Lecture 3

• Exam will only cover the first four weeks of content

Outline

• Risk Management (continued from last week)
• Indirect Ownership Structures
• REITs
• LPTs
• PPPs
• JVs, partnerships, clubs etc
• Modern Portfolio Theory Overview
• Acquisition and Disposal Process

Risk Management

• What is Risk?
  • The extent to which an actual outcome is adverse and differs from the expected/predicted outcome
  • The probability of the adverse outcome occurring
    • NOTE: expect x to happen, what is the likelihood of y happening
    • What is a mitigated vs unmitigated risk, and find out how much it costs to mitigate the risk
    • Include an opportunity register, contract more for xy etc.
    • Risks costs were offset against opportunities you might have
• Risks vs Issues
  • Risks are potential adverse outcomes
  • Issues are actual adverse outcomes
    • NOTE: people often confuse them in projects
    • Manage risks and issues differently; risks you monitor, issues you have to put an action in place to manage it.
    • Risks aren't real until they become an issue. Risks are potential issues that have a probability of becoming an issue that are used to allocate a costs, but they are not issues.
    • Challenge: properly evaluated the risk and pass on many opportunities
    • Good property developers don't price the risks originally, and miss many 'potential' risks that never become an issue.
    • How do you individually manage all your risks?
• Risk vs Returns
  • The greater the degree of risk should correspond with a greater expected return

• Worst risk that can happen is someone dying
• when evaluating a project, which risks do you escalate, mitigate, etc?
• e.g. anything medium or below we just monitor

Financial Risks

• Systematic Risk (beta):
  • Variance attributable to the market and influences all assets.
  • Example: RBA changes interest rates
  • Cannot be diversified away.
• Unsystematic Risk:
  • Is asset / firm specific risk and unrelated to the market.
  • Example: Balance sheet changes in a firm or vacancy in property asset due to a tenant restructure.
  • Diversification is key for the protection against unsystematic risk

Property Risk

• Risks that affect the property investment but not the market as a whole. May damage location, buildings and tenants.

Risks:

• location rental and capital value impacts: trading potential of a retail store impacted by reduced pedestrian access
• Building failure- unexpected running costs, claims against owners allowing contaminating uses etc
• Soundness or 'covenant' of a tenant - checks on financial stability of a tenant prior to purchasing a property
• Many building risks can be insured against

Other major risks impacting property ownership:

Business Risk

• Business risks due to fluctuations in economic activity that affect the variability of income produced by the property.
• Properties with well-diversified tenant mixes are less subject to business risk

Financial Risk

• Use of debt financing magnifies business risk.
• Degree of financial risk increases as the amount of debt increases and depends on the cost and structure of debt

Liquidity Risk

• Occurs when a continuous market with many buyers and sellers and frequent transactions is not available. The more difficult an investment is to liquidate, the greater the risk that a price concession may have to be given to a buyer should the seller have to dispose of the asset quickly.
  • NOTE: Not just a problem which is limited to property

Management Risk

• Most investments rely on management to keep space let and maintained.
• The rate of return that the investor earns can depend on the competency of the management
  • NOTE: the quality of the management will directly impact its performance and potential litigation and liabilities
  • e.g. outsourced the management of supermarket to a bad management company and the property is never cleaned, more susceptible to TP accidents, e.g.

Interest Rate Risk

• Changes in interest rates will affect the price of all securities and investments.
• Real estate tends to be highly levered, thus, rate of return earned by equity investors can be affected by changes in interest rates.
  • rates go up, property prices go back
  • Residential real estate is opposing this trend - should have stabilised -> supply not keeping uop with demand

Legislative Risk

• Real estate is subject to numerous regulations such as tax laws, rent control, zoning and other restrictions imposed by government.
• Changes in legislation can adversely affect the profitability of an investment - especially for new development.
  • NOTE: legislation impacts property, zoning, environmental heritage. Dealing with three layers of government
  • State reserves rights with respect to property law
  • Local government have delegated the laws of town planning
  • Council makes decisions about planning that impacts peoples lives

Environmental Risk

• Value of real estate is often affected by changes in the environment or sudden awareness that the existing environment is potentially hazardous. E.g. Asbestos
  • NOTE: clean up costs with contamination
• Environmental risk can cause more of a loss than other risks mentioned because the investor can be subject to clean-up costs that far exceed the property value.
  • NOTE: is there an excessively large 'environmental risk' e.g.

