DAVID HARTZELL is Steven D. Bell and Leonard W. Wood Distinguished Professor of Finance and Real Estate and Director, Wood Center for Real Estate Studies, University of North Carolina. He is a Fellow of the Private Equity Research Consortium, Kenan Institute and serves on the Board of Directors of Highwoods Properties, a publicly traded Real Estate Investment Trust (REIT), and has served on the Investment Advisory Committee of the [...] billion North Carolina Retirement System.

ANDREW BAUM is Professor of Practice, Saïd Business School, University of Oxford and Professor Emeritus, University of Reading. He is Director of the Oxford Future of Real Estate Initiative, Chairman of Newcore Capital Management, and has held senior executive and non-executive positions with Grosvenor, The Crown Estate, CBRE Global Investors and others.

Acknowledgements xxi

About the Authors xxiii

Preface xxv

Part One Real Estate as an Investment: An Introduction

Chapter 1 Real Estate - The Global Asset 3

1.1 The Global Property Investment Universe 3

1.2 Market Players 6

1.2.1 Investors 6

1.2.2 Fund Managers 9

1.2.3 Advisors 9

1.3 Property - Its Character as an Asset Class 11

1.3.1 Property Depreciates 12

1.3.2 Lease Contracts Control Cash Flows 13

1.3.3 The Supply Side is Inelastic 13

1.3.4 Valuations Influence Performance 14

1.3.5 Property is Not Liquid 15

1.3.6 Large Lot Sizes Produce Specific Risk 16

1.3.7 Leverage is Commonly Used in Real Estate Investment 18

1.3.8 Property Appears to be an Inflation Hedge 19

1.3.9 Property is a Medium-Risk Asset 21

1.3.10 Real Estate Cycles Control Returns 22

1.3.11 Property Appears to be a Diversifying Asset 24

Specific Risk 27

Leverage 27

Illiquidity 28

Taxes, Currency, and Fees 28

1.4 Conclusion 28

Chapter 2 Global Property Markets and Real Estate Cycles, 1950-2020 33

2.1 Introduction and Background 33

2.1.1 The Property Cycle 33

2.2 A Performance History 34

2.2.1 Before 1970: Real Estate Becomes a Medium-Return Asset 34

2.2.2 The 1970s: Inflation, Boom, and Bust 36

The USA 36

The UK 37

2.2.3 The 1980s: New Investors Flood the Real Estate Capital Market 38

The USA 38

The UK 42

2.2.4 The 1990s: The Rise of REITs 43

The USA 43

The UK: Deep Recession, Low Inflation, and Globalization 45

2.2.5 2002-7: A Rising Tide Lifts All Boats 47

The USA 47

The UK 59

2.2.6 The Global Real Estate Credit Crisis Hits 60

The USA 60

The UK 67

2.2.7 The Markets Recover Post-crisis 70

2.3 The Global Market 72

2.3.1 The European Market Develops 72

2.3.2 Asia Emerges 75

2.4 Real Estate Cycles: Conclusion 80

Lesson 1: Too Much Lending to Property is Dangerous 80

Lesson 2: Yields are Mean-Reverting - Unless Real Risk-Free Rates Change 81

Lesson 3: Look at Yields on Index-Linked 81

Chapter 3 Market Fundamentals and Rent 83

3.1 Introduction: The Global Property Cycle and Rent 83

3.2 The Economics of Rent 84

3.2.1 Rent and Operational Profits 84

3.2.2 Theories of Rent 86

Ricardo 86

von Thünen 87

Fisher 89

3.2.3 Rent as the Price of Space 90

3.2.4 Supply 91

3.2.5 Demand 93

The Cyclical Demand for Space 93

The Structural Demand for Space 94

Variations in Locational Demand by Use 95

3.2.6 The Relationship Between Rental Value and Rental Income 97

3.2.7 The Impact of Currency Movements on Rent 99

3.2.8 Property Rents and Inflation 99

3.3 Forecasting Rents 101

3.3.1 Forecasting National Rents 101

Model Types 101

Price 102

Demand 102

Supply 102

Building the Model 104

An Historical Model 104

A Forecasting Model 105

3.3.2 Forecasting at the Local Level 105

Conceptual and Modelling Problems 106

