Real Estate Finance and nvestments

Transcription

1 Real Estate Finance and nvestments Fourteenth Edition William B. Brueggeman, Ph.D. Corrigan Chair in Real Estate Edwin L. Cox School of Business Southern Methodist University Jeffrey D. Fisher, Ph.D. Charles H. and Barbara F. Dunn Professor of Real Estate Kelley School of Business Indiana University McGraw-Hill Irwin

2 PART ONE OVERVIEW OF REAL ESTATE FINANCE AND INVESTMENTS Chapter 1 Real Estate Investment: Basic Legal Concepts 1 Property Rights and Estates 2 Definition of Estate 4 Two General Classifications of Estates 4 Examples of Freehold Estates 4 ^ Estates Not Yet in Possession (Future Estates) 5 Examples of Leasehold Estates 5 Interests, Encumbrances, and Easements 6 Assurance of Title 7 The Meaning of Title 7 Deeds 9 Methods of Title Assurance 9 Abstract and Opinion Method 11 The Title Insurance Method 11 Recording Acts 12 Limitations on Property Rights 13 Chapter 2 Real Estate Financing: Notes and Mortgages 16 Notes 16 The Mortgage Instrument 18 Definition of a Mortgage 18 Relationship of Note to Mortgage 18 Interests That Can Be Mortgaged 19 Minimum Mortgage Requirements 19 Important Mortgage Clauses 20 Assumption of Mortgage 22 Acquiring Title "Subject to" a Mortgage 23 Properly Covered by a Mortgage 23 Junior Mortgages 24 Recording of Mortgages 24 Other Financing Sources 24 Seller Financing 24 Land Contracts 25 Default '26 What Constitutes Default? 26 Alternatives to Foreclosure: Workouts 26 Restructuring the Mortgage Loan 27 Transfer of Mortgage-to a New Owner 28 Voluntary Conveyance 29 Friendly Foreclosure 30 Prepackaged Bankruptcy 30 Short Sale 30 Foreclosure.31 Judicial Foreclosure' 31 Redemption 32 Sales of Property 32 Effect of Foreclosure on Junior Lienors 35 Deficiency Judgment 35 Taxes in Default 36 Bankruptcy 37 Chapter 7 Liquidation 37\ Chapter Chapter PART TWO MORTGAGE LOANS Chapter 3 Mortgage Loan Foundations: The Time Value of Money 42 Compound Interest 42 Compound or Future Value 43 Calculating Compound Interest Factors 47 Using Financial Functions: Calculators and Spreadsheets 49 ( Present. Value 52 A Graphic Illustration of Present Value 52 Expanding the Use of Calculators for Finding Present Values 54 Compound.or Future Value of an Annuity 56 Use of Compound Interest Factors for Annuities 58 Present Value of an Annuity 60 Use of the Present Value of an Annuity Factors 61 Accumulation of a Future Sum 64 Determining Yields, or.internal Rates of Return, on Investments 65 Investments with Single Receipts 65 Yields on Investment Annuities 68 Equivalent Nominal Annual Rate (ENAR): Extensions 70 Solving for Annual Yields with Partial Periods: An Extension 72 Chapter 4 Fixed Interest Rate Mortgage Loans 77 Determinants of Mortgage Interest Rates: A Brief Overview 77

3 xii Table of Contents The Real Rate of Interest: Underlying Considerations 78 Interest Rates and Inflation Expectations 78 Interest Rates and Risk 79 A Summary of Factors Important in Mortgage Loan Pricing 81 Understanding Fixed Interest Rate Mortgage (FRM) Loan Terms 81 Calculating Payments and Loan Balances Fixed Interest Rate Loans 83 The Importance 'of Accrued Interest and Loan Payments 83 Loan Amortization Patterns 83 Fully Amortizing, Constant Payment Mortgage (CPM) Loans 84 t ; Partially Amortizing, Constant Payment Mortgage (CPM) Loans 88 Zero Amortizing, or Interest Only Constant Payment. Mortgage (CPM) Loans 89 Negative Amortizing, Constant Payment Mortgage (CPM) Loans.90 Summary and Comparisons: Fixed Interest Rate, Constant Payment Mortgage (CPM) Loans with Various Amortization Patterns 91 Determining Loan Balances 92 Finding Loan Balances Other Amortization Patterns 94 Loan Closing Costs and Effective Borrowing Costs 95 Loan Fees and Early Repayment: Fully Amortizing Loans 98 Charging Fees to Achieve Yield, or "Pricing" FRMs 102 Other FRM Loan Patterns Declining Payments and Constant Amortization Rates 103 Amortization Schedules and Callable Loans 104 Reverse Annuity Mortgages (RAMs) 105 Inflation, Mortgage Pricing, and Payment Structuring 111 Chapter 5 Adjustable and Floating Rate Mortgage Loans 120 The Price Level Adjusted Mortgage (P.LAM) 122 PLAM: Payment Mechanics 122 ARMs and Floating Rate Loans: An Overview 124 Variations: ARM and Floating Rate Loans 127 Risk Premiums, Interest Rate Risk, and Default. Risk 131 y Expected Yield Relationships and Interest Rate Risk 133 More Complex Features 134 ARM Payment Mechanics 136 Expected Yields on ARMs: A Comparison 141 Chapter 6 Mortgages: Additional Concepts, Analysis, and Applications 148 Incremental Borrowing Cost 148 Early Repayment 150 Origination Fees 151 Incremental Borrowing Cost versus a Second Mortgage 152 Relationship between the Incremental Cost and the Loan-to-Value Ratio 152 Differences in Maturities 155 Loan Refinancing 156 Early Repayment: Loan Refinancing 157 Effective Cost of Refinancing 159 Borrowing the Refinancing Costs 159 Other Considerations 160 Early Loan Repayment: Lender Inducements 162 Market Value of a Loan 163 Effective Cost of Two or More Loans 164 Second Mortgages and Shorter Maturities 166 Effect of Below-Market Financing on Property Prices 167 Assuming a Lower Loan Balance 169 Cash Equivalency 170 Cash Equivalency: Smaller Loan Balance 1-71 Cash Equivalency: Concluding Comments 172 Wraparound Loans 172 Buydown Loans 175 After-Tax Effective Interest Rate 179 PART THREE RESIDENTIAL HOUSING Chapter 7 Single Family Housing: Pricing, Investment, and Tax Considerations 183 Overview 183 House Prices 183 Income and Employment 184 Renting versus Owning 185 Analyzing Expected House Prices 193

4 Table of Contents xiii Economic Base Analysis Location Quotients 197 Housing Supply: An Overview 198 Submarkets: Neighborhoods/Municipalities 199 Capitalization Effects: Price Premiums 199 Pricing Property in Specific Submarkets/Locations 201 Investing in "Distressed Properties" 209 Financial Framework for Analyzing Distressed Properties 210 Acquisition Phase 210 Holding Period Phase 214 Disposition Phase Exit Strategies 218 Chapter 8 Underwriting and Financing Residential Properties 222 Underwriting Default Risk 222 Classification of Mortgage Loans 223 Conventional Mortgage-Loans 223 Insured Conventional Mortgage Loans 225 FHA Insured Mortgage Loans 226 VA Guaranteed Mortgage Loans 226 The Underwriting Process 227 Borrower Income 227 Verification of Borrower Assets 229 Assessment of Credit History 229 Estimated Housing Expense 231 Other Obligations 231 Compensating Factors 231 *" The Underwriting Process Illustrated 233 Underwriting Standards Conventional and Insured Conventional Mortgages 233 Underwriting Standards FHA Insured Mortgages 235 Underwriting Standards VA Guaranteed Mortgages 237 Underwriting and Loan Amounts A Summary 238 The Closing Process 239 Fees and Expenses 240 Prorations, Escrow Costs, and Payments to Third Parties > 240 Statutory Costs 242 Requirements under the Real Estate Settlement and Procedures Act (RESPA) 243 Settlement Costs Illustrated 245 Federal Truth-in-Lending (FTL) Requirements 246 Truth-in-Lending Sample Disclosure 247 Establishing the