Question #1 of 26 Question ID: 1586356

Which of the following least accurately identifies a type of publicly traded real estate
security?

A) Investment trusts.
B) Direct mortgage lending.
C) Operating companies.

Explanation

The main types of publicly traded real estate securities are REITs (real estate investment
trusts), REOCs (real estate operating companies), and RMBS and CMBS (residential and
commercial mortgage-backed securities). Direct mortgage lending is most likely to be a
private rather than public investment.

(Module 33.1, LOS 33.a)

Question #2 of 26 Question ID: 1586357

Which of the following is most likely to represent a publicly traded real estate debt
investment?

A) A real estate operating company (REOC).

B) Secured bank debt collateralized by real estate.
C) A mortgage real estate investment trust (Mortgage REIT).

Explanation

Mortgage REITs are publicly traded securities that make loans secured by real estate,
therefore they are publicly traded debt investments. REOCs are classified as equity (not
debt) securities, while bank debt is classified as a private rather than public investment.

(Module 33.1, LOS 33.a)

Question #3 of 26 Question ID: 1586375

Patricia Ly, CFA, is a portfolio manager who wishes to add diversification to her portfolio
through the addition of a real estate investment. Ly finds the following data for a particular
industrial REIT:

Net operating income (NOI): $710,000

Funds from operations (FFO): $630,000

Assumed cap rate: 6%

Shares outstanding: 90,000 shares

Storage property average P/FFO multiple: 13x.

Industrial property average P/FFO multiple: 10x.

Ly decides to perform a valuation on this REIT. The value per share of this REIT using a price-
to-FFO approach is closest to:

A) $91
B) $112
C) $70

Explanation

FFO/share = FFO / Shares outstanding = $630,000/90,000 shares = $7/share.

The relevant subsector average P/FFO multiple is the value for industrial properties of 10x.

FFO/share × P/FFO multiple = $7.00 × 10x = $70.00

(Module 33.2, LOS 33.h)

Question #4 of 26 Question ID: 1586362

Which of the following is least likely a difference between real estate investments and
traditional asset classes like stocks and bonds?

A) Real estate tends to be indivisible

B) Real estate tends to be difficult to value
C) Real estate tends to be homogenous

Explanation
Investment in real estate is complicated by difficulty in valuing real estate, indivisibility of
real estate investment (high unit value) and heterogeneity of different real estate
properties even within the same class/geographical location.

(Module 33.1, LOS 33.b)

Question #5 of 26 Question ID: 1586366

Compared to transaction-based indices used to track the performance of private real estate,
appraisal-based indices are most likely to exhibit an apparent:

A) time lag.
B) higher volatility.
C) higher correlation with other asset classes.

Explanation

Appraisal-based indices tend to lag transaction-based indices, as appraised values adjust

only slowly to sudden shifts in the market.

Appraisal-based indices are "smoothed" by this lag, which causes appraisal-based indices
to appear to have lower volatility and lower correlation with other assets than a
transaction-based index would.

(Module 33.1, LOS 33.e)

Kent Clarkson, Tony Chekov and Peter Chanwit are investment consultants for a large public
pension fund. They are partners in Clarkson, Chekov and Chanwit Consulting also known as
3CC. From previous meetings with the pension board, it has been established there will be
an increase in exposure to real estate for the overall portfolio. Because of the defined
benefit plan's significant size and their staff's expertise, the pension fund can invest and
manage all forms of real estate investments. Partners of 3CC are to recommend a form of
real estate investments, and recommend potential investments.

Expected Real Estate Market Conditions

Both residential and commercial real estate prices have fallen over the last five years. This
trend is not expected to persist. It is a 'buyer's market' – the current supply exceeds the
current demand and prices are lower than the intrinsic value. Although interest rates have
fallen to historically low rates, the volume of real estate transactions remains low. Current
average 20-year commercial mortgage rates are 3.75% and expected to stay relatively flat for
at least 7 more years.
Loan underwriting standards have become more stringent and loan-to-value (LTV) ratios are
expected to be lower than the earlier average rate of 80%.

