Assumptions: Reversion

In the One Reversion Model, specific tenant assumptions overrule the general assumptions on the
previous slide. The specific assumptions are an extension of the tenancy schedule in the One Reversion
Model

Reversionary Assumptions Revisited

Is the Base Case realistic?

- The previous assumptions imply that the building will be 100% let at exit date. However, in our
specific submarket, tends to be a vacancy rate between 10-25% (Letting voids: High vacancy rates
in cities e.g., Ldn, LA, NY (20%) ..., need to bump up the letting void before you rent up the building)

- To bring some realism to the underwriting let us therefore assume (hardcode) that 2,000 sqms will
never be let (lazily modelled by assuming that 2,000 sqms will only be let after 100 months -
beyond the time span of this model) (never Have to spend the cost of refurbishing)

22
 Play with the model & check the impact on the IRR of this assumption

3. Key Stage of Analysis - Stage 3: Exit

Exit calculated as follows:
We look at each of these components, you try to adjust,
whatever I do for 5 years (assume 5 year duration + exit), and
then I use a market multiple and capitalize my expected cash
flow into perpetuity. you buy a building, you do something to it,
then reversion, and then you sell it.

• The exit Cap Rate (or exit yield) denotes the yield with which one capitalises one’s income at the
assumed time of exit [now prime fully-rented yield is 5% in London – need to adjust as not purely comps
+ adjust for costs u want to cover, over-rented, some vacancy]; (most important thing for the cap rate is your
comparables)
• The exit Cap Rate should be the market yield (the directly comparable yield that one is using when
comparing one comparable investment with another)
• One should cap income at the point when it is stabilised and at market or adjust accordingly
• Both the exit Cap Rate and what is being capped tends do have a huge effect on expected returns
• Exit Cap Rates can become a guessing game in illiquid markets or periods of illiquidity. A fair dose of
scepticism should be applied when assessing third party valuations in illiquid markets

Capping the Exit

- What is being capped? i.e., what U using as the numerator when calculating the exit price, will depend on:
• Country
• Convention
• Real Estate Asset Class
• Valuation Convention
• Comparables (** Most Important ~ NIY)

-Convention often rules and the details of the comparables are generally also important determining
factors
-In the literature, the capped income is generally the NOI I, but even here a difference is often made
between NOI I (before tenant incentives and leasing costs) and NOI II (after tenant incentives and
leasing costs). In most cases NOI I would be the appropriate measure, but net rent may also be
appropriate. NOI II may be the appropriate measure when analysing very large buildings when one
expects a continuous stream of Tis and LCs (i.e. in which case Tis/LCs are often treated recurring
operating expenditure)
-In markets where quoted yields are gross yields one needs to be careful not to compare apples with
oranges. In these contexts one either tries to estimate the implied NOI I or one caps gross income and
then adjusts the yield to reflect potential differences in non-recoverables across comparables. In
markets with close to full recoverability/FRI leases (e.g. UK) there is little difference between using
NOI I and rent

 In some countries (e.g. France) comparables sometimes tend to be quoted in terms of ‘net initial
yields’ (i.e. taking into account non-recoverables and the acquisition costs of a buyer). In these
situations one again needs to be careful to use the right comparable measure when calculating the exit
IN LONDON MARKET – YOUR COMPARABLES ARE WHAT YOU CALL NET INITIAL
YIELDS

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In the model. You should just replicate this. You change a couple of assumptions.

Comparables
- One’s exit cap rates should ideally be based on actual cap rates from ‘comparable’ transactions
- As discussed, whenever possible it is extremely important to use comparables that are truly comparable.
E.g., one should not use the yield of a transaction involving a brand-new building with a long lease in a
core location as a comparable yield for an older building in a B location.
- Also one needs to make check that if one’s comparables are quoted in terms of gross yields one then
adjusts for differences in non-recoverables (i.e. that the NOI I/Rent ratio is roughly the same).

- The more illiquid or intransparent markets are the more difficult it is to find comparables and
comparables, if they exist, often show gross yields. In these situations one carefully has to consider
the validity of one’s exit assumptions.

Exit Costs
Most jurisdictions, buyer pays real estate transfer tax. In these contexts, typical sales costs are:
• Legal advisory cost of the seller - stamp duty
• Sales agents/advisors (if used)
• Technical advisory costs or tax advisory
• Pre-payment penalties on in-place debt
- The volume of these fees varies depending on the country, context and convention.
- A rule of thumb is that acquisition & exit costs are around 10%, all included, even if
structures can sometimes be found to reduce these costs ++). Taxes vary significantly across
countries.

