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    Alternative Investments and Fixed Income O) IKKAPLAN\ SCHOOL OF PROFESSIONAL UNIVERSITY) AND CONTINUING EDUCATION BOOK 4 — ALTERNATIVE INVESTMENTS AND FIXED INCOME Readings and Learning Outcome Statements Study Session 13 ~ Alternative Investments .. 2152 Self-Test — Alternative Investments, Study Session 14 — Fixed Income: Valuation Concepts ... 155 Study Session 15 — Fixed Income: Structured Securities . 236 Self-Test ~ Fixed Income 317 Formulas... 320 Index 326 (©2013 Kaplan, Ine. Page 1 Page 2 SCHWESERNOTES™ 2014 CFA LEVEL Il BOOK™: ALTERNATIVE INVESTMENTS AND FIXED }NCOME, ©2013 Kaplan, Inc. All rights reserved. Published in 2013 by Kaplan, Inc. Printed in the United States of Ametica. ISBN: 978-1-4277-49 13-09, 124277-4913-2 PPN: 3200-4014 TF this boolgper nor have the hologram with the Kaplan Schwescr logo on the back coven, fe was distribyeed Without permission of Kaplan Schweser, a Division of Kaplan, Inc. and is in ditect violation of lobshcopyright laws, Your assistance in pursuing potential violators of cis lav i greatly appreciate. Required CFA Inwiate disclaimer: “CFA and Chartered Financial Analys® are wademarks owned by CCEA Institute. CFA Insist (formerly the Association for Investment Management and Research) does not endorse, promote, review, or warrant the accuracy of the product or services offered by Kaplan Sehweser” (Certain materials contained within tis text ate the copyrighted property of CFA Insteut. The following i the copyright disclosure for these materials: “Copyright, 2013, CFA Institute. Reproduced and republished from 2014 Learning Outcome Statements Level I, I, and Il questions from CEA® Program Materials, CFA Institute Standards of Profesional Conduct, and CFA Institute's Global Investment Performance Standards with permission from CFA Instat. All Rights Reserved.” ‘These materials may not be copied without written permission from the author. The unauthorized duplication ofthese notes is violation of global copyright laws and the CFA Institute Code of Ethics. Your assistance in pursuing potential violators of this aw is greatly appreciated. Disclaimer: The Schwerer Notes should be used in conjunction withthe orginal readings as ast forth by CFA Institute in their 2014 CEA Level Il Study Guide. The information contained in these Notes covers topics contained in the readings referenced by CFA Insite and is believed tobe accurate. However, their acuracy cannot be guaranted nor is any warranty conveyed as o your ultimate exam success, The authors of the referenced readings have not endorsed or sponsored these Note. ©2013 Kaplan, Inc READINGS AND LEARNING OUTCOME STATEMENTS READINGS The following material is a review of the Alternative Investments and Fixed Income principles designed to address the learning outcome statements set forth by CFA Institut. 6 Sacer one) oe? Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, S Volume 5, Level II (CFA Institute, 2013) © 40. Private Real Estate Investments page 9 41. Publicly Traded Real Estate Securities page 42 42, Private Equity Valuation page 69 43. Investing in Hedge Funds: A Survey page 117 44, A Primer on Commodity Investing page 132 STUDY SESSION 14 Reading Assignments yo Alternative Investments and Fixed In *, CFA Program Curriculum, Volume 5, Level II (CFA Institui 13) 45. Credit Analysis Models?" page 155 {Volatility of lncerest Rates page 174 with Embedded Options page 201 Readitig Assignments AltePnative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2013) 48, Mortgage-Backed Sector of the Bond Marker page 236 49. Asset-Backed Sector of the Bond Market page 268 50. Valuing Mortgage-Backed and Asset-Backed Securities page 293, (©2013 Kaplan, Ine. Page 3 Bool lreenative Investments and Fixed Income Readings and Learning Outcome Statements Page 4 Learninc Outcome Statements (LOS) The CFA Institute Learning Outcome Statements are listed below. These are repeated in each topic review; however, the order may have been changed in order to get a better fit with the flow of the review. wpe ION 13 The topical coverage corresponds with the following CFA Institute assigned reading: 40. Private Real Estate Investments The candidate should be able to: a. Classify and describe basic forms of real estate investments: page 9) b. Describe the characteristics, the classification, and basie Segments of real esta. (page 10) x c. Explain the role in a portfolio, economic yalilé determinants, investment characteristics, and principal risks of private feal estate. (page 12) 4. Describe commercial property typess including their distinctive investment characteristics. (page 14) e. Compare the income, cost, and sales comparison approaches to valuing real estate