The four forms of real estate under consideration as an investment choice for the pension
fund are:

Private: equity option is to buy commercial properties and manage them; debt option
is to directly lend to commercial property investors.
Public: equity option is to buy equity REITs; debt option is to buy mortgage REITs or
CMOs.

The following information was collected by 3CC partners to aid their analysis. The returns
and standard deviations of the four possible forms of real estate investments considered
are listed in Exhibit 1. Correlations of real estate index with Treasury bill returns, US
aggregate bond returns and US stock returns are listed in Exhibit 2.

Exhibit 1: Returns and Standard deviation (past 20 years)

Returns σ

Private Equity 9.5% 6.5%

Private Debt 5.5% 8.5%

Public Equity 11.5% 21.0%

Public Debt 6.2% 22.5%

Treasuries 3.5% 0.6%

Exhibit 2: Correlation of Real Estate Index With Other Asset Classes (past 20 years)

Real Estate Index

ρ
Correlations

US Treasuries 0.35

US Aggregate Bonds -0.05

US Stocks 0.25

The partners make the following statements:

Kent Clarkson: We should eliminate the private debt option from consideration. Returns for
private debt are likely to be low since interest rates are likely to remain low and the amount
of underwriting that is going to be required as a lender doesn't seem worth it.
Tony Chekov: I like the equity options better than the debt options based on Clarkson's
private debt expectations.

Peter Chanwit: I prefer the private option over the public option since the pension fund staff
can better actively manage the real estate projects and possibly outperform the index.

The partners have identified specific REIT managers who have consistently outperformed
their indices for the public option. They have also contacted potential high creditworthy
borrowers in case of private debt. For the private equity option, the partners are looking at
different commercial properties. They have narrowed their choices to hotels and multi-
family units.

Peter Chanwit is analyzing two specific buildings. Green Oaks Hotel and Blue Ridge
Apartments are next to each other; have exactly the same number of units, same amenities;
were built 10 years ago by the same construction company; and managed by the same
property management company. They are currently owned by different entities that are also
looking to provide the financing on the following basis.

Green Oaks Hotels Blue Ridge Apartments

Asking Price $25,000,000 Asking Price $25,000,000

Annual NOI End of Year Annual NOI End of Year

$2,187,500 $2,125,000
1 1

LTV 75.0% LTV 70.0%

Loan Interest Rate 4.00% Loan Interest Rate 3.50%

Monthly Debt Service $113,621 Monthly Debt Service $101,493

Loan Term 20 Years Loan Term 20 Years

Expected Sales Price in Expected Sales Price in

$30,000,000.00 $30,000,000.00
10 Yrs 10 Yrs

Principal Owed at End Principal Owed at End of

$11,222,397 $11,144,755
of 10 Yrs 10 Yrs

The pension fund can buy one or both buildings provided they meet the minimum criteria of
a debt service coverage ratio of at least 1.50X and a levered IRR of at least 17.5%.

The indices under consideration as the benchmark for private real estate equity investing
are:

Jackson Property Index (JPI) is an appraisal based index.

Taft's Sales Index (TSI) is a repeat sales index.
 Lincoln Hedonic Index (LHI) is a hedonic index.

Concerns regarding the index choice were verbalized at a 3CC meeting:

Kent Clarkson: I'm worried about Lincoln Hedonic Index. This index may adjust for
differences in property characteristics but I'm not sure it can be effective given that some
properties may not sell more than once during the index's coverage period.

Tony Chekov: I don't like the Jackson Property Index. Appraisals are estimates; there haven't
been many transactions lately so I question the reliability of the returns.

Peter Chanwit: I'm not sure about Taft's Sales Index. It relies on actual transactions but there
are so few sales recently so how reliable are the returns?

Question #6 - 8 of 26 Question ID: 1586351

Based on projected real estate conditions and the partners' discussion given in the vignette,
3CC's top recommendation would most likely be:

A) public debt.
B) private equity.
C) public equity.