Entry and Exit assumptions Base Case

(1) Key items: exit Yield, your

costs, and what you capitalize,
when & at what rate?
(2) And whether you capitalize
NOI I or Gross Rent??
(3) How do you treat vacancies?
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4. Key Stage of Analysis - Stage 4: Discounting

Acquisition
The Acquisition Price is either:
1. Given, or (as an input)
2. A result of one’s target discount rate (or IRR) (as an output)

Acquisition costs are typically:

1. Transfer taxes (e.g., Real Estate Transfer Tax (RETT), Stamp Duty, etc.)
2. Legal advice (contract, structuring, tax)
3. Due diligence costs (e.g., technical, legal or environmental due diligence)
4. Third party valuation (if carried out)
5. Brokerage or advisory fees (if applicable)

What discount rate should one use?

- Remember, the discount rate is given by the NPV decision rule.
- The NPV, the net present value of an investment, is

where P is the price (including all acquisition costs arising in period 0) and CF(i) is the expected
cash flow until and including a sale in period T.
The NPV decision rule for an investment is NPV ≥ 0. Investors should choose the investment
with the highest NPV, assuming all other important factors are otherwise identical between the
investments. The NPV decision rule will be further considered in Session 5 when we consider
real options.
- The IRR is defined as the discount rate that sets the NPV = 0, where:

- The IRR is the dominant financial criteria for many investors. However, in practise it is always
combined with other criteria (and so it should be).

IRR
Is the discount rate/IRR an input or an output in one’s analysis?

1) If the acquisition price is not given (i.e. it is an output) then the discount rate ‘d’ or IRR is an
input to derive the price

• One’s discount rate is either given by one’s cost of capital (e.g. the minimum IRR hurdle of
one’s fund) or by some other measure (e.g. the discount rate implied by the pricing of the
shares in the case of a REIT; risk free rate plus a deal’s appropriate risk premium)

2) If the acquisition price is given (i.e. an input) then the “discount rate” d as an output, that is, the
discount rate (or IRR) is the mathematical result of one’s cash flow and acquisition price

• In this case one has to decide whether to carry out an investment based on whether the IRR
meets one’s hurdle rate (or cost of capital) and whether the IRR is preferable to other
investments which also meet the hurdle rate (and are otherwise comparable)

25
Remember, no professional investor would solely base his/her decision on an IRR or NPV test – and
a range of other criteria should always be considered (e.g., real estate fundamentals like location, risk,
leverage, size, diversification, multiple) and are often more important

IRR CONT’D
Notes

1) There are no directly & readily observable comparables for the IRR, as it is a total return measure
over a specified hold period

2) The discount rate d=IRR should be thought of as the opportunity cost of capital (OCC) i.e. what one
foregoes/gives up in order to carry out an investment. The opportunity cost of capital is of course also not
observable in real estate markets (it is also not readily observable in stock markets)

3) The opportunity cost of capital can be thought of as consisting of the risk free rate plus a project’s
specific risk premium (OCC = rf + RP). However, also the risk premium cannot be readily observed
(unlike transaction prices and perhaps gross yields). There are of course ways to estimate implied
required risk premia for publicly traded real estate companies based on modern portfolio theory, but most
real estate transactions do not involve publicly traded vehicles. Hence, whilst this way of thinking about
discount rates and opportunity cost is insightful, in practice it is not very useful

4) In practice, most fund investors are given a minimum or target IRR that they need to achieve and
which they work towards. They then solve backwards to price any particular suitable asset that falls
within their target risk range. IRRs are increased or decreased around a target IRR hurdle, depending on
the particulars and specific risks in an investment.

Other Financial Investment Criteria

When assessing an ivstmt, most non-core investors take into account the IRR, + they also need to
consider a range of other measures (risk, diversification, size, etc.). We look at some of these now:
Multiple

- It follows that a Multiple= 0 implies a total loss of capital and a Multiple=1 a return of capital (But no more)
- The Multiple is often combined with the IRR. e.g., for most opportunistic investors the
IRR hurdle of ca. 20% is combined with a minimum multiple hurdle of 2.0x. This rule is meant
to weed out high IRR/low multiple deals (e.g. short term development transactions). One
should also always look at the multiple of the unleveraged transaction

Another important measure is of course the amount of equity needed. For this, sophisticated investors
generally look at the peak equity concept (which includes expected equity funding during the whole life
of the deal).
Peak Equity
 Peak equity is the MAX equity that needs to be injected during the whole life of a deal. (Compressed
number that reflects your sources & uses)
 There are essentially 2 # ways to define peak equity:
1) Sum of all negative cash flows during the hold period (not taking into account positive
distributions to investors prior to further capital injections)

2) Cumulative maximum equity (i.e., negative cash flows will be offset with prior positive ones
as if the positive ones had not been distributed)

So the first way to calculate Peak Equity does not take into account any distributions prior to having to
make fresh capital injections.