Inflation Risk

• Unexpected inflation can affect an investors expected rate of return if the income of the property does not increase sufficiently to offset the impact of inflation.

INDIRECT OWNERSHIP STRUCTURES

Investor types: Wholesale

Wholesale Investor Types:

• Sophisticated investor:
  • Deemed to have sufficient investing experience and knowledge to weigh the risks and merits of an investment opportunity.
    • Net assets of at least $2.5m or;
    • Gross income for each of last two financial of at least $250,000
• Professional Investor:
  • Australian financial services licensee;
  • A body regulated by APRA outside of Superannuation;
  • A body registered under the Financial Corporations Act 1974
  • Trustees of superannuation funds with assets >$10m

NOTE:

• good projects are fully subscribed or offered to wholesale investors before retail investors
• retail investors tend to get the 'dregs' of bad investment

Wholesale Funds: Overview:

• vehicles set up for acquiring 1 or more properties
  • normally sector specific
  • gearing - the amount of leverage. Typical low and spread across a variety of assets

• Institutional investors make investments to wholesale funds based on a view that unlisted private equity format accurately represents the true returns of the underlying real estate assets

• Wholesale unlisted property trusts are aimed at institutional investors

  • Predominantly AU superannuation funds or foreign pension and sovereign wealth funds
  • May include Ultra High Net Worth Individuals

• Each trust tends to have a specific strategy or mandate to invest within a particular sub sector of the real estate market and takes two forms:

  • Open-ended vehicles:
    • No fixed life, target ‘core’ real estate assets across industrial, retail and office sectors
  • Closed-end fixed-life vehicles:
    • Invest in higher risk real estate
    • Involves value-add opportunities or development projects
      • Within life, get these assets and distribute back after 5 years e.g.

Clubs/Mandates

• Clubs and segregated mandates becoming more popular
• Investors:
  • Tend to be large domestic superannuation funds
  • Sovereign wealth funds
  • International institutions
• Most vehicles no or low gearing
• Particular strategy, particular risk profile ie. Mandate
• Reasons for growth
  • Larger investors favour a more hands on approach with asset managers
  • Investors are becoming more sophisticated and are looking for specialist skills in asset classes and geographies
  • Ability to gain tailored exposure to specific asset classes

NOTES:

• e.g. selling the national broadband network. Mandate might come together to create a management vehicle (fund) under a mandate to acquire a particular fund
  • generally needs a lot of money, often no gearing
• reasons for growth, bring in people that have particular skills. Some funds want to partner with entities that have expertise

Syndicates

• Closed-end funds with a fixed life expectancy

  • Further capital is not raised after initial offering

• Target high net-worth individuals and SMSF

• Investors hold their interest until property is sold or rolled over

• Offer document such as a product disclosure statement (PDS)

• Repetitive process

  • Identify opportunity
  • Negotiate structure and investment
  • Purchase building
  • Raise debt and pool investor equity

• Individual property strategies

• Enhanced regulatory focus in recent years

• Recent resurgence in popularity for syndicates

• Retail funds management industry is less consolidated

  • Lower barriers to entry and wider investment base
  • Difficult to identify all players due to small size of typical funds

• NOTE: directly investing in properties without the capital hurdle

Fund investment strategies

Core

• Primarily invest in:
  • Stabilised existing properties
  • Current cash flows
  • Low vacancy
  • Located in major metropolitan areas
• Invest in a wide variety of property types
• Use limited leverage - low risk

Core Plus

• Core plus properties can be a minor component of core fund:
  • Core assets in need of minor improvements
  • “a B property in an A location”
  • Core property that includes current undeveloped land

Value Add:

• Take on more risk by purchasing properties which:
  • Carry current vacancies
  • Have upcoming major tenant rollovers
  • In need of renovation and capital outlay
• Funds create value by renovating and leasing up the property
• Use more leverage compared to core plus

Opportunistic

• Take on even more risk by doing ground up development projects
• Expose the fund to additional construction risks:
  • Entitlements
  • Construction delays
  • Cost overruns
  • Complex JV management issues, etc.
• High degree of financial leverage
• May be less diversified and concentrate in certain geographic areas or property types
• Strategy may involve purchasing “distressed property assets”

NOTE:

• not diversified, because you mitigate legislative and planning risk because you have to make sure what you build on there makes a massive profit
  • pick a market, council, state, etc.