Data Issues 106

3.4 Conclusion 107

Chapter 4 Asset Pricing, Portfolio Theory, and Real Estate 109

4.1 Risk, Return, and Portfolio Theory 109

4.1.1 Introduction 109

4.1.2 Risk and Return 110

4.1.3 Portfolio Theory 111

The Efficient Frontier 111

4.1.4 Risk and Competitors 112

4.1.5 Risk and Liabilities 113

4.1.6 Property Portfolio Management in Practice 113

The Investment Strategy 114

4.2 A Property Appraisal Model 115

4.2.1 Introduction: The Excess Return 115

4.2.2 The Cap Rate or Initial Yield - A Simple Price Indicator 116

UK Terminology 116

US Terminology 117

How are Cap Rates Estimated in Practice? 118

Cap Rates are the Inverse of Price/Earnings Ratios 118

What Drives the Cap Rate? 119

4.2.3 The Fisher Equation 121

4.2.4 A Simple Cash Flow Model 121

4.2.5 Gordon's Growth Model (Constant Income Growth) 122

4.2.6 A Property Valuation Model Including Depreciation 122

4.3 The Model Components 123

4.3.1 The Risk-Free Rate 123

4.3.2 The Risk Premium 124

What is Risk? 124

The Capital Asset Pricing Model 125

4.3.3 Inflation 127

4.3.4 Real Rental Growth 128

4.3.5 Depreciation 128

4.3.6 'Correct' Yields 129

4.3.7 An Analysis in Real Terms 129

4.4 The Required Return for Property Assets 130

4.4.1 The Sector Premium 130

4.4.2 The City Premium 131

4.4.3 The Property Premium 131

4.4.4 Example 131

Tenant 131

Tenure 132

Leases 132

Building 132

Location 132

4.5 Forecasting Real Estate Returns 135

4.5.1 The Origin and Uses of Property Forecasts 135

4.5.2 Forecasting Cap Rates 136

4.5.3 Forecasting Property Cash Flows 138

4.5.4 The Portfolio Model 138

4.5.5 Example 139

4.5.6 Fair Value Analysis 141

4.6 Conclusion: A Simple Way to Think About Real Estate Returns 141

Part Two Making Investment Decisions at the Property Level

Chapter 5 Basic Valuation and Investment Analysis 145

5.1 Introduction 145

5.1.1 Cash Flow 146

5.1.2 Risk and the Discount Rate 147

5.1.3 Determining Price 147

5.1.4 Determining Return 148

5.2 Estimating Future Cash Flows 148

5.2.1 Introduction 148

5.2.2 Holding Period 149

5.2.3 Lease Rent 149

5.2.4 Resale Price 149

Estimated Rental Value at Resale 150

Going-Out Capitalisation Rate 150

5.2.5 Depreciation 150

5.2.6 Expenses 152

Fees 152

Taxes 152

Debt Finance (Interest) 153

5.3 The Discount Rate 153

5.4 Conclusion 156

Chapter 6 Leasing 159

6.1 Introduction 159

6.2 Legal Characteristics of Leases 160

6.3 The Leasing Process 161

6.4 Important Economic Elements of a Lease 161

6.4.1 The Term of the Lease 162

6.4.2 Base Rent and Rent Escalation Provisions 162

6.4.3 Options 163

Renewal Options 163

Expansion, Contraction, and Termination Options 163

6.4.4 Measurement of Space 164

6.4.5 Expense Treatment 165

Gross Lease 165

Triple Net Lease 168

6.4.6 Concessions: Tenant Improvement Allowance and Rental Abatement 170

Tenant Improvement Allowance or Tenant Upfit/Fitout 170

Rental Abatement (Rent-Free Periods) 171

6.4.7 Brokerage Commissions 172

6.4.8 Other Key Elements of a Lease 174

6.4.9 Leasing Differences Across Property Types 175

6.5 Lease Economics and Effective Rent 177

6.5.1 Comparing Leases with Different Expense Treatment 177

The Landlord's Perspective 177

The Tenant's Perspective 178

6.5.2 Comparing Leases with Different Concession Allowances 179

Landlord's Perspective 180

Tenant's Perspective 181

6.6 Conclusions 183

Appendix: Modeling Lease Flexibility In The Uk 183

Example 185

Assumptions 185

Result 185

Explanation 186

Chapter 7 Techniques for Valuing Commercial Real Estate and Determining Feasibility: The Unleveraged Case 187