properties. (page 15) £, Estimate and interpreceinputs (For example, net operating income, capitalization rate, and discount rate) Yo the direct capitalization and discounted cash flow valuation method (page 17) g. Calculate the value of a property using the direct capitalization and discounted cash flow valuation methods. (page 17) th. Compafe the direct capitalization and discounted cash flow valuation methods. (page 25) i, Calculate the value of a property using the cost and sales comparison approaches, (page 26) j. Describe due diligence in private equity real estate investment. (page 31) k. Discuss private equity real estate investment indices, including their construction and porential biases. (page 31) 1. Explain the role in a portfolio, the major economic value determinants, investment characteristics, principal risks, and due diligence of private real estate debt investment. (page 12) m. Calculate and interpret financial ratios used to analyze and evaluate private real estate investments. (page 32) The topical coverage corresponds with the following CFA Institute assigned reading: Al. Publicly Traded Real Estate Securities The candidate should be able to: a. Describe types of publicly traded real estate securities. (page 42) bb. Explain advantages and disadvantages of investing in real estate through publicly traded securities. (page 43) Explain economic value determinants, investment characteristics, principal risks, and due diligence considerations for real estate investment trust (REIT) shares. (page 45) 4. Describe types of REITS. (page 47) Justify the use of net asset value per share (NAVPS) in REIT valuation and estimate NAVPS based on forecasted cash net operating income. (page 51) ©2013 Kaplan, Ine. 42. 43. 44, Book 4 ~ Alternative Investments and Fixed Income Readings and Learning Outcome Statements £ Describe the use of funds from operations (FO) and adjusted funds from ‘operations (AFFO) in REIT valuation. (page 54) Compare the net asset value, relative value (price-to-FFO and price-to-AFFO), and discounted cash flow approaches to REIT valuation. (page 55) hh. Calculate the value of a REIT share using net asset value, price-to-FFO and price-to- AFFO, and discounted cash flow approaches. (page 55) The topical coverage corresponds with the following CFA Institute assigned reading: Private Equity Valuation The candidate should be able to: a. Explain sources of value creation in private equity. (page 70) b. Explain how private equity firms align their interests with those of the managefs. 6 portfolio companies. (page 71) ¢. Distinguish berween the characteristics of buyout and venture capital investinents. (page 72) Describe valuation issues in buyout and vencure capital transactigns) (page 76) e. Explain alternative exit routes in private equity and their imfser oh value. (page 80) £. Explain private equity fund structures, terms, valuation, anche diligence in the context of an analysis of private equity fund returnss(page 81) Explain risks and costs of investing in private equity, (Page 86) hh. Interpret and compare financial performance of private equity funds from the perspective of an investor. (page 88) i, Calculate management fees, carried interés; net asset value, distributed to paid in (DP2), residual value to paid in (RVPN), and coral value to paid in (TVPI) of a private equity fund. (page 91) j. _ Calculace pre-money valuation, post-money valuation, ownership fraction, and price per share applying the vefiture capital method 1) with single and multiple financing rounds and 2) in termsOF IRR. (page 93) k. Demonstrate altéenative methods co account for risk in venture capital. (page 98) The topical coperag? corresponds with the following CFA Institute assigned reading: Investing in Hedge Funds: A Survey The candidate should be able to: 2. Distinguish berween hedge funds and mutual funds in terms of leverage, use of ‘derivatives, disclosure requirements and practices, lockup periods, and fee structures. (page 117) Describe hedge fund straregics. (page 118) Explain possible biases in reported hedge fund performance. (page 120) Describe factor models for hedge fund returns. (page 121) Describe sources of non-normaliy in hedge fund returns and implications for performance appraisal. (page 122) £ Describe motivations for hedge fund replication strategies. (page 123) g. Explain difficulties in applying traditional portfolio analysis to hedge funds. (page 124) hh. Compare funds of funds to single manager hedge funds. (page 125) peor The topical coverage corresponds with the following CFA Institute assigned reading: A Primer on Commodity Investing ‘The candidate should be able to: a. Describe types of market participants in commodity futures markers. (page 132) b, Explain