Investment management fees

• Fees charged by fund managers generally fall into one/more of the following categories:

• Acquisition fees charged when each property is acquires and typically a percent of the acquisition cost

• Disposition fees charged when asset is sold.

• Performance fees paid as an added incentive to enhance fund performance

  • Based on the extend to which the fund managers return exceeds a “hurdle rate of return”
  • Typically paid to fund managers to compensate them for taking on additional risks in development or repositioning properties
  • Performance fees disappearing from the Wholesale ‘Core’ landscape

• Management fees:

  • Charged to the investor for the entire term of the fund
  • Core funds charge base fees on equity capital
  • Generally expressed annually as a percentage or basis points (bps)

• Management fees may be calculated on:

  • Committed capital or invested capital
  • A percentage of cash flow distributions
  • Project Revenues
  • Project costs

• NOTE: property management is very admin intensive

• fund manager will want more performance fees if exceeds expected performance of the asset

A-REIT

• A Real Estate Investment Trust (REIT) is an investment vehicle that allows investors to purchase an interest in a diversified and professionally managed portfolio of real estate that is listed on the stock exchange.
• A-REITS or Listed Property Trusts (LPT) make up one of the largest sectors on the Australian Stock Market
• A-REITs were established to allow investors to gain exposure to high-grade real estate both domestically and offshore, without the need for large levels of capital, and with the addition of liquidity.

Generates wealth in two ways:

• They provide exposure to the value of the real estate assets that the trust owns and the accompanying capital growth,

• as well as rental income.

• The fund manager selects the investment properties and is responsible for all administration, improvements, maintenance and rental.

• Some A-REITs specialise in particular sectors, and usually fall into one of the following categories:

  • Industrial trusts invest in warehouses, factories, and industrial parks
  • Office trusts include medium- to large- scale office buildings in and around major cities
  • Hotel and leisure trusts invest in hotels, cinemas and theme parks
  • Retail trusts invest in shopping centres and similar assets
  • Diversified trusts invest in a mixture of industrial, offices, hotels and retail property.

NOTE

• all day-to-day running of the property
• tend to be sectorised

Why invest in REITS?

• A-REITs have been the preferred property asset class for retail investors and some wholesale investors over direct property.
• The key benefits of investing in A-REITs are:
  • Exposure to high quality assets
  • Diversification - geographic, sector etc
  • High yielding
  • Liquidity
  • Management efficiency and quality
  • Low transaction costs (no stamp duty)
  • Corporate governance
• On the negative side – volatility, fee leakage.

NOTES:

• Able to review the efficiency, effectiveness and performance of the management company, lot of information about their costs, how they performed in the past
• low transaction costs - easy to get in and out. If listed, under all the asx rules
• negatives: profit in capital growth or income bled through fees
• Volatility - management is not performing well and you unit is losing value as a result

Fund From Operation (FFO)

There are 5 ways a REIT can grow income and increase funds from operations:

• Growing income from existing properties
  • Renting more space
  • Raising rent
  • Redevelopment
• Growing income through acquisitions
• Growing income through development
• Growing incomes through provision of services
• Financial engineering
  • refinancing and allocate resources and capital

REIT characteristics

• Legal Form
  • No specific REIT rules in Australia - can be listed or unlisted
    • May be sector specific or diversified
  • Corporations Act states a REIT must be registered as a Managed Investment Scheme
• Capital Requirements
  • No capital requirements for a REIT if listed (but must meet ASX requirements)
  • Capital requirements for a manager
• Listing Requirements
  • No listing requirements – REITs can be listed or unlisted
• Restrictions on investors
  • No investment restrictions on investors
• Restrictions on foreign assets
  • No restrictions on foreign assets
• Distribution requirements
  • Undistributed income on gains taxed at 46.5%
    • gains are taxed at your prevailing personal tax rate
  • Full distribution of income and gains by REITS generally occurs

REIT Distributions

• Trusts distribute 90% to 100% of earnings
• AREIT trusts do not have franking credits – income is not taxed at trust
• Distributions taxed at the individual income tax rate
• REIT distribution includes a tax deferred component
• Tax deferred component – represents the return of capital rather than income
  • Plant and equipment depreciate which reduces taxable income - can be distributed to beneficiaries of the REIT - can get some of the capital back too
• As REITs collect income – manager can decide if the payments made to investor are income collected or capital invested

A-REIT forms

• Broadly speaking, A-REITs comprise one of two forms:
  • Externally Managed (passive); or
  • Stapled (active).