Explanation

The category that 3CC would most likely recommend as first choice is private equity
option. Chekov prefers equity to debt option and Chanwit prefers private over public
option. Clarkson wants to eliminate private debt option. Their statements are also
consistent with the real estate market expectations.

(Module 33.1, LOS 33.a)

Question #7 - 8 of 26 Question ID: 1586352

If the pension fund chooses to invest in hotels over apartments, one possible reason for this
is that hotels:

A) may offer higher rates of returns because of higher operational risk.

B) are commercial properties while apartments are residential properties.
C) are not affected by cost and availability of debt capital.

Explanation
All real estate values are affected by cost and availability of capital. Apartments and other
multi-family units are considered commercial real estate. Hotels require more active
management making them more risky ventures as more operational expertise is needed.
This additional risk requires a higher rate of return.

(Module 33.1, LOS 33.a)

Question #8 - 8 of 26 Question ID: 1586353

Which statement regarding issues with indices is least likely correct?

A) Chekov’s statement.
B) Chanwit’s statement.
C) Clarkson’s statement.

Explanation

Clarkson's concerns about Lincoln Hedonic Index if individual properties don't sell more
than once are unfounded. Hedonic Index construction does not require multiple sales of
the same property.

(Module 33.1, LOS 33.a)

Question #9 of 26 Question ID: 1586358

Which of the following most accurately identifies one of the disadvantages of investing in
real estate through publicly traded securities? Compared to other real estate investment
vehicles, publicly traded securities expose investors to:

A) unlimited liability.
B) more-volatile returns.
C) inferior liquidity.

Explanation

Disadvantages of investing in real estate through publicly traded securities include the
volatile returns that result from pricing that is determined by the stock market. Publicly
traded real estate securities offer investors the advantages of superior liquidity, and
liability that is limited to the amount invested.

(Module 33.1, LOS 33.a)

Question #10 of 26 Question ID: 1586373

A key difference between Funds From Operations (FFO) and Adjusted Funds From
Operations (AFFO) is that AFFO excludes:

A) non-cash rent while FFO does not.

B) depreciation while FFO does not.
C) deferred tax charges while FFO does not.

Explanation

AFFO is FFO adjusted to remove straight-line rent and to provide for leasing costs and
maintenance-type capital expenditures. FFO is accounting net earnings excluding deferred
tax charges, depreciation, and gains or losses on sales of property and debt restructuring.

(Module 33.2, LOS 33.h)

Question #11 of 26 Question ID: 1586361

Which of the following most accurately identifies non-core real estate property types?

A) Office and industrial.

B) Hotel and hospitality.
C) Retail and multi-family residential.

Explanation

Hospitality properties such as hotels represent relatively risky investments because these
properties do not use long-term leases and their performance may be highly correlated
with the business cycle. The core commercial income-producing real estate property types
are retail, multi-family, office, industrial and warehouse. These "core" property types are
the main properties used to create a low-risk real estate portfolio.

(Module 33.1, LOS 33.a)

Question #12 of 26 Question ID: 1586355

Which of the following most accurately identifies one of the characteristics of a private
equity investment in income-producing real estate?

A) Sensitivity to the credit market.

B) Homogeneity.
C) Passive management.

Explanation

Real estate values are sensitive to the cost and availability of debt capital since large
amounts of borrowing are required to purchase real estate properties. Real estate is
heterogeneous, as no two properties are the same. Direct ownership of real estate
properties is management intensive. Other unique characteristics possessed by real estate
properties include: fixed location, high unit value, depreciation, high transaction cost,
illiquidity, and difficult to value.

(Module 33.1, LOS 33.a)

Question #13 of 26 Question ID: 1586359

Which of the following most accurately identifies one of the advantages of investing in real
estate through publicly traded securities?

A) Publicly traded corporate structures cost less to maintain.

B) Diversification by geography and property type is facilitated.
C) Structural conflicts of interest are eliminated.