Cost of Capital
Coming back to our example of the Frankfurt office deal we started the session with, let us assume that
the fund you work for looks for situations where it can earn:
26
- Minimum unleveraged IRR of 9.0%
- Minimum leveraged return/IRR of 15% - next session
- Minimum 1.4% multiple on equity invested
- Maximum Leverage (65%) – next session

How Are Value Add Returns Generated - Interrelated Explanations

• Risk
- Value Add or opportunistic investors are in the business of taking risk. However, they work hard
to minimise their risk through due diligence (removing uncertainty) and through carefully
selecting investment opportunities. However, one will generally have to accept some risk
• Cap rate compression
- Assumption that yield will decrease over hold period (e.g. from 6.25% to 5.75%). This type of
assumption needs to be justified and it is frequently abused in practice. One should use this
assumption if one can improve something in the building (physically or in terms of the tenancy
structure). However, it is also often used to convey the belief that the market will improve over
and above the fact that one’s building is 5 years older at the time of exit
• Re-gearing of leases
- Removing leasing risk by for example extending the average lease duration (also called the
Weighted Average Lease Term – WALT) or the quality of tenants during hold period
• Opportunistic buying
- Buying at a good price or in special circumstances (e.g. distressed seller, buying a loan with the
intention of foreclosing the loan & purchasing at a price below value) – one hears this argument
a lot but it is also often just marketing
• Increasing rents during hold period
- Indexation of current leases and market (ERV) growth over hold period (frequently abused
assumption)

P.S. Need to find comparables than what you’re selling rather than what you’re buying. Or the other way around?
- Might be overrented/ under-rented:
o Market rate is 60e/sqft, he pays 40e/sqft. -> underpays
o Also depends on option to lease extention or right to extend
- Living asset: Internal models to revaluate your asset on a regular basis. Depends on your equity sources

27
 selling one year earlier, what happens? -> You're applying a multiple of the reverse of your multiple at
exit (your cap rate) to a different cash flow, because you have higher vacancy at the time So essentially,
you're using less income. That's your basis for calculating your exit price. But then, you think, is this
correct? And again, there's no right or wrong -> depends on your market? The market gives you some
comparables, so you must be very careful to look at your comparables. Are they relevant to your exit?
of course, you also must use your comparables when you enter, because you say like, do I get it wrong?

UNLEVERAGED RETURNS
Estimate how much of the profit comes from the exit (vs.
the hold) Is the Base Case realistic?

UNDERSTANDING THE SENSITIVITY OF PARAMETERS (IRR)

Did you expect this result and what appears unusual? What other variables would you expect to
exhibit high sensitivity and why?

28
 Change rarely happens in isolation. It is always a good idea to run scenarios, looking at multiple
changes of inputs simultaneously. Carry out your own scenario analysis in the model

Analysing The Investment

Is the Base Case realistic?
• Is it realistic to assume 11% exit vacancy
• What about ERV growth? • What other assumptions would you like to highlight?

What Else Does One Need To Consider?

We will continue our analysis of this investment in the next section, when we look at:
• Other factors we need to consider
• Finance
• Tax
• Fine-tuning the model

29
Lecture 3: Debt markets for real estate; DCF with Finance and Tax

You get a higher return when your cost of debt is higher than your unlevered IRR.

Expect rent to go up or (…)

Ways of cutting the capital structure

Usually, mezzanine needs permission from junior and senior to break a clause(?)
Mezz is more secured than the Equity. Yet, in last GFC, if things go wrong, who do we care
about?

If a property is management intensive, e.g., prop needs refurbishment, we might need equity
before mezz. Many family offices tend to go for mezz, but when things go wrong, e.g. when
there is operational risk, it’s very quick on the way down.

How to price debt?

Parameters to take into considerations:
Libor rate / Euribor, Swaps, banks refinancing costs + Gross Margin
=> determinants of the interest rate

Example of simplified covered bond structure & pricing

Covered bonds = secured bonds, specific performance during crisis
- The equity portion gets expensive

MLV depends highly on the jurisdiction.

The loan is what you want e.g., 60% LTV of MV

Who provides financing?

CMBS completely collapsed in the GFC. Now in the US, issue the CMBS, put them is the SPV,
then sell them for cheaper.

The difference now vs 07’ GFC is extreme levels of leverage v now rapid accelerations from
negative/low IR to very high IR.

--

Waterfalls:

In loan agreements – who gets the money first.

+ special case of when you have a derivative.

---
Your investor multiple is higher than IRR as it’s effect of timing

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UNIT 4

31