storability and renewability in the context of commodities and determine whether a commodity is storable and/or renewable. (page 134) (©2013 Kaplan, Inc. Pages Bool lreenative Investments and Fixed Income Readings and Learning Outcome Statements Page 6 Explain the convenience yield and how it relates to stock (inventory level) of a commodity. (page 134) 4. Distinguish among capital assets, store-of-value assets, and consumable or transferable assets and explain implications for valuation. (page 135) €. Compare ways of participating in commodity markets, including advantages and disadvantages of each. (page 136) £ Explain backwardation and concango in terms of spot and futures prices. (page 138) Describe the components of return to a commodity furures and a portfolio of commodity futures. (page 141) fh. Explain how the sign of the roll return depends on the term structure of futures prices. (page 143) i. Compare the insurance perspective, the hedging pressure hypoxhesis, and the theory of storage and eheir implications for futures prices and expected future spor prices. (page 144) STUDY SESSION 14 The topical coverage corresponds with the fillowing CFA Insitute assigned reading: 45. Credit Analysis Models Tenia Be shlae a. Explain probability of dfailt, loss given defaule, expected loss, and present value of the expected lossrantt- describe the relative importance of each across the credit spectrum. (page’155) bb. Explain credit'séoring and credie ratings, including why they are called ordinal rankingss(page 156) Explain strengths and weaknesses of credit ratings. (page 158) cd. Explain structural models of corporate credic risk, including why equity can be ‘viewed as a call option on the company’s assets. (page 158) Explain reduced form models of corporate credit risk, including why debt can be valued asthe expected discounted cash flows after adjusting for risk. (page 160) £ Explain assumptions, strengths, and weaknesses of both structural and reduced form models of corporate credit risk. (page 162) g- Explain the determinants of the term structure of credit spreads. (page 164) hh, Calculate and interpret the present value of the expected loss on a bond over a given time horizon. (page 164) i. Compare che credit analysis required for asset-backed securities with analysis of corporate debt. (page 166) The topical coverage corresponds with the following CFA Institute assigned reading: 46. Term Structure and Volatility of Interest Rates The candidate should be able to: a. Explain parallel and nonparallel shifts in the yield curve. (page 175) bb. Describe factors thar drive U.S. Treasury security returns, and evaluate the importance of each factor. (page 176) Explain various universes of Treasury securities that are used to construct the theoretical spot rate curve, and evaluate their advantages and disadvantages. (page 178) 4. Explain the swap rate curve (LIBOR curve) and why market participants have used the swap rate curve rather than a government bond yield curve as a benchmark. (page 180) ©2013 Kaplan, Ine. Book 4 ~ Alternative Investments and Fixed Income Readings and Learning Outcome Statements €. Explain the pure expectations, liquidity, and preferred habitat theories of the term. structure of interest rates and the implications of each for the shape of the yield curve. (page 181) £ Calculate and interpret the yield curve risk ofa security or a portfolio by using key rate duration. (page 186) g Calculate and interpret yield volatiliy, distinguish berween historical yield volatiicy and implied yield volatiiry, and explain how to forecast yield volatility. (page 188) The topical coverage corresponds with the following CFA Institute assigned reading: /aluing Bonds with Embedded Options ‘The candidate should be able to: a. Evaluate, using relative value analysis, whether a security is undervalued, fairly valued, or overvalued. (page 201) 'b. Evaluate the importance of benchmark interest rates in interpreting spread measures. (page 206) Describe the backward induction valuation methodology withinh¢ binomial interest rate tree framework. (page 207) dd. Calculate the value ofa callable bond from an incerese rate tite (page 207) ¢. Explain the relations among the values of a callable (purable) bond, the corresponding option-free bond, and the embeddéd'option. (page 208) £ Explain the effect of volatility on the arbitrage-fiee value of an option. (page 209) g Interpret an option-adjusted spread with respact to a nominal spread and to benchmark interest rates. (page 211) hh. Explain how effective duration and effective convexity are calculated using the binomial model. (page 213) i. Calculate the value of a putabfe Bond, using an interest rate tee. (page 215) j. Describe and evaluate a cohyértible bond and ies various component values. (page 217) k, Compare the risk-return characteristics of a convertible bond with the riskereturn characteristics of yinership of the underlying common stock. (page 222) 47. 