Real Estate Technical Interview Guide PDF

WALL STREET PREP 1st EDITION Real Estate Technical Interview Guide Core principles, interview guidelines, and how to strategically answer technical interview questions Copyright © 2023 by Wall Street Prep. All rights reserved. This publication may not be reproduced, stored, or transmitted in any form or by any means, electronic, mechanical, photocopying, scanning, or otherwise, without Wall Street Prep's prior written permission. Wall Street Prep makes no representations or warranties regarding the accuracy or completeness of the contents of this guide and specifically disclaims any implied warranties of merchantability or fitness for a particular purpose. The advice and recommendations contained herein may not be suitable for your specific situation. Neither the publisher nor the author shall be liable for any loss of profit or other commercial damages, including but not limited to special, incidental, and consequential damages. | Real Estate Technical Interview Guide 3 About Wall Street Prep Wall Street Prep was established in 2004 by investment bankers to train the financial services industry. Today, Wall Street Prep conducts training at more than 150 investment banks, private equity firms, asset managers, and Fortune 500 companies, and works with over 125+ universities and colleges to bridge the gap between academia and the real world by teaching the practical skills needed to succeed on the job. Our client list has since grown to include the world’s top investment banks, such as Goldman Sachs, Evercore, Lazard, Morgan Stanley, and Perella Weinberg. We are also pleased to announce that our training material is now used at several of the leading global investment firms, including KKR, Blackstone, Bain Capital, and Carlyle. For general information on our products and services or technical support, please visit our website at wallstreetprep.com, or contact our office at (617) 314-7685. | Real Estate Technical Interview Guide 4 Our real estate technical interview guide is designed to introduce the fundamentals of real estate finance and investing strategies The material in this guide covers the core real estate principles in a comprehensible manner, regardless of your prior experience in the field. We’ve compiled a list of brief interview guidelines, followed by technical interview question you may be asked during the recruitment process with examples of strategic answers. | Real Estate Technical Interview Guide 5 Table of Contents How to Prepare for the Real Estate Interview............................................................................................................................................................. 8 The Real Estate Interview Process............................................................................................................................................................................... 10 Beginner-Level Questions................................................................................................................................................................................................ 13 Q: Why real estate?.........................................................................................................................................................................................................................................................................................14 Q: What are the different types of real estate firms?..........................................................................................................................................................................................................................15 Q: What are the different property classes in real estate investing?............................................................................................................................................................................................16 Q: What are the four main real estate investment strategies?........................................................................................................................................................................................................17 Q: What is the real estate capital stack?..................................................................................................................................................................................................................................................18 Q: What are the four phases of the real estate cycle?.........................................................................................................................................................................................................................19 Q: What factors influence the real estate cycle?...................................................................................................................................................................................................................................20 Q: What are vacancy and credit losses?..................................................................................................................................................................................................................................................20 Q: How is the vacancy rate of a commercial property determined?.............................................................................................................................................................................................21 Q: What is NOI in real estate?.....................................................................................................................................................................................................................................................................22 Q: How is the cap rate used to value a property?................................................................................................................................................................................................................................22 Q: Why is the cap rate the inverse of a multiple?.................................................................................................................................................................................................................................23 Q: Compare the cap rates for the main property types.....................................................................................................................................................................................................................24 Q: Explain the relationship between the cap rate and risk..............................................................................................................................................................................................................25 Q: What is the difference between the cap rate and cash-on-cash return?................................................................................................................................................................................25 Q: How are property values and NOI multiples affected if the market cap rate rises?..........................................................................................................................................................26 Q: What does funds from operations (FFO) measure?......................................................................................................................................................................................................................26 Q: What is the difference between FFO and AFFO?............................................................................................................................................................................................................................27 Q: What is the difference between NOI and EBITDA?........................................................................................................................................................................................................................28 Q: What are the three methods of appraising a property?...............................................................................................................................................................................................................29 