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Real Estate Financial Modeling’s

Guide To The Real Estate Business

www.realestatefinancialmodeling.com

Photograph by Zoltan Farago. All rights reserved.


All Other Contents Copyright © 2009 Real Estate Financial Modeling, LLC. All rights reserved.
Table of Contents

Foreword 3
Why Real Estate? 4
A Big-Picture Real Estate Business Framework 5
Types of Real Estate 6
Types of Real Estate Investors 7
Elements of Real Estate Investment 8
Types of Capital 9
Equity 9
Debt 10
1031 Exchange 11
Uses of Capital 12
Investment Objectives and Methods 13
Income (Maximizing Cash Flow and Yield) 13-14
Recouping of Investment and Profit Taking 15
Valuation of Real Estate 16
Discounted Cash Flow and Time Value of Money Model 16-17
NOI, Cap Rates and Comparable Sales Model 18-19
Replacement Cost 19
Additional Resources 20-21
Foreword. This guide has been kept concise so that it can be read in a single
afternoon. It is written on a basic level and is primarily intended to bring up to speed
those with little prior exposure to the world of real estate. However, there is likely
something of interest in the guide for readers of all levels of expertise. The guide
takes a big-picture view of the industry and attempts to show how all of the pieces fit
together. It is by no means an exhaustive treatment, and is best read as a companion
to Professor Peter Linneman’s Real Estate Finance & Investments: Risks and
Opportunities textbook, with the Barron’s Dictionary of Real Estate Terms at hand. I
wish you all the best in your real estate endeavors.

Bruce Kirsch
Principal
Real Estate Financial Modeling, LLC
www.realestatefinancialmodeling.com
Why Real Estate? Real estate is a dynamic, high-stakes industry where massive
fortunes have been made, lost, and sometimes made again. Real estate is the
suburban American dream home with the white picket fence, the tiny overpriced
New York studio apartment, the Nike corporate campus, the Empire State Building,
the shopping mall, the monstrous Wal-Mart Supercenter, and the Hawaiian vacation
resort with the oceanside golf course, to name a few manifestations.

The industry is enormous in size (the U.S. commercial market alone is a multi-trillion
dollar market) and expansive in scope. Real estate is often the majority of a U.S.
family’s wealth, and is usually a major portion of a corporation’s assets. It is home to
both low-key moguls such as Walter Shorenstein and Gerald Hines and flamboyant
personalities like Sam Zell and Donald Trump. Real estate is about people,
properties, deal making and value creation. If all of this interests you, read on!
A Big-Picture Real Estate Business Framework. Below is one framework in
which to view the real estate business (it is by no means the only way!). The
comprising elements are explored separately on the following pages.
Types of Real Estate Investors Types of Capital
Private Non-REIT Equity
Individual Pension funds Personal and/or family investment
Family Life/insurance companies Private equity
Investment Firm Opportunity (private equity) funds Tax credits
&
REIT Other Debt
Equity Investment banks Commercial mortgage loans
Mortgage Commercial banks Government bonds
Hybrid State and city governments 1031 Exchange

Residential Commercial
Detached single family homes Office Industrial
Townhomes Central Business District (generally highrise and midrise) Heavy industrial (manufacturing) facilities
Class A (e.g., The GM Building in NYC) Light assembly
Class B (increasingly lesser in quality and location) Storage and distribution facilities
Class C Research and development facilities
Suburban (generally midrise)
Class A Retail
Class B Shopping centers
Class C Super regional centers (e.g., Mall of America)
Medical Office Regional center
Community center
Multifamily (apartments, condominiums and cooperatives) Neighborhood center
Small properties Convenience center
Suburban garden apartments Specialty center
Urban midrise Big box (freestanding) store (e.g., Home Depot)
Urban highrise Strip commercial

Hotels and resorts Other


Limited service Golf courses Land
Full service (e.g., The Ritz Carlton or Marriott) Assisted living Health Care
Extended stay Student housing Institutions

Valuation Methods Uses of Capital


Discounted Cash Flow and Acquisition of existing rental property
Time Value of Money Model Rehabilitation/Repositioning
NOI, Cap Rates and Comparable Sales Land entitlement or rezoning
Replacement Cost Ground-up new property development

Investment Objectives and Methods

Income (Maximizing Cash Flow and Yield) Recouping of Investment and Profit Taking
Escalation of rents Favorable tax re-assessment Condominium (ownership interest) sale
Achieving operational efficiencies Deferring maintenance Sale and leaseback
Refinancing of debt at a lower rate Lowering debt amortization Refinancing
Paying down debt Offering ancillary property services Fee simple disposition
Acceleration of depreciation
Types of Real Estate. Real estate is generally separated into residential and commercial
categories. Detached single family homes and townhomes are usually what fall under
residential (some will also include multi-family in this category), while commercial is
comprised of multiple sectors as broken out below.