7.1 Introduction 187

7.2 Background on the Investment Opportunity 188

7.2.1 Project Details 188

7.2.2 Where Do You Find Information About Income and Expenses? 189

7.3 Developing a Pro Forma Income Statement 190

7.3.1 Calculating Total Revenues 191

7.3.2 Estimating Vacancy Loss 191

7.3.3 Estimating Operating Expenses 192

7.3.4 Calculating Net Operating Income 193

7.4 Valuation Using Net Operating Income: Single-Year Cash Flow 193

7.4.1 An Aside on Capitalization Rates 194

Estimating the Market Cap Rate 194

Cap Rates are the Inverse of Price/Earnings Ratios 195

Using Cap Rates to Value the Apartment Project 195

Calculating the Implied Cap Rate for the Apartment Investment Opportunity 196

7.5 Investment Analysis Using Operating Income: Multiple-Year Cash Flows 197

7.5.1 Operating Cash Flows from Leasing 197

7.5.2 Cash Flows from Disposition 198

7.6 Applying Discounted Cash Flow to Analyze Investment Feasibility 200

7.6.1 Determining Feasibility 200

7.6.2 Equity Multiple 200

7.6.3 Partitioning the Internal Rate of Return 201

7.6.4 Calculating the Maximum Price to Pay 202

7.7 Sensitivity Analysis 202

7.8 Conclusion 203

Chapter 8 Mortgages: An Introduction 205

8.1 Introduction 205

8.2 What is a Mortgage? 206

8.2.1 Promissory Note 206

8.2.2 Mortgage Instrument 206

8.3 The Risks and Returns of Mortgage Investment 207

8.4 The Financial Components of a Mortgage 208

8.4.1 The Bond Component 208

8.4.2 The Call Option Component 208

8.4.3 The Put Option Component 209

8.5 The Mortgage Menu 210

8.5.1 Fixed or Floating-Rate Loans 210

8.5.2 Fully or Partially Amortizing Loans 211

8.6 An Introduction to Mortgage Math 212

8.6.1 Calculating the Monthly Payment 212

8.6.2 The Mortgage Loan Constant 213

8.6.3 The Amortization Schedule 213

8.6.4 Converting from the Contract Rate to the Compounded Rate 217

8.6.5 Determining the Cost of Borrowing 217

Borrowing Cost without Up-front Fees 217

Borrowing Costs when the Lender Charges Fees 219

Borrowing Costs when the Loan is Prepaid Prior to Maturity 220

8.7 Calculating Prepayment Penalties 220

8.7.1 Lockout Periods 221

8.7.2 Step-down Prepayment Penalties 221

8.7.3 Yield Maintenance Penalties and Yield Calculations 222

8.7.4 Treasury Flat Prepayment Penalty 225

8.7.5 Defeasance 228

8.8 Conclusion 228

Chapter 9 Commercial Mortgage Underwriting and Leveraged Feasibility Analysis 229

9.1 Introduction 229

9.2 Mortgage Underwriting and the Underwriting Process 229

9.2.1 Ratios and Rules of Thumb 230

Loan-to-Value Ratio 230

Debt Coverage Ratio 230

Debt Yield 232

9.2.2 Determining the Maximum Loan Amount 232

Operating Expense Ratio 236

Breakeven Ratio 236

Debt Yield 237

9.3 Investment Feasibility with Leverage: Before-Tax Analysis 238

9.3.1 The Two-Part Nature of Cash Flows: Operating Income and Disposition Income 238

9.3.2 Financing Impact on Investor Income Statements: Adding Debt Service Cash Flows 238

Income from Disposition 239

9.3.3 Determining Investment Feasibility: The Leveraged Before-Tax Case 240

Static or Single-Year Measures of Investment Performance 240

Determining Investment Feasibility Using Multiple Year Cash Flows 242

Equity Multiple 242

Partitioning the IRR and NPV 242

Determining the Maximum Price to Pay with Leverage 243

9.4 Sensitivity Analysis 244

9.5 Conclusion 245

Chapter 10 Real Estate Development 247

10.1 Introduction 247

10.2 The Development Process 248

10.3 Preliminary Analysis of "The Station" Development 250

10.3.1 "Back-of-the-Envelope" Analysis 250

Estimating Construction Costs 251

Estimating Market Value 251

10.3.2...