APR under Federal Truth-in-Lending Requirements 247 ARMs and Truth-in-Lending Disclosure 248 PART FOUR INCOME-PRODUCING PROPERTIES Chapter 9 Income-Producing Properties: Leases, Rents, and the Market for Space 254 Property Types 254 Supply and Demand Analysis 256 Local Market Studies of Supply and Demand 259 Location and User-Tenants 260 The Business of Real Estate 262 The "Market" for Income-Producing Real Estate 263 Income Potential Real Estate Assets Vacancy 265 Underwriting Tenants 266 General Contents of Leases 266 Leases and Rental Income 270 Leases and Responsibility for Expenses (Recoveries) 270 Comparing Leases: Effective Rent 2 73 Developing Statements of Operating Cash Flow 277 Case Example: Office Properties 278 Rent Premiums and Discounts for Office Space 278 Pro Forma Statement of Cash Flow Office Properties 281 Case Example: Industrial and Warehouse Properties 281 / Pro Forma Statement of Cash Flow Industrial/ Warehouse Properties 283 Case Example: Retail Properties 284 The Retail Leasing Environment 284 CAM Charges Recoveries 286 Pro Forma Statement of Cash Flow Retail Properties 286 Case Example: Apartment Properties 288 Chapter 10 Valuation of Income Properties: Appraisal and the Market for Capital 296 Introduction 296 Valuation Fundamentals 296 Appraisal Process and Approaches to Valuation 297 Sales Comparison Approach 298 Income Approach 300 Capitalization Rate 302 Capitalization Rates A Note of Caution 305 Discounted Present. Value Techniques 306

5 xiv Table of Contents Land Values: Highest and Best Use Analysis 313 Volatility in Land Prices 314 "Highest and Best Use "Analysis Vacant Site 314 "Highest and Best Use"Analysis Improved Property 315 Mortgage-Equity Capitalization 315 Reconciliation: Sales Comparison and Income Capitalization Approaches 318 Exploring the Relationships between Changing Market Conditions, Cap Rates, and Property Values 318 A Closing Note on Cap Rates and Market Conditions A Word of Caution Simultaneous Effects of Real Market Forces and Interest Rates on Property Values 322 Leases: Valuation of a Leased Fee Estate 323 Cost Approach 324 Valuation Case Study Oakwood Apartments 328 ARGUS Solution 331 Chapter 11 Investment Analysis and Taxation of Income Properties 339 Motivations for Investing 339 Real Estate Market Characteristics and Investment Strategies 340 The "RealEstate Cycle" 340 Investment Strategies 342 Market Analysis 345 Supply of Space 348 Market Rents 348 Forecasting Supply, Demand, Market Rents, and Occupancy 349 Making Investments: Projecting Cash Flows 352 Office Building Example 352 Base Rent 353 CPI Adjustment 353 Expense Stops 354 Net Operating Income 355 Expected Outlays for Replacements and Capital Improvements 355 Estimated Sale Price 356 Introduction to Investment Analysis 358 Internal Rate of Return (IRR) 358 Present. Value 358 ARGUS Solution 359 Introduction to Debt Financing 359 Measures of Investment Performance Using Ratios 359 Before-Tax Cash Flow from Sale 361 Summary of Investment Analysis Calculations 362 Taxation of Income-Producing Real Estate 363 Taxable Income from Operation of Real Estate 363 Depreciation Allowances 364 Loan Points 365 Tax Liability and After-Tax Cash Flow 365 Taxable Income from Disposal of Depreciable Real Property 366 After-Tax Investment Analysis 366 After-Tax Cash Flow from Operations 366 After-Tax Cash Flow from Sale 368 After-Tax IRR 369 Effective Tax Rate 369' A Note about Passive Losses 370 Special Exceptions to PAL Rules 371 Approaches to Metro Area Market Forecasting: Basic Concepts and