Types of Real Estate

Residential Commercial
Detached single family homes Office
Townhomes Central Business District (generally highrise and midrise)
Class A (e.g. The GM Building in NYC)
Class B (increasingly lesser in quality and location)
Class C
Suburban (generally midrise)
Class A
Class B
Class C
Medical Office

Multifamily (apartments, condominiums and cooperatives)


Small properties
Suburban garden apartments
Urban midrise
Urban highrise

Hotels and resorts


Limited service
Full service (e.g., Ritz Carlton or Marriott)
Extended stay

Industrial
Heavy industrial (manufacturing) facilities
Light assembly
Storage and distribution facilities
Research and development facilities

Retail
Shopping centers
Super regional centers (e.g., Mall of America)
Regional center
Community center
Neighborhood center
Convenience center
Specialty center
Big box (freestanding) store (e.g., Home Depot)
Strip commercial

Other
Golf courses Land
Assisted living Health Care
Student housing Institutions
Types of Real Estate Investors. Real estate is a well-established investment
vehicle, and unsurprisingly, real estate investors have grown in number, type and
sophistication over time. Investors fall into the four main categories that are shown
and described below.

Types of Real Estate Investors


Private REIT Non-REIT Other
Individual Equity Pension funds Investment banks
Family Mortgage Life/insurance companies Commercial banks
Investment Firm Hybrid Opportunity (private equity) funds State and city governments

• Private individuals, families, or investment operations make both small and large
investments. Developers, those who transform raw land or an existing property to
an improved (and hopefully more valuable) state, often fall in this category.

• REITs (real estate investment trusts), which own about one third of the
commercial investment properties in the U.S., can be either privately or
publicly owned.

o Equity REITs develop, manage, invest in and own properties. Their


revenues come primarily from rents from tenants and capital gains
realized upon sales of assets.

o Mortgage REITs do not generally own real estate – they typically loan
money to people or companies that buy real estate. They also purchase
existing mortgages or mortgage-backed securities. Their revenues
come from the interest paid to them on the capital they loan.

o Hybrid REITs combine the two types of investment explained above.

• Non-REIT equity investors, which can be either privately or publicly owned,


include large money managers such as pension funds1, life/insurance
companies, and “opportunity funds” (private equity funds), all of which make
equity investments, and the latter of which tends to invest in transactions with
higher risk/return profiles.

• In the “other” category fall investment banks that raise equity and debt for
REITs and other types of real estate firms wishing to access the capital
markets, and commercial banks such as Wachovia, which make loans on real
estate investments. Lastly are state and city governments, which issue bonds
that private investors fund and then sell to developers.

1
Pension funds are funds managed for large groups of public and private sector employees who hope to be
supported through their retirements based on investment returns achieved by their former employers’
investments in vehicles such as real estate and the stock market.
Elements of Real Estate Investment. Below is a basic way to view the
components of real estate investment. The pages that follow address each element.

Elements of Real Estate Investment

Types of Capital

Equity
Personal and/or family investment
Private equity
Tax credits

Debt
Commercial mortgage loans
Government bonds

1031 Exchange

Uses of Capital

Acquisition of existing rental property


Rehabilitation/Repositioning
Land entitlement or rezoning
Ground-up new property development

Investment Objectives and Methods

Income (Maximizing Cash Flow and Yield)


Escalation of rents
Achieving operational efficiencies
Refinancing of debt at a lower interest rate
Paying down debt
Acceleration of depreciation
Favorable tax re-assessment
Deferring maintenance
Lowering debt amortization
Offering ancillary property services

Recouping of Investment and Profit Taking


Condominium (ownership interest) sale
Sale and leaseback
Refinancing
Fee simple disposition

(Continued)

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