Explanation

One of the advantages of publicly traded real estate securities is that they offer investors
greater potential for diversification by geography, property, and property type.
Disadvantages of publicly traded real estate securities include the costs of maintaining a
publicly traded corporate structure, and the potential for structural conflicts of interest
that can occur between the partnership and REIT shareholders under an UPREIT or
DOWNREIT structure.

(Module 33.1, LOS 33.a)

Question #14 of 26 Question ID: 1586367

A real estate market is characterized by frequent transactions. However, individual

properties have long holding periods. Which real estate pricing index would be least suitable
in such an environment?

A) Repeat sales index.

B) Hedonic price index.
C) Appraisal based index.

Explanation

Repeat sales index relies on repeat sales of individual properties. Since individual
properties have long holding periods, repeat sales index would be least suitable. Hedonic
price index relies on transaction data and the regression model explains the variation in
transaction prices based on differences between individual properties sold. Appraisal
based indices use transaction prices also to estimate value after adjustments for
differences. Since there are plenty of transactions, appraisal and hedonic price index have
sufficient data to provide good value estimates.

(Module 33.1, LOS 33.e)

Question #15 of 26 Question ID: 1586363

Retail sales growth is most likely to be a top economic factor affecting the economic value of
a(n):

A) industrial REIT.
B) residential REIT.
C) health care REIT.

Explanation

Other than retail REITs, retail sales growth is an important factor driving economic value of
industrial REITs.

(Module 33.1, LOS 33.b)

Question #16 of 26 Question ID: 1586372

The net asset value approach to valuation makes sense for REITs because:

A) NAV equals the value that public equity investors attach to a REIT.
B) there exist active private markets for real estate assets.
C) the price at which a REIT trades very closely tracks NAV.

Explanation
Because active private markets for real estate assets exist, REITs lend themselves to a net
asset value approach to valuation. NAV reflects the estimated value of REIT assets to a
private market buyer, however this may be different from the value that public equity
investors would attach to the REIT. REITs have historically traded at a large premium or
discount to NAV.

(Module 33.2, LOS 33.g)

Question #17 of 26 Question ID: 1586376

Which of the following most accurately describes an approach to REIT valuation?

The discounted cash flow approach typically consists of intermediate-term cash

A)
flow projections plus a terminal value based on cash flow multiples.
B) The P/AFFO approach avoids estimates and assumptions in its calculation.
The P/FFO approach adjusts for the impact of recurring capital expenditures
C)
needed to keep properties operating smoothly.

Explanation

In discounted cash flow REIT models, investors generally use intermediate-term cash flow
projections and a terminal value based on historical cash flow multiples. FFO does not
adjust for the impact of recurring capital expenditures needed to keep properties
operating. AFFO adjusts for routine maintenance type capital expenditures, but
assumptions and estimates (which may vary widely) are required in the calculation of
AFFO.

(Module 33.2, LOS 33.i)

Question #18 of 26 Question ID: 1586360

Which of the following is the most likely to represent an advantage of investing in publicly
traded real estate securities over direct ownership of property? Publicly traded real estate
securities offer:

A) more control over investment decisions.

B) greater liquidity.
C) lower price volatility.

Explanation
One of the main advantages of investing in publicly traded equity real estate securities
stems from the fact that these securities trade on stock exchanges, which results in
greater liquidity compared with buying and selling real estate directly. The downside of
trading on a stock exchange is that publicly traded equity real estate securities have
greater price volatility than do directly owned properties. Another disadvantages of
publicly traded real estate securities is that they offer investors little to no control over
investment decisions.

(Module 33.1, LOS 33.a)

Question #19 of 26 Question ID: 1586374

Which of the following is an expense normally deducted from accounting net earnings but
not from FFO?