Q: Walk me through the income approach to real estate valuation..............................................................................................................................................................................................29 Q: What does the cash-on-cash return measure?................................................................................................................................................................................................................................30 Q: What is the intuition behind the cost approach?............................................................................................................................................................................................................................30 Q: What is the difference between the yield on cost (YoC) and cap rate?..................................................................................................................................................................................32 Q: Explain how to calculate net operating income (NOI) from effective gross income (EGI)..............................................................................................................................................32 Q: What is the loan-to-value ratio (LTV)?..............................................................................................................................................................................................................................................33 Q: What does the loan to cost ratio (LTC) measure?..........................................................................................................................................................................................................................34 Q: From the perspective of a lender, is a higher or lower debt yield preferred?.....................................................................................................................................................................35 Q: What is the operating expense ratio (OER)?....................................................................................................................................................................................................................................35 Q: What is the difference between a capital lease and operating lease?.....................................................................................................................................................................................36 Q: What is the difference between the gross and net rental yield?...............................................................................................................................................................................................37 Q: What is the difference between operating and non-operating expenses in real estate?.................................................................................................................................................38 Q: What is the equity multiple?..................................................................................................................................................................................................................................................................38 Q: What is the difference between levered IRR and unlevered IRR in real estate investing?..............................................................................................................................................39 Q: What is the difference between the going-in and terminal cap rate?.....................................................................................................................................................................................40 Q: How does cap rate compression impact property valuation?...................................................................................................................................................................................................41 Q: How does the interest rate environment impact property values?.........................................................................................................................................................................................42 Q: What are the three common commercial lease structures?.......................................................................................................................................................................................................43 | Real Estate Technical Interview Guide 6 Q: What does the term “stabilization” refer to in property development?.................................................................................................................................................................................43 Q: What is a good debt service coverage ratio (DSCR) in commercial real estate?.................................................................................................................................................................44 Q: What is the net absorption rate?..........................................................................................................................................................................................................................................................45 Q: How does loan sizing work?..................................................................................................................................................................................................................................................................45 Q: What is the development spread used to determine?..................................................................................................................................................................................................................46 Q: What is breakeven occupancy in commercial real estate?.........................................................................................................................................................................................................47 Q: What are the step to calculate the unlevered free cash flow of a property?.........................................................................................................................................................................47 Q: What are the step to calculate the levered cash flow of a property?.......................................................................................................................................................................................48 Intermediate-Level Questions........................................................................................................................................................................................ 49 Q: Suppose a rental property has 100 units available for rent in total, of which 16 are vacant. What is the property’s vacancy rate (and occupancy rate)?...................50 Q: Suppose a rental property generated $24 million in gross potential rent (GPR) and $1 million in ancillary income. If we assume vacancy and credit losses were 5% of potential gross income (PGI) while operating expenses were $3.75 million, what is the property’s net operating income ( NOI)?........................................................51 Q: Suppose a rental property generated $100k in NOI, and the market cap rate is 8%. Estimate the market value of the property as of the present date.......................52 Q: Suppose the forward NOI of a property is $420k while the market cap rate is 6%. What is the implied property value?.................................................................................53 Q: Suppose a REIT reported $1.2 million in net income. Calculate FFO given the following adjustments: $800k D&A, $600k Gain on Asset Sale, $400k Loss on Asset Impairment, and $200k in FFO Attributable to Non-Controlling Interest (NCI)......................................................................................................................................................................54 Q: Calculate the AFFO of the REIT from the prior example assuming $400k in maintenance Capex and a downward adjustment of $100k in straight-line rent...........55 Q: Estimate the value of an investment property expected to generate $200k in NOI at an 8% market cap rate.......................................................................................................56 Q: Suppose a property was acquired for $100k at a 10% cap rate using 75% leverage with a 5% interest rate. What is the cash-on-cash return?.....................................57 Q: Suppose a commercial building was purchased for $20 million using 80% leverage. What is the required sale price to achieve an equity multiple of 2.0x?............58 Q: Suppose a rental property is currently on the market with an asking price of $1 million. Given a 5% cap rate and 50% leverage ratio, calculate the interest rate at which the breakeven point is reached.....................................................................................................................................................................................................................................................59 Q: Suppose a rental property generated $200k in potential gross income (PGI) with vacancy and credit losses expected to be 5.0% of PGI. If operating expenses are $90k while the annual debt service is $40k, what is the cash-on-cash return if the equity investment is $750k?.....................................................................................................60 Q: Suppose a residential building has 50 rental units, and the monthly market rate rent is $4k. If the property's market valu e is $12 million, what is the gross rent multiplier (GRM)?...........................................................................................................................................................................................................................................................................................61 Q: Suppose a commercial property is expected to generate $800k in effective gross income (EGI) and $320k in direct operating expenses at stabilization. If the total development cost is $4 million, calculate the yield on cost (YoC).................................................................................................................................................................................................62 Q: Suppose a real estate investor acquired a property for $2 million that generated $300k in annual cash distributions for the next five years. If the property is sold at the end of Year 5 at a sale price of $2.5 million, what is the equity multiple?......................................................................................................................................................................63 Q: Suppose a property appraised at a fair value of $600k is acquired using 75.0% leverage. What is the implied down payment by the investor and loan -to-value ratio (LTV)?.......................................................................................................................................................................................................................................................................................................64 Q: Suppose a commercial real estate investment firm is considering a potential development project to build an office building. The stabilized NOI is projected to be $5 million, while the total development cost is around $47.5 million. What is the development spread if the market cap rate is 8%?.............................................................65 Q: Suppose a lender has set the maximum loan-to-cost ratio (LTC) at 80.0%. What is the required equity contribution if the total development cost is $40 million?...............................................................................................................................................................................................................................................................................................................................66 Q: Suppose a rental property has 40 units, and the current market rent is $4k monthly. What is the breakeven occupancy rate if the property’s total operating expenses and debt service are $100k and $40k, respectively?......................................................................................................................................................................................................67 Q: Suppose a building expected to generate $10k in cash flow per year was acquired for $100k. If the holding period was five years, after which the property was sold for $150k, what is the unlevered IRR?...........................................................................................................................................................................................................................................68 Q: Suppose a property is purchased for $1 million at a 60% leverage ratio. The property generates $50k in annual NOI across the 5-year holding period. If the investment is sold at the end of Year 5 at a 4% terminal cap rate. What is the equity multiple?......................................................................................................................................69 Q: Suppose a building was acquired at a 6% entry cap rate for $10 million. If the acquisition was funded using 60% leverage, priced at a 5% cost of debt, what is the DSCR in Year 1?...............................................................................................................................................................................................................................................................................................70 | Real Estate Technical Interview Guide 7 INTRODUCTION How to Prepare for the Real Estate Interview Create a Plan Research Beforehand Our first piece of advice is to create a plan – which might If a candidate puts in the time to research the role and firm, sound trivial initially – but the right preparation is that fact becomes quickly evident to the interviewer. Start instrumental to performing well at an interview and preparing as soon as possible and retrieve as much securing an offer. information about the firm as possible, as it’ll reflect in your One practical question to ask yourself to frame the right responses and demonstrate your commitment (or lack plan is, “What do I bring to the table that makes me stand thereof) to joining the firm. Interviewers can easily out above the rest of the competition?” distinguish between candidates who came prepared versus The answer you settle on is your unique “selling point” and those who put in the bare minimum. differentiating factor. Considering the entirety of the The following list contains examples of topics to research recruiting process is a competition, at the end of the day, on the firm: figure out a strategy to stand out from the rest of the Q: What is the investment strategy of the firm? candidates. Q: Which types of properties does the firm invest in? Q: What is the investment criteria of the firm? Understand the Firm’s Incentive Q: What is the sector focus of the firm? Of course, no two interviews are the same, nor are the Q: What is the structure of the firm’s current and realized profiles of the target candidates from the perspective of the investment? interviewing firm. However, there still is a pattern in recurring traits that firms perceive positively. Q: What is one investment completed by the firm that you Be attentive in each conversation and ask the right found particularly intriguing? questions while networking to identify the firm's needs and understand where you could add value if hired – the mishap to avoid here is placing your self-interests above the firm’s. INTRODUCTION Identify the Decision-Makers From each response, the interviewer must recognize your understanding of the underlying technical concept and Each employee at the firm, including the receptionist, capacity to articulate a thoughtful response. should view you in a positive light. But the fact of the matter While each answer should be sufficient and directly address is that a select few individuals with outsized influence the question (less than 1 minute), avoid saying more than determine the hiring decisions of a firm. necessary, especially if you’re extending beyond