RHS:

• investors put money into the trust
• trustees purchase properties and hire a manager
• entity managing the property is not necessarily the same as the trustee that owns the property

LHS:

• unit holder holds shares in the trust and the management company
  • have an equity position in the company also
• unit in the trust, and shares in the management company
• most common

Stapled securities

• Some trusts adopt hybrid structures called ‘stapled securities’ funds.
• Stapled securities A-REITs provide investors with exposure to a funds management and/or a property development company, as well as a real estate portfolio.
• A share in a stapled securities fund usually consists of one trust unit and one share in the funds management company.
• These securities are ‘stapled’ and cannot be traded separately.
• The trust holds the portfolio of assets, while the related company carries out the fund’s management functions and/or manages any development opportunities.

Externally Managed model:

• Management taken on by separate entity to the property trust
• Slowly collapsing over time
• Often conflicts of interest between management and trust
• Can provide better resourcing and management services than some REITs have capacity for

MODERN PORTFOLIO THEORY

• For many investors income properties are just one part of an investment portfolio:
  • May include other properties or asset classes (shares, interest bearing securities)
  • The key is that the risk of a property as an isolated investment is greater than the risk the property adds to a portfolio.
• Modern portfolio theory (MPT) has become a well-accepted framework to construct or rebalance real estate portfolios
• MPT assumes investors are risk-averse
  • Given two assets offer the same expected return, investors will prefer the less risky one
  • Investors will accept increased risk if compensated by higher expected returns

NOTE:

• balancing real estate portfolios
• assets with different risks and returns, when aggregating them you are overall mitigating aggregate risk
• By balancing multiple assets with different risk profiles, you overall have a better risk portfolio and better risk management

Asset Returns

• Total (Accumulation) Return accounts for two categories of return: income and capital
  • Income includes interest paid by fixed-income investments, distributions dividends or the net income of direct property
  • Capital/ Price return represents the change in the market price of an asset.
    • income and capital
• Initial Yield
  • The income yield for the asset. Shows the ratio of the current passing rent to the current property value
    • IY = passing rent / property value
    • passing yield - how much rent I am currently versus from the current property value
• Reversionary Yield
  • The market yield for the asset. Shows the ratio of the market rent to the current property value (on properties rented below market)
  • RY = market rent / property value
  • what is the market rent of the property value
  • reversionary - at the end of the lease term, the right to possess the property reverts back to the owner
  • in a perfect world, initial yield and reversionary yield is the same

Income return

A property is valued at $2.5m and has a current net income of $150,000 p.a. The assessed market income for the property is $175,000 p.a. Compute the initial yield and reversionary yield for the asset.

Capital Return

The change in capital value of an investment over a holding period as a percentage between any change in capital value and the purchase price or value at the beginning of the measurement period.

Capital Return=

$$\frac{CV_{1} - CV_{0}}{CV_{0}} \times 100$$

Income Return

• Net income over the measurement period divided by the purchase price or capital value at the beginning of the measurement period.

Income return =

$$\frac{NI}{CV_{0}} \times 100$$

Total Return

Percentage relationship between any capital gain or loss and income over the capital value at the beginning of the measurement period.

• True return to the investor on their money.

Total return =

$$\frac{CV_{1} - CV_{0} + NI}{CV_{0}} \times 100$$

CV = capital value at the beginning of the measurement period CV1 = capital value at end of the measurement period NI = net income received during the period

• Over time, land tends to appreciate while building depreciate
• If the majority of the value is attributed to the build component, over time the future capital value will be a small part of it increasing the land and a large part decreasing the value
• common to have small income (and small building) but large capital component or other way around

Asset Yields vs Asset Returns

• Yield reflects the relationship between a current net income and the purchase price and does not take into account any capital loss or gain made.
• Return usually reflects any income, expenditure and/or capital gain or loss made on investments.
• Return gives a clear indication of the financial position of the investor.
• Yields are used to estimate the market value of an investment while a return is used as a means of comparing the financial attractiveness of different investments to an investor.

Portfolio returns

• Return is a weighted average of expected return on each asset.
• Consider two assets with weights, w 1 w 2 and returns r 1 r 2 .

Portfolio return:

$$r_{p}=(w_{1}r_{1})+(w_{2}r_{2})+...$$

Acquisition and Disposal process

• Direct or indirect ownership decision

• Timing – what stage of the property cycle do you buy into?