1ON The tepical coverage corresponds with the following CFA Institute assigned reading: 48. Mottgage-Backed Sector of the Bond Market The candidate should be able to: a. Describe a mortgage loan, and explain the cash flow characteristic level payment, and fully amortized mortgage loan. (page 236) b, Explain investment characteristics, payment characteristics, and risks of mortgage passthrough securities. (page 238) Calculate the prepayment amount on 2 mortgage passthrough security for a month, given the single monthly morealty rate. (page 242) d. Compare the conditional prepayment rate (CPR) with the Public Securities Association (PSA) prepayment benchmark. (page 240) Explain why the average life of a mortgage-backed security is more relevant than the ’s maturity. (page 244) £ Explain factors that affect prepayments and the types of prepayment risks. (page 243) g Explain how a collateralized mortgage obligation (CMO) is created and how it provides a berter matching of assets and liabilities for institutional investors. (page 245) of a fixed-rate, (©2013 Kaplan, Ine. Page7 Book 4 ~ Alternative Investments and Fixed Income Readings and Learning Outcome Statements Page 8 hh, Distinguish among the sequential pay tranche, the accrual tranche, the planned amortization class tranche, and the support tranche in a CMO. (page 245) i. Evaluate the risk characteristics and relative performance of each type of CMO tranche, given changes in the interest rate environment. (page 252) j. Explain investment characteristics of stripped mortgage-backed securities. (page 253) k. Compare agency and nonagency mortgage-backed securities. (page 255) 1. Compare credit risk analysis of commercial and residential nonagency mortgage- backed securities. (page 256) m, Describe the basic structure of a commercial mortgage-backed security (CMBS) and explain the ways in which a CMBS investor may realize call protection at the loan level and by means of the CMBS structure. (page 257) The topical coverage corresponds with the following CFA Instute'assigned reading: 49. Asset-Backed Sector of the Bond Market ‘The candidate should be able to: a. Describe the basic structural features of and pies to a securitization transaction. (page 268) b. Explain and contrast prepayment tranching and credit tranching, (page 269) Distinguish between the payment stfucture and collateral structure of a securitization backed by amortizingyassets and non-amortizing assets. (page 270) d._ Distinguish among variougtypes of external and internal credit enhancements. (page 271) Describe cash low and-prepayment characteristics for securities backed by home equity loans, maniifactured housing loans, auromobile loans, student loans, SBA loans, and credit Card receivables. (page 274) £ Describe cbllaceralized debt obligations (CDOs), including cash and synthetic DOR page 280) g Distinguish among the primary motivations for creating a collateralized debe ‘obligation (arbitrage and balance sheet transactions). (page 282) The topical coverage corresponds with the following CFA Institute assigned reading: '50. Valuing Mortgage-Backed and Asset-Backed Securities The candidate should be able to: a. Explain the calculation, use, and limitations of the cash flow yield, nominal spread, and zero-volatility spread for a mortgage-backed security and an asset-backed security. (page 293) 'b. Describe the Monte Carlo simulation model for valuing a mortgage-backed sceuriry (page 295) Describe path dependency in passthrough securities and the implications for valuation models. (page 296) 4. Explain how the option-adjusted spread is calculated using the Monte Carlo simulation model and how this spread measure is interpreted. (page 296) Evaluate a mortgage-backed security using option-adjusted spread analysis. (page 300) £ Explain why effective durations reported by various dealers and vendors may differ. (page 301) g Analyze the interest rate risk ofa secu effective convexity. (page 302) hh. Explain cash flow, coupon curve, and empirical measures of duration, and describe limitations of each in relation to mortgage-backed securities. (page 303) i. Determine whether the nominal spread, zer0-volatility spread, of option-adjusced spread should be used to evaluate a specific fixed income security. (page 305) siven the security’ effective duration and ©2013 Kaplan, Inc. ‘a review of the Alternative Investments principles ‘outcome statements set forth by CFA Institute. This topic is also covered Private Rear EstaTe INVESTMENTS Study Session 13 