Data Sources 375 Chapter 12 Financial Leverage and Financing Alternatives 381 Introduction to Financial Leverage 381 Conditions for Positive Leverage Before Tax 382 Conditions for Positive Leverage After Tax 386 Break-Even Interest Rate 388.Risk and Leverage 390 ' Underwriting Loans on Income Properties 392 Market Study and Appraisal 392 Borrower Financials 392 The Loan-to- Value Ratio 393 The Debt Coverage Ratio 393 Other Loan Terms and Mortgage Covenants 394 Alternatives to Fixed Rate Loan Structures 396 Participation Loans 397 Lender Motivations 397 Investor Motivations 398 Participation Example 398 Sale-Leaseback of the Land 402 Effective Cost of the Sale-Leaseback 404 Interest Only Loans 404 Accrual Loans 406 Structuring the Payment for a Target Debt Coverage Ratio 406 Convertible Mortgages 408 Lender's Yield on Convertible Mortgages 408 Comparison of Financing Alternatives 410 Monument Office-Building Example ARGUS Solution.with a Loan 412 Other Financing Alternatives 414,

6 Table of Contents xv Chapter 13 Risk Analysis 418 Introduction 418 Comparing Investment Returns 418 Types of Risk 449 Due Diligence in Real Estate Investment Risk Analysis 421 Sensitivity Analysis 421 Partitioning the IRR 425 Variation in Returns and Risk 426 Retail Case Study Westgate Shopping Center 430 Westgate Shopping Center Scenario Analysis 433 Westgate Shopping Center ARGUS Analysis 433 Lease Rollover Risk 433 '.' Market Leasing Assumptions with Renewal Probabilities 435 Market Rent 436 Months Vacant 436 Leasing Commissions 436 Tenant Improvements 436 Industrial Case Study Worthington Distribution Center 437 Solution with ARGUS 438 Risk and Leverage 438 A "Real Options" Approach to Investment Decisions 443 Traditional Approach to Land Valuation 444 Real Option Approach to Land Valuation 444 Real Options Extensions and Strategy 445 Chapter 14 Disposition and Renovation of Income Properties 449 Disposition Decisions 449 A Decision Rule for Property Disposition 450 IRR for Holding versus Sale of the Property 451 Return to a New Investor 454 Marginal Rate of Return 454 Refinancing as an Alternative to Disposition 458 Incremental Cost of Refinancing 458 Leveraged Return from Refinancing and Holding an Additional Five Years 459 Refinancing at a Lower Interest Rate 461 Other Disposition Considerations Portfolio Balancing 462 Tax-Deferral Strategies upon Disposition 462 Installment Sales 463 Tax-Deferred Exchanges 468 Renovation as an Alternative to Disposition 475 Renovation and Refinancing 478 Rehabilitation Investment Tax Credits 478 Low-Income Housing 480 Chapter 15 Financing Corporate Real Estate 485 Lease-versus-Own Analysis 486 Leasing versus Owning An Example 486 Cash Flow from Leasing 487 Cash Flow from Owning 487 Cash Flow from Owning versus Leasing 489 Return from Owning versus Leasing 489 Importance of the Residual Value of Real Estate 490 The Investor's Perspective 492 A Note on Project Financing 493 Factors Affecting Own-versus-Lease Decisions 494 The Role of Real Estate in Corporate Restructuring 499 Sale-Leaseback 500 Refinancing 503 Investing in Real Estate for Diversification 503 Real Estate Asset Pricing and Capital Budgeting Analysis: A Synthesis 506 PART FIVE FINANCING REAL ESTATE DEVELOPMENT Chapter 16 Financing Project Development 508 Introduction 508 Overview: The Planning and Permitting Process 508 The Development of Income-Producing Property 511 Market Risks and Project Feasibility 513 Project Risks 515 Project Development Financing An Overview 515 Lender Requirements in Financing Project Development 517 Loan Submission Information for Loan Requests An Overview 517 Contingencies in Lending Commitments 521 The Construction or Interim Loan 522 Methods of Disbursement Construction Lending 523 Interest Rates and Fees 523 Additional Information for Interim Loan Submission 524