• Asset physical characteristics

  • Segment
  • Size
  • Location
  • Age and condition of improvements

• Financial characteristics

  • Hurdle rate for return on investment/return on capital
  • WALE (weighted average lease expiry)
  • Income and capital growth opportunities

• process purchasing every kind of infrastructure, e.g.

• timing - hot market, buying/selling market will impact due diligent time frames etc.

• WALE - 100 leases expiry at the end of year, WALE is one year. Average the lease expiry

  • can also weight based on income too, or how much space is becoming available

Acquisition Process

Typical Expression of Interest process (can be over 12 months)

1. Initial Review of an Asset
2. Engage Consultants
3. First Round Bids
4. Second Round Bids
5. Third Round Bids
6. Due Diligence
7. Contract Signing
8. Settlement

• normal process to acquire a project
• 12 months is not an unusual EOI

1. Initial Review of an Asset

• Meet with agents to discuss opportunity
• Review of Information Memorandum
• Initial Pricing of Asset based on Financial Pack - Budget, Outgoings recovery model, Tenancy Schedule
• Initial review of documents provided in data room
• Multiple pricing scenarios and sensitivity analysis
  • not uncommon to pay $50-150K for an unsuccessful property purchase

2. Engage Consultants

• Usually only applicable in complicated transactions such as large scale retail for a market / trade area analysis

3. First Round Bids

• Submission of First Round Bids to Agents
• Includes price and terms
  • i.e. $80,500,000, subject to FIRB Approval, subject to Board Approval, 60 day settlement, subject to Due Diligence period of 4 weeks etc etc
• NOTE: look at them, how compliant are they to community objective, etc. Aligns to policy objective to what the seller has outlined

4. Second Round Bids

• Shortlisted parties (usually 3) are invited to provide a second round bid
• Usually a higher/ more competitive bid based on sensitivity analysis, market assessment undertaken throughout first round bids and assumption clarification

5. 3rd Round Bids (BAFO – Best and Final Offer)

• Only applicable in very competitive markets
• Not always applicable in the bid process - subject to vendor and agent’s preference

6. Due Diligence

• Often 4 - 6 weeks
• Hot / competitive market is reducing DD periods to 4 weeks or less
• Some transactions in the market have taken place with no DD
• Allows for detailed analysis of financial, technical and legal review of the asset

7. Contract Signing

• Property sale contract signed by all parties

8. Settlement

• Settlement varies dependent on vendor and purchaser preferences
• Often 30 - 60 days
• Can be as long as 6 months

Typical Due Diligence Checklist

1. Rent Roll Analysis
2. Lease Agreement Review
3. Review of Service and Maintenance Agreements
4. Pending or threatened matters review
5. Review of Title/deed documents
6. Property Survey
7. Government Compliance
8. Physical Inspection
9. Tax Matters
10. Insurance Policies
11. Engineering studies
12. Market studies
13. List of personal property

Divestment Criteria

• Reposition of Fund
  • Too much retail in a Fund benchmarked against diversified assets. i.e. high capital returns in funds invested in Sydney/ Melbourne office markets have increased the return benchmark for funds that might carry too much retail (lower total returns compared to certain office markets)
• Cyclical Play - i.e. Office Market - buy low, sell high
• Closed end Fund
  • requires divestment of assets at the end of the Fund
• Capital Requirements
  • Liquidity windows and unit redemption may force sale of assets
    • sell assets to offset leverage

Disposal Process

1. Internal Approvals

• Internal Board and Investment Advisory Committee Approvals

2. Data Collection

• Collection of all documents relating to the asset
• Leases, management agreements, service contracts, maintenance records, tenant tax invoices, dispute notices

3. Internal Valuation of the Asset

• Multiple pricing scenarios to target marketing date, use for recommendation of divestment.

4. Due Diligence

• Validation of all documents related to asset
• Can be 2,000 - 3,000 documents requiring validation

5. Agency Appointment

• Agency submissions and appointment of successful agent
• Agent’s domestic and international reach taken into consideration as well as fees
• One or two agents dependant on size of transaction

6. Launch Campaign

• International campaign typically 1-2 weeks ahead of domestic campaign
• Campaign length typically 4 weeks domestically

7. Bid Submissions

• Bid submissions taken and parties shortlisted

8. Second Round Bids

• Shortlisted parties invited to submit second round bids
• Parties shortlisted dependant on bid price, terms, perceived settlement risk

9. Due Diligence
10. Contract Signing
11. Settlement

• data rooms, partially redact data and can see what data the other entity has accessed