Exam Focus This topic review concentrates on valuation of real estate. The focus is on the three valuation approaches used for appraisal purposes, especially the income approach. Mikey sure you can calculate the value of a property using the direct capitalization method! and the discounted cash flow method. Make certain you understand the relatign3hip between the capitalization rate and the discount rate, Finally, understand ¢he\iaivestment ‘istics and risks involved with real estate investments. LOS 40. lassify and describe basic forms of real c&ateinvestments. CFA® Program Curriculum, Volume 5, page 7 Forms or Reat Estate. ‘There are four basic forms of real esr4fé investment that can be described in terms of a vwo-dimensional quadrant. In théfirst dimension, the investment can be described in terms of public or privaté markets. In the private market, ownership usually involves a direct investment like purchasing property or lending money to a purchaser. Direct investments can be solely owned or indirectly owned through partnerships or commingled realestate funds (CREF). The public market does not involve direct investment; rathetyownership involves securities that serve as claims on the underlying assets. Publié real estate investment includes ownership of a real estate investment trust (REIT),@ real estate operating company (REOC), and mortgage-backed securities. The second dimension describes whether an investment involves debt or equity. An equity investor has an ownership interest in real estate or securities of an entity that owns real estate. Equity investors control decisions such as borrowing money, property management, and the exit strategy. {A debt investor isa lender that owns a mortgage or mortgage securities. Usually, the mortgage is collateralized (secured) by the underlying real estate. In this case, the lender has a superior claim over an equity investor in the event of default. Since the lender ‘must be repaid first, che value of an equity investor’ interest is equal to the value of the property less the outstanding debr. Each of the basic forms has its own risk, expected returns, regulations, legal issues, and market structure. Private real estate investments are usually larger than public investments because real estate is indivisible and illiquid. Public real estate investments allow the property to (©2013 Kaplan, Ine. Page 9 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #40 — Private Real Estate Investments 3 Page 10 remain undivided while allowing investors divided ownership. As a result, public real estate investments are more liquid and enable investors to diversify by particip ‘more properties. Real estate must be actively managed. Private real estate investment requires property management expertise on the part of the owner or a property management company. In the case of a REIT or REOC, the real estate is professionally managed; thus, investors need no property management expertise. Equity investors usually require a higher rate of rerurn than mortgage Jenders because of igher risk. As previously discussed, lenders have a superior claim,in the event of default. As financial leverage (use of debr financing) increases, return requifeimients of both lenders and equity investors increase a a result of higher rh 7 ‘Typically, lenders expect to receive returns from prontised-tash flows and do not participate in the appreciation of the underlying property. Equity investors expect to receive an income stream as a result of renting’the property and the appreciation of value over time. \ Figure 1 summarizes the basic formsof real estate investment and can be used to identify, the investment that best meets an‘investor’s objectives. Figure 1: Basic Forms off Real Estate Investment Deli Equity Privare Morrgages Direct invescments such as sole ownership, partnerships, and other forms of commingled Funds. Moregage-backed Shares of REITs and REOCs aN securities LOS 40.b: Describe the characteristics, the classification, and basic segments of real estate. CFA® Program Curriculum, Volume 5, page 9 Rea Estate CHARACTERISTICS Real estate investment differs from other asset clases, like stocks and bonds, and can complicate measurement and performance assessment. ‘+ Heterogeneity. Bonds from a particular issue are alike, as are stocks of a specific company. However, no two properties are exactly the same because of location, size, age, construction materials, tenants, and lease terms. ‘+ High unit value. Because real estate is indivisible, the unit value is significantly higher than stocks and bonds, which makes it difficult to construct a diversified portfolio. ©2013 Kaplan, Ine. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #40 ~ Private Real Estate Investments + Active management. Investors in stocks and bonds are not necessarily involved in the day-to-day management of the companies. Private real estate investment requires active property management by the owner or a property management company. Property management involves maintenance, negotiating leases, and collection of rents. In either case, property management costs must be considered. + High transaction costs. Buying and selling real estate is costly because it involves appraisers, lawyers, brokers, and construction personnel. ‘+ Depreciation and desirability. Buildings wear out over time. Also, buildings may become less desirable because of location, design, or obsolescence. + Cost and availability of debt capital. Because of the high costs to acquire and develop real estate, property values are impacted by the level of interest rates and availability of debt capital. Real estate values are usually lower when interest rareare high and debe capital is searce. + Lack of liquidity. Real estate is illiquid. Ie takes time to market and complete the sale of property. + Difficulty in determining price. Stocks and bonds of public firm uswally trade in active markets. However, because of heterogeneity and low.trahsaction volume, appraisals are usually necessary to assess real estate values, Ever then, appraised values are often based on similar, not identical, properties)'The combination of limited market participants and lack of knowledge of the local markets makes it difficult for an outsider to value property. As a result, che market is less efficient. However, investors with superior informacion aad skill may have an advantage in exploiting the marker inefficiencies. ‘The market for REITs has expanded «.6¥¢rcome many of the problems involved with direct investment. Shares of a REIT, 4ré actively traded and are more likely to reflect, market value. In addition, investing in 2 REIT can provide exposure to a diversified real estate portfolio. Finally, invéstdts’don't need property management expertise because the REIT manages the properfics? Property OLAssiicarions Real estate“ Commonly classified as residential or non-residential. Res estate includes single-family (owner-occupied) homes and multi-family properties, such as apartments. Residential real estate purchased with the incent to produce income is usually considered commercial real estate property. Non-residential real estate includes commercial properties, other than multi-family properties, and other properties such as farmland and timberland. Commercial real estate is usually classified by its end use and includes multi-family, office, industrial warehouse, retail, hospitality, and other types of properties such as parking facilities, restaurants, and recreational properties. A mixed-use development is a property that serves more than one end user ‘Some commercial properties require more management attention than others. For example, of all che commercial property types, hotels require the most day-to-day attention and are more like operating a business. Because of higher operational risk, investors require higher rates of return on management-intensive proper (©2013 Kaplan, Ine. Page 11 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #40 — Private Real Estate Investments Farmland and timberland are unique eategories (separate from commercial real estate classification) because each can produce a saleable comme as well as have the potential for capital appreciation. LOS 40.c: Explain the role in a portfolio, economic value determinants, investment characteristics, and principal risks of private real estate. 3 LOS 40.1: Explain the role in a portfolio, the major economic value determinants, investment characteristics, principal risks, and dye diligence of private real estate debt investment. 70 3" CEA® Program eon Volume 5, page 13 OD Reasons To Invest tN Reat Estate Current income. Investors may expect to earnfincome from collecting rents and after paying operating expenses, financing costs)and taxes. av Capital appreciation. Investors usually ékpect property values to increase over time, which forms part of their coral vetheh. Inflation hedge. —— investors expect both rents and property values to oem sin especially private equity investment, is less than perfectly coer 1 returns of stocks and bonds. Thus, adding private real estate investmént to a porefolio can reduce tisk relative to the expected return. benefits. In some countries, real estate investors receive favorable tax treatment. For \\ foes in the United States, the depreciable life of real estate is usually shorter than the actual life. As a result, depreciation expense is higher, and taxable income is lower resulting in lower income taxes. Also, REITs do not