Summary
Samenvatting - Real Estate Finance (6314M0296Y)
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Comprehensive summary including articles from the Real Estate Finance course.
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Capital structure and equity financingCapital structure
7
the firms mix of debt and equity financing, to operate its operations and growth
total assets - total debt
7
example
>
borrowed money
costs are 100 million, after one year the project will either generate 95 million or 125 million, depending on
a strong or weak economy, these scenarios are equally likely. As there is market risk, we demand a risk
premium of 8% over risk free rate of 2%, how much are you willing to pay?
1
2
expected cash flow: 2
+
125 + x
95 =
110m
110
7
then the present value is , hence the levered equity is 0, as we obtain 100, but invested
PV =
1 10
.
=
100 m
also 100
now what happens if we finance using dept?
suppose we to finance 50 million with debt (owe debt holders 51 million after one year)
t=0 t=1
strong economy weak economy
hence by financing the project with debt, the
E E E95m
project 100 m
value of the value increased from 0 to 3.6
125 m
E
debt E 50m E5i 51 m m
*
levered equity *
E3 E .
2x44
6 m
x
note leverage refers to using debt to
74 +
74 m E44m
> =
increase the potential return on investment
1 .
10
-
50 = E 3 .
6m
N
leveraged equity: equity in a company, which have used financial leverage, such as debt, to finance its
investments
unleveraged equity: the company has financed its operations without relying on borrowed funds
further with example
this table above is wrong, as leverage increases the risk of equity of a company, hence it is inappropriate to
again use the 10% discount rate, investors in levered equity require a higher expected return to compensate
for this increased risk, the table now looks as follows
t=0 t = 1: cash flows t = 1: returns
strong economy weak economy strong economy weak economy expected return
E E 95m % % %
Unlevered equity 100 m 125 m 25 -
5 10
Levered equity E 50 m 74m = 44 m 40 % -
12 % 18 %
, What is the optimal leverage? note cost of capital is the weighted average cost of the various
There are four theories: resources of funds a company uses to finance its investments
MM propositions:
' > one without taxes, bankruptcy costs, agency costs, or asymmetric information
MMI: in a perfect market, the total value of a company is equal to the market value of the total
cash flows generated by its assets and is not affected by its choice of capital structure v" vo =
"
MMII: the cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium
that is proportional to the market-value debt-equity ratio
return on unlevered equity ( Ru ) is weighted average returns of levered equity ( RE ) and debt ( Rp)
>
I
:
EPDRD
L
E + DRE + =
Ru < Re =
Ru + (Ru Rp) -
2
Trade-off theory
imperfect markets
7
financial agency
V = V +
P)(
interest
tax shield - PV)
distress
costs -
PV
agency costs
of debt + 4)
benefits of
debt
&
interest tax shield: when we borrow money, we pay a certain interest over it, the government allows
you to substract this interest costs from you income before calculating how much tax you need to pay,
hence this results in paying less tax
>
with tax-deductible interest, the effective after tax borrowing rate is (1 5) and the rx + -
E D
weighted average cost of capital becomes WACC ED Drn(i-s =
re + E +
E D
=
E + DrE +
E + D rD
-
E + D roJe
= pre-tax WACC = reduction do to tax shield
>
financial distress costs:
~
direct costs: ex. cost of experts and advisors, cost of reorganization
I
indirect costs: loss of consumers, costs to creditors, inefficient liquidation, fire sale of assets, loss
of employees, loss of suppliers, loss of receivables
>
agency costs of debt: potential conflicts and associated costs that arise when issuing debt between
different stakeholders, particularly between shareholders and managers
example shareholders may want to take on more debt to benefit from tax shields and increase
returns, while managers may have different risk preferences and may be concerned about the
increased financial risk associated with higher debt levels
>
agency benefits of debt:
concentration: allows original stakeholders to maintain their equity stake
commitment: commits managers to pursue strategies with great vigor
motivation: avoids managers to make decisions that benefit themselves at investors expense
wastefulness: managers are motivated to run the firm as efficiently as possible
,3
Pecking order theory
Lemons principle: when a seller has private information about the value of a good, buyers will discount the
price they are willing to pay due to adverse selection (possibility that managers have bad news)
example if the seller of a car has private information about eg quality of the car (information asymmetry),
7
then his desire to sell reveals the car is probably of low quality. As a result buyers are reluctant to buy
except at heavily discounted prices. However, owners of high quality cars are reluctant to sell as they
know buyers will think they are selling a lemon and offer only a low price
>
Overcome this problem with debt signaling theory: use leverage to signal good information to investors
example assume a large firm has a new profitable project, but cannot discuss the project for
>
competitive reasons (information asymmetry). One way to communicate this positive information is
to commit the firm to large future debt payements.