A) Property operating expenses

B) Depreciation expense
C) Property taxes

Explanation

Depreciation on real estate is excluded from FFO because most investors believe that real
estate maintains its value to a greater extent than does other types of long-term business
assets. Therefore, taking depreciation deductions, which reduce the value of the real
estate, does not represent economic reality. FFO is accounting net earnings excluding
depreciation charges on real estate, deferred tax charges, and gains or losses from sales
of property and debt restructuring. Property operating expenses and property taxes are
both normal rental expenses deducted to arrive at operating income.

(Module 33.2, LOS 33.h)

Question #20 of 26 Question ID: 1586371

If a REIT has assets with a current market value of $3,000,000, liabilities with a current
market value of $2,000,000, and 100,000 shares outstanding, what is the NAVPS per share?

A) $50.00
B) $30.00
C) $10.00

Explanation
NAVPS per share can be calculated by beginning with assets, subtracting liabilities, and
then dividing the result by the number by shares outstanding. Thus,
$3,000,000-$2,000,000 = $1,000,000 and $1,000,000/100,000 = $10.00 per share.

(Module 33.2, LOS 33.g)

Question #21 of 26 Question ID: 1586364

Appropriate due diligence in a private real estate investment is most likely to:

A) mitigate unforeseen potential problems.

B) lower existing operating costs.
C) review lease and rental history.

Explanation

Due diligence can be very costly but it can potentially lower risk of unexpected legal and
physical real estate problems. Due diligence will usually increase current operating costs.
A review of lease and rental history is one example of due diligence not a possible result of
due diligence.

(Module 33.1, LOS 33.d)

Question #22 of 26 Question ID: 1586368

Compared with REITs, real estate operating companies (REOCs) are most likely to feature
higher:

A) yields.
B) levels of income tax exemption.
C) operating flexibility.

Explanation

REOCs have greater operating flexibility to invest in a wide range of real estate than do
REITs. REITs offer higher yields compared to REOCs. REITs offer income tax exemption
while REOCs generally do not.

(Module 33.2, LOS 33.f)

Question #23 of 26 Question ID: 1586354

Which of the following most accurately identifies a private equity investment in income-
producing real estate?

A) Investment in a real estate investment trust (REIT).

B) Direct ownership of real estate properties.
C) Private market mortgage lending by an insurance company.

Explanation

Real estate investments take four major forms: private equity, publicly traded equity,
private debt, and publicly traded debt. Private equity investment in real estate refers to
direct ownership of real estate properties. Mortgage lending by banks or insurance
companies is best described as private debt. Indirect ownership of real estate through
equity securities such as REITs is an example of publicly traded equity.

(Module 33.1, LOS 33.a)

Question #24 of 26 Question ID: 1586369

The most likely consequence of the high income distribution that REITs are required to make
is:

dividend yields that are nearly on-par with the yields of other publicly traded
A)
equities.
B) high volatility of reported income.
C) frequent secondary equity offerings compared to other kinds of companies.

Explanation

Because REITs are not able to retain earnings as other companies do, REITs make frequent
secondary equity offerings, in order to finance growth and property acquisitions. REITs'
required distributions result in a dividend yield that is significantly higher than those of
most other publicly-traded equities. REITs' focus on income from rental properties leads to
low volatility of reported income.

(Module 33.2, LOS 33.f)

Question #25 of 26 Question ID: 1586370

When calculating NAVPS, a real estate company's assets and liabilities are valued at their:
A) book value.
B) liquidation value.
C) market value.

Explanation

All assets and liabilities of a company are taken at current market value when calculating
NAVPS. NAVPS is a superior measure of a company's net worth when compared to its book
value per share.

(Module 33.2, LOS 33.g)

Question #26 of 26 Question ID: 1586365

Which of the following least accurately describes a major category of due diligence factors
that should be investigated in determining the value of a property?

A) Operating expenses.
B) Structural integrity.
C) Pipeline analysis.

Explanation

The major due diligence factors that are likely to affect the value of a property include:
operating expenses; structural integrity; environmental issues; leases and lease history;
lien, ownership, and property tax history; and compliance with relevant regulations and
laws.

(Module 33.1, LOS 33.d)