pay taxes in some countries, which allow investors to escape double taxation (e.g., taxation at the corporate level and the individual level). Principat Risks Business conditions. Numerous economic factors—such as gross domestic product (GDP), employment, household income, interest rates, and inflation—affect the rental market. New property lead time. Market conditions can change significantly while approvals are obtained, while the property is completed, and when the property is fully leased. During the lead time, if market conditions weaken, the resultant lower demand affects rents and vacancy resulting in lower returns. Cost and availability of capital. Real estare must compere with other investments for capital. As previously discussed, demand for real estate is reduced when debt capital Page 12 ©2013 Kaplan, Ine. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #40 ~ Private Real Estate Investments is scarce and interest rates are high. Conversely, demand is higher when debe capital is easily obtained and interest rates are low. Thus, real estate prices can be affected by capital market forces without changes in demand from tenants. Unexpected inflation. Some leases provide inflation protection by allowing owners to increase rent or pass through expenses because of inflation. Real estace values may not keep up with inflation when markets are weak and vacancy rates are high. Demographic factors. The demand for real estate is affected by the size and age distribution of the local market population, the distribution of socioeconomic groups, and new household formation rates. Lack of liquidity. Because of the size and complexity of most real estate transaérions, buyers and lenders usually perform due diligence, which takes time and is costly. A quick sale will typically require a significant discount. Environmental issues. Real estate values can be significantly redticed'when a property has been contaminated by a prior owner or adjacent propert}howner. Availability of information. A lack of information when pérforming property analysis increases risk. The availability of data depends on che,country, but generally more information is available as real estate investmen& Become more global. ‘Management expertise. Property managersand asset managers must make important, operational decisions—such as negotiatifig leases, property maintenance, marketing, and renovating the property—when fiegeksary. Leverage. The use of debr (o¥erage) to finance a real estate purchase is measured by the loan-to-value (LTV) fitio. Higher LTV results in higher leverage and, thus, higher risk because lenders Rave a superior claim in che event of default. With leverage, a small decrease in nér opefating income (NOD) negatively magnifies the amount of cash flow available o-équity investors after debt service. Othe faetors. Other risk factors, such as unobserved property defects, natural disasters, and acts of terrorism, may be unidentified at the time of purchase. In some cases, risks that can be identified can be hedged using insurance. In other cases, risk can be shifted to the tenants. For example, a lease agreement could require the tenant to reimburse any unexpected operating expenses. ‘The Role of Real Estate in a Portfolio Real estate investment has both bond-like and stock-like characteristics. Leases are contractual agreements that usually call for periodic rental payments, similar to the coupon payments of a bond. When a lease expires, there is uncertainty regarding renewal and fature rental rates. This uncertainty is affected by the availability of competing space, tenant profitability, and the state of the overall economy, just as stock prices are affected by the same factors. As a result, the risk/return profile of real estate as an asset class, is usually between the risk/retur profiles of stocks and bonds. (©2013 Kaplan, Ine. Page 13 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #40 — Private Real Estate Investments 3 Page 14 Role of Leverage in Real Estate Investment So far, our discussion of valuation has ignored debe financing, Earlier we determined that the level of interest rates and the availability of debe capital impact real estate prices. However, the percentage of debr and equity used by an investor to finance real estate does not affect the property’s value. Investors use debt financing (leverage) to increase returns. As long as the investment return is greater than the interest paid to lenders, there is positive leverage and returns are magnified. OF course, leverage can also work in reverse. Because of the greater uncertainty involved with debt financing, risk is higher since lendershave a superior claim co cash flow. Qo’

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