7 xvi Table of Contents Requirements to Close the Interim Loan 524 The Permanent Loan Closing 525 Project Development Illustrated 526 Project Description and Project Costs 526 Market Data and Tenant Mix 531 Pro Forma Construction Costs and Cash Flow Projections 532 Feasibility, Profitability, and. Risk Additional Issues 535 Profitability before and after Taxes 535 Sensitivity Analysis, Risk, and Feasibility Analysis 538 Chapter 17 Financing Land Development Projects 545 ' ' Characterization of the Land Development Business 545 The Land Development Process AJI Overview 547 Acquisition of Land Use of the Option Contract 547 Financing and Development 549 Lender Requirements in Financing Land Development 552 Detailed Cost Breakdowns 554 General Contracts and Subcontracts 554 Residential Land Development Illustrated 555 Market Conditions and. Site Plan 556 Estimating Development Cost and Interest Cany 558 Estimating Release Prices per Parcel Sold 566 Loan Request and Repayment Schedule 566 Project Feasibility and Profitability 567 Project IRR and Net Present. Value 569 Entrepreneurial Profits 570 Sensitivity Analysis 571 PART SIX ALTERNATIVE REAL ESTATE FINANCING AND INVESTMENT VEHICLES Chapter 18 Structuring Real Estate Investments: Organizational Forms and Joint Ventures 574 Introduction 574 Sole Proprietorships 574 Partnerships 575 Limited Liability Companies 577 Corporations 578 Joint Ventures 579 Organizational Forms 580 Profit Sharing 580 Initial Capital Contributions 581 Sharing Cash Flow from Operations 581 Sharing of Cash Flow from Sale 582 Summary of Cash Flows Distributed in Each Operating Year 583 Cash Flow from Sale 585 IRR to Each Joint Venture Party 585 Variation on the Preferred IRR IRR Lookback 586 Syndications 587 Use of the Limited Partnership in Private and Public Syndicates 588 Private Syndication Problem Illustrated 588 Financial Considerations Partnership Agreement 589 Operating Projections 590 Statement of Before-Tax Cash Flow (BTCF) 591 Calculation of Net Income or Loss 591 Calculation of Capital Gain from Sale 592 Capital Accounts 593 Distribution of Cash from Sale of Asset 593 Calculation of After-Tax Cash Flow and ATI RR on Equity 594 Partnership Allocations and Substantial Economic Effect 596 Capital Accounts and Gain Charge-Backs 597 Use of the Limited Partnership in Private and Public Syndicates 600 Use of Corporate General Partners 600 Private versus Public Syndicates 601 Accredited Investors Regulation D 601 Regulation of Syndicates 602 Investment Objectives and Policies 602 Promoters' and Managers' Compensation 603 Investor Suitability Standards 603 Federal and State Securities Authorities 604 Chapter 19 The Secondary Mortgage Market: Pass-Through Securities 608 Introduction 608 Evolution of the Secondary Mortgage Market 608 Early Buyers of Mortgage Loans 609 The Secondary Market after FNMA s Changing Role 610 The Government National Mortgage Association 611 Mortgage-Backed Securities and the GNMA Payment Guarantee 611 The Federal Home Loan Mortgage Corporation 612

