Veritas Financial GroupIntroduction to the Financial Universe

Week 6 – Real Estate

Today’s Agenda – Real Estate

• What is Real Estate?

• How can you invest in real estate?

• How do you finance real estate?

• What drives real estate prices?

• What is a “housing bubble”?

• How did real estate contribute to the 2008-2009 financial crisis?

What is Real Estate?

• Real Estate is an ownership interest in land and/or buildings positioned on land

• Sometimes land + building do not go together

• Long-term operating leases are real estate

What is Real Estate?

Three broad categories of real estate

•Residential: houses, apartments, and condos• Next subdivision: single-family vs. multi-family

• Outside investment more common in multi-family

•Commercial: shopping centers, offices, etc.

•Industrial: warehouses, factories

How can you invest in real estate?

• Direct Investment

• Simplest and easiest to understand

• Buy an interest in a particular piece of property

• Requires large amounts of capital, especially if you are looking to build a diversified portfolio

• High transaction costs and low liquidity

Rent versus Buy

Home Price $1,000,000 % Down 20%Amount Downpayment $200,000

Home Loan Amount $800,000 Loan to Value/ "LTV" 80%Interest Rate 5%Term Loan 30Expected House Appreciation 2%

Monthly Rent $5,000 Annual Rent $60,000 Rent Inflation 2%

0 1 2 3 4 5 6 7 8 9 10Home Value 1,000,000 1,020,000 1,040,400 1,061,208 1,082,432 1,104,081 1,126,162 1,148,686 1,171,659 1,195,093 1,218,994 Equity (200,000) Interest & Amort. (52,041) (52,041) (52,041) (52,041) (52,041) (52,041) (52,041) (52,041) (52,041) (52,041) Interest (40,000) (39,398) (38,766) (38,102) (37,405) (36,673) (35,905) (35,098) (34,251) (33,361) Value of Loan 800,000 787,958.85 775,315.65 762,040.28 748,101.15 733,465.06 718,097.16 701,960.87 685,017.77 667,227.51 648,547.73 Cash Out (200,000) (52,041) (52,041) (52,041) (52,041) (52,041) (52,041) (52,041) (52,041) (52,041) (52,041) Equity Value less Loan 570,446.69

Annual Rent (60,000) (61,200) (62,424) (63,672) (64,946) (66,245) (67,570) (68,921) (70,300) (71,706) (73,140)

Difference (140,000) 9,159 10,383 11,631 12,905 14,204 15,529 16,880 18,258 19,664 591,545 Discount Rate 7%NPV $233,634.38

How can you invest in real estate?

Real Estate Development is a form of Direct Investment

• Build something new (residential or commercial development)

• Improve an existing property • Can either sell off entire property or individual units

How can you invest in real estate?

• Indirect Investment • REITs – Real Estate Investment Trusts

• Comingled vehicle for buying real estate

• Mutual funds are for stocks what REITs are for real estate

• Pool your money with other investors to purchase a particular type of real estate in a particular market

• Examples: Commercial real estate in Seattle, residential real estate in New England, etc.

Real Estate Pros and Cons

Pros

• Real estate is a ‘store of value’

• Projects can have significant upside

• Long term outlook

Cons

• Relatively Illiquid• High capital

requirements can make it difficult to diversify risk sources

• Negative cash flow at the beginning

• Exposed to broader macro trends

How can you finance real estate?

• Cash – simple, but uncommon• Standard financing – down payment (20%) and

bank financing for the rest• Adjustable Rate Mortgages (ARMs)

• “Interest Only” – no principal payments; essentially renting but you’ve taken title

• Second Mortgages – used for down payment

Loan-to-Value a key factor in determining the interest rate on these loans

What drives real estate prices?

• Cash flow from real estate• In theory, this is a simple DCF calculation• Value of a building is determined by cash flow and

discount rate

• General market pricing techniques• Analogous to a multiples analysis for stock• Pricing per square foot is most common• Other measures include price per parking space, square

foot of selling space, etc.

What drives real estate prices?

• Old-fashioned supply and demand• Market forces drive real estate prices just like they do

stock prices and prices for other goods.• When markets are “hot” prices rise dramatically because

investors get excited about a market• Bubbles are primarily driven by investors and not buyers

who intend to use the space themselves

• Government incentives• Governments often provide tax incentives to locate

businesses or homes in certain geographic areas. This will raise prices.

What is a housing bubble?

• Unsustainable rise in housing prices caused by a stream of outside investment into a particular market

• Why are bubbles dangerous?• Home equity loans – “Make your home work for you”• High loan-to-value ratios – “Zero Down!”• No doc mortgages• Both categories of products put houses at a high risk if going “under

water” if there is a decline in prices (which there almost always will be)

• What happens when you are under water?• The bank is in trouble because if you default, they cannot recover

the loan balance from the property

Mortgage Securitization

Mortgage Securitization

How did real estate contribute to the 2008-2009 financial crisis?

Textbook real estate bubble• People believed that housing prices would go up forever

How did real estate contribute to the 2008-2009 financial crisis?

Loan standards deteriorated

Constant refinancing and home equity loans

How did real estate contribute to the 2008-2009 financial crisis?

• US economy began to slow. A few people couldn’t pay their loans (subprime)

• Everyone got nervous about the economy. Economy continued to slow. More people couldn’t pay. Defaults rose to previously unbelievable levels.

How did real estate contribute to the 2008-2009 financial crisis?

• Banks, who had a lot of housing exposure, suffered from greater than expected losses and restricted lending

The “Great Recession”