if the information is true, the firm will have no trouble making the debt payment
if the information is false, the firm will have trouble paying its creditors and will experience
financial distress
&
Assymetric information affects the choice between internal and external financing, and between new
issues of debt and equity securities (financing by first using retained earnings, then debt and finally equity)
4
Market timing theory
Firms have no preference between debt of equity, but choose the most appropriate source of funding under
the prevailing market conditions
REIT = real estate investment trust: a Determinant = a factor/cause
company that owns, operates or finances that makes something happen
income-generating real estate or lead to direct decision
Capital structure of real estate firms this part was the general theory, now we look how this works in REIT in practice
We start this part by analyzing the article, 'on the determinants of REIT capital structure: evidence from
around the world', by Dogan, Ghosh and Petrova
where is the article about?
The articles uses sample of REITs from twelve countries around the world, and examine the determinants of
REIT capital structure. They look at firm-specific and country-based specific factors and account for the unique
legal requirements that REITs face in each country
introduction and motivation
REITs are highly regulated, there are no taxes, and payout requirements and leverage restrictions. As a result
there is no tax shield and there are limited retained earnings. total debt
We expect that according to the trade off theory, the debt ratio ( total equity ) is low, because REITs don't pay
tax. The theory also predicts that REITs specialised in properties with more volatile cash flows have lower
leverage
, According to the pecking theory, we expect high debt ratio because REITs are required to distribute large
amounts of earnings. note debt ratios are double the average of industrial firms
study
The country-based specific factors are divided into several groups depending on countries with or without
payment restrictions (exempt or not exempt from tax) and if countries have payout and/or leverage
restrictions (France and Canada have no leverage restrictions, Turkey had until 2008 no minimum pay-out
requirement, South Africa is required to distribute 75% of earnings).
For the firm-specifics, they focus on five determinants of leverage: asset tangibility, profitability, growth
opportunities, firms size and interest coverage.
results
Countries with high pay-out requirements and Countries with no pay out requirements and
no leverage restrictions have high leverages. leverage restrictions have low leverages. Hence
Hence in this case REITs prefer debt over in this case REITs prefer internal financing over
equity external financing
Consistent with packing order theory
...
Furthermore, they find that legal regulations influencing the impact of firm-specific factors, yield no consistent
pattern
Next, we consider different articles to discuss the difference between companies and REIT, first we look at
regular companies. IPO = initial public offering: offering
private shares to the public
Remember the lemons principle, where information asymmetry is particular acute when a firm accesses the
capital markets because managers can exploit their information advantage. As a result stock prices decline on
the announcement of an equity issue. IPO underpricing: an IPO stock closes at a higher price at the end
>
of the first day of trading than the initial offer price
how is this with REITs? Deliberately underpricing IPOs is a strategy that has been
>
used by many companies for their issues (Lemons problem)
Using a bid-ask spread to measure information asymmetry, it is suggested that REITs increase transparency
(less information asymmetry) when they access capital markets. This could be due to the fact that REiTs has
limited investment in human capital, and fewer strategies growth opportunities and REITs assets are
relatively easier to value. Furthermore, because of the payment-out requirements, REITs frequently access
the capital markets and increase their disclosure when tapping the market.
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