Real Estate Finance 101

1
Real Estate Finance 101

• Richard Krumholz
• Harvard Investment Association
• November 2006

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Introduction

• What are the three Ls in real estate?
• Leverage, Leverage, Leverage!
• Can produce extraordinary returns on equity
• But adds much risk
• Why understanding real estate finance is so vital
  to succeeding in real estate
• Mechanism to magnify returns but also need to
  understand risks and rewards from alternatives

3
Why and When to Use Leverage

• Positive vs. Negative Leverage
• Definition of Capitalization Rate (NOI/Building
  Value)
• Definition of Debt Constant (Debt
  Service/Mortgage)
• If cap rate is greater than debt constant, then
  using leverage will magnify returns (positive
  leverage)
• If cap rate is less than debt constant, then more
  leverage will actually hurt the overall returns
  (negative leverage)
• Example 100,000 property with 10 cap rate
• Higher leverage in real estate because tangible
  assets with more permanent value than other forms
  of collateral

4
What is a mortgage?

• Loan where the real estate asset serves as
  security
• What does this mean in the case of a default?
• Key elements
• Length of Loan and of Periods
• Interest Rate
• Payment Form
• Loan to Value Ratio

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Financial Structure of RE Investment

• Equity (5-50)
• Ownership interest
• Mezzanine Loan (0-15)
• Optional if want higher leverage
• Take over property before mortgage default
• Mortgage (50-80)
• Debt using property as collateral
• Want to ensure they will not lose their money in
  a worst case scenario

Equity
Mezzanine
Mortgage
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Mortgage Type Interest Rate

• Fixed Rate Mortgage
• Locked interest rate, large prepayment penalty,
  measured as spread over Treasuries
• Adjustable Rate Mortgage
• Floating interest rate, more prepayment
  flexibility, spread over LIBOR

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Mortgage Type- Payment Structure

• Amortizing Loan
• Interest plus principal included in payment
• Interest-Only Loan
• Payment only includes interest due on loan
  balance
• Balloon payment of principal at end
• Negative Amortization Loan
• Payment is less than total interest due
• Interest is added to principal amount of loan
• When would you want to use interest-only or
  negative amortization loan?

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Construction Loan

• Line of credit that is drawn upon at different
  stages of construction
• Bank tightly controls money so that only pays out
  work that is currently being done
• Recourse or Non-Recourse?
• Total value of construction loan is determined by
  what projected take-out loan will be
• What factors would cause someone to walk away
  from a construction project?

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How Lenders analyze assets?

• Tenant Quality
• High or low credit ratings? Why does credit
  matter?
• Market Conditions
• Demographics, Economic projections
• Sponsor
• Experienced? What is their track-record?
• Competition
• What is the supply of similar assets in this
  market?
• How many new structures are being built?

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Why is leverage dangerous?

• Real Estate is very cyclical
• Lags between demand and when supply comes online
  leads to inequalities between them
• Overbuilding during periods of strong demand
• With oversupply, rents and prices fall leading to
  defaults when overleveraged
• REITS (early 90s) and CMBS (mid-90s)
• Do public markets make real estate more efficient
  or more volatile?

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Job Opportunities in Real Estate Finance

• Balance Sheet Lending at Commercial Banks
• CMBS Lending at Investment Banks
• Finance Expert for Real Estate Companies
• Investment Banking Advisor for REITs, hotels, and
  casinos
• Mortgage Broker

12
Q A Period

• Real Estate Finance 101
• Richard Krumholz
• HIA