8 Table of Contents xvii Operation of the Secondary Mortgage Market 612 Direct Sale Programs 613 The Development of Mortgage-Related Security Pools 614 Mortgage-Backed Bonds 614 Pricing Mortgage-Backed Bonds 615 Subsequent Prices 617 Mortgage Pass-Through Securities 618 Important Characteristics of Mortgage Pools 620 Mortgage Pass-Through Securities: A General Approach ' to Pricing 623 Mortgage Pass-Through Payment Mechanics Illustrated 625 Prepayment Patterns and Security Prices 627 Prepayment Assumptions 628 The Effects of Prepayment Illustrated 630 Security Prices and Expected Yields 631 Market Interest Rates and Price Behavior on Mortgage Pass-Throughs 632 A Note on MBBs and MPTs 633 Chapter 20 The Secondary Mortgage Market: CMOs and Derivative Securities 635 Introduction 635 Mortgage Pay-Through Bonds (MPTBs) 635 Collateralized Mortgage Obligations 636 CMOs Illustrated 637 CMO Mechanics 639 CMOs: Pricing and Expected Maturities 645 CMO Price Behavior and Prepayment Rates 64 7 CMO Tranche Variations 649 Subprime Mortgage-Backed Securities 650 Derivatives Illustrated 651 Yield Enhancement 654 1O and PO Strips 654 Convexity 657 Residential Mortgage-Related Securities: A Summary 657 Residential Mortgage-Related Securities: Some Closing Observations 659 Commercial Mortgage-Backed Securities (CMBSs) 660 Rating Commercial Mortgage-Backed Securities 663 Collateralized Debt Obligations (CDOs) 666 Mortgage-Related Securities and REMICs 669 REMICs: Other Considerations 671 Duration An Additional Consideration in Yield Measurement 675 Chapter 21 Real Estate Investment Trusts (REITs) 678 Introduction 678 Legal Requirements 678 Tax Treatment 681' Violation'.Penalties and Status Termination 681 Taxable REIT Subsidiaries 681 Types of Trusts 682 Equity Trusts 682 The Investment Appeal of Equity Trusts 684 Private REITs 687 Importance offfo (Funds from Operations) 688 REIT Expansion and Growth 689 Important Issues in Accounting and Financial Disclosure: Equity REITs 694 Tenant Improvements and Free Rents: Effects on FFO 694 Leasing Commissions and Related Costs 695 Use of Straight-Line Rents 695 FFO and Income from Managing Other Properties 696 Types of Mortgage Debt and Other Obligations 696 Existence of Ground Leases 69 7 Lease Renewal Options and REIT Rent Growth 697 Occupancy Numbers: Leased Space or Occupied Space? 698 Retail REITs and Sales per Square Foot 698 Additional Costs of Being a Public Company 698 The Investment Appeal of Mortgage REITs 699 Financial Analysis of an Equity REIT Illustrated 700 Valuing REITs as Investments 703 Valuation of Midwestern America Property Trust 704 Chapter 22 Real Estate Investment Performance and Portfolio Considerations 710 Introduction 710 The Nature of Real Estate Investment Data 710 Sources of Data.Used for Real Estate Performance Measurement 711 REIT Data: Security Prices 711 Hybrid and Mortgage REITs 712 NCREIF Property Index: Property Values ' 713 Data Sources for Other Investments 713 Cumulative Investment Return Patterns 713 Computing Holding Period Returns 714 Comparing Investment Returns 716 Risk, Return, and Performance Measurement 716 Risk-Adjusted Returns: Basic Elements 717

9 xviii Table of Contents Elements of Portfolio Theory 718 Real Estate Performance and Inflation 728 Calculating Portfolio Returns 720 Diversification by Property Type and Location 728 Portfolio Risk 720 Global Diversification 731 Portfolio Weighting: Trading Off'Risk and Return 723 Risks of Global Investment 733 Real Estate Returns, Other Investments, and the Use of Derivatives to Hedge Portfolio Risk 734 Potential for Portfolio Diversification 725 Example Swap Office for Retail 735 Portfolio Diversification: EREITs and Other Investments 725 incjpx 739 Public versus Private Real Estate Investments 727