the scope Start by identifying the “decision-makers” and prioritize of your knowledge. impressing those individuals because their overall impression and opinion of your candidacy hold disproportionate weight. Handle Pressure Effectively If you’re unsure how to answer a technical question – an Show Humility inevitable outcome that close to all candidates encounter – remain calm and state up front that you’re not certain of the The interviewer sitting across from you is far more correct answer. experienced and possesses knowledge about investing in However, instead of outright stating that you have the real estate industry multiple tiers above yours. absolutely no clue, it is preferable to walk through your Therefore, respect the firm's hierarchy and avoid acting as thought process, as that will open a dialogue for if you’re more knowledgeable and experienced than the conversation. interviewer because you’re not. While your performance on the interview should convey that you’re well-versed in the technical side of real estate The mistake to avoid is to not let one investing, the delivery of your answers and choice of words menial mistake completely derail the should implicitly express that you are here to learn. The entirety of your interview and odds of employees at a firm, particularly those who’ll be directly receiving an offer. managing new hires, enjoy working with those receptive to constructive criticism (and thus easier to teach) rather than There is no shame in admitting that you are unsure about a those difficult to work with because of their inflated egos. technical concept, and rarely is the situation truly that big of a deal – so brush off the minor setback, retain your composure, and focus on finishing the rest of the interview Keep Answers Succinct on a positive note. Before responding to each question, take a brief moment to think before expressing a concise, straight-to-the-point answer. Interviews are not timed competitions, where candidates compete on the basis of answering the most questions in the least amount of time, so there is no need to rush. Ensure to avoid rambling into tangents, as that risks opening the door for advanced counter-point questions. BEGINNER-LEVEL QUESTIONS The Behavioral Interview Know Your Resume Before interviewing, be prepared to discuss your Common Behavioral Questions resume in depth, considering that a substantial percentage of the behavioral questions are sourced Suppose real estate is genuinely the right career path for a directly from your resume. Therefore, come into the candidate, and sufficient time was spent researching the firm interview capable of expanding upon each bullet beforehand. Given those circumstances, the behavioral point listed on your resume and answering the interview should be relatively effortless and conversational. predictable follow-up questions. The following list contains the most frequently asked While crafting your resume, “less is more,” as it is behavioral questions to expect in an interview: far better for the interview to focus on the past Q: Tell me about yourself / Walk me through your resume. experiences relevant to the role for which you’re Q: Why are you interested in joining our firm? currently interviewing. Q: What do you know about our firm? If you are unable to explain a particular portion of Q: What aspects of our investment strategy interest you? your resume in detail, remove those bullet points to trim the “excess” that contributes no real value to Q: Why should we hire you out of all the other qualified your overall candidacy (i.e., minimal “upside” yet candidates? significant “downside”). Q: What is your current level of proficiency with Excel? (and ARGUS if applicable) No “Fit”, No Offer Q: What tasks do you expect to perform on a typical day? Before we delve into our technical interview Q: What are some of the near-term and long-term goals you hope questions, ensure enough time was allocated to achieve at our firm? toward preparing for behavioral questions. In fact, Q: Where do you see yourself five years from now? the behavioral interview is just as important – if not Q: What are some of your strengths and weaknesses? more – as the technical interview. Q: How would your peers and past employers describe you? The cultural fit with the team is one of the most influential factors that dictate hiring decisions, so Q: Tell me about a time in which you failed. do not neglect it. Q: Do you prefer working independently or on a team? Candidates often prioritize preparing for the Q: Do you have any questions for me? technical interview questions and modeling tests, which is completely understandable, but connecting with the firm’s employees at a more personal level and showing cultural fit with the team must not be overlooked. | Real Estate Technical Interview Guide 10 BEGINNER-LEVEL QUESTIONS The Real Estate Interview Process First Round: The Informational Interview The informational interview is an informal screening conversation with a human resources (HR) member or a junior to mid-level firm employee intended to vet a candidate. Early on, the priority should be demonstrating your interest and personal reason for wanting to join the firm, which requires an in-depth understanding of the role and the firm itself. Therefore, spend plenty of time preparing for the common behavioral questions and learn as much as possible about the firm’s origins, investment strategy, and past deals. Compile a list of potential questions based on your resume, and prepare strategic anecdotes that can be quickly modified to answer a range of scenario-based questions. But while most of the questions should be behavioral, still be prepared for an unexpected technical question or two, especially if the interviewer is a junior or mid-level employee. For example, an interviewer could deliberately disrupt a smooth- sailing interview by asking, “How might you value the building we’re currently at?” Second Round: The Technical Interview Passed the informational interview? The next stage is the technical interview, normally conducted by an experienced mid-level professional such as a senior associate. The scope of technical questions is relatively limited. There should not be too many unexpected “curve balls.” Instead, anticipate mostly “check the box” technical questions meant to ensure an understanding of the foundational real estate concepts. Why? Real estate firms have increasingly relied on modeling tests and case studies to evaluate the technical acumen of candidates. The “Superday” Interview The Superday interview is the final round of the process, most often conducted in person, barring unusual circumstances. Come prepared to interview with a wide range of junior to mid-level professionals, including more senior members of the firm. Generally, most of the technical questions will be asked by the junior to mid-level employees of the firm. On the other hand, the more senior professionals at the firm tend to be more conversational and ask predominately behavioral questions. The Superday is a continuation of putting your technical knowledge Everything is fair game at this point, so of the real estate asset class, investment strategies, and technical concepts, but more attention is now paid to the cultural fit aspect. prepare for all sorts of questions. | Real Estate Technical Interview Guide 11 BEGINNER-LEVEL QUESTIONS Financial Modeling Test and Case Study Assignment The final part of a Superday interview is the modeling test and/or a take-home case study assignment. The difficulty of the modeling test can range from an easy exercise conducted on-premise (around 1 to 2 hours) to a take-home case study assignment that must be submitted within the next couple of days. The modeling test is frequently the most challenging part of the interview process for candidates, as performing poorly on the test can be enough to ruin one’s chances of receiving an offer in the final rounds. Financial Modeling Tests To perform well on the modeling tests, ensure mastery of the following financial modeling topics: Common Excel Functions and Shortcuts Real Estate Financial Model Architecture (“Best Practices”) Pro Forma Cash Flow Build Debt Schedule and Amortization Table Joint Venture (JV) Waterfall Schedule Exit Returns Analysis with Sensitivity Analysis Case Studies Certain firms, most often real estate private equity (REPE) firms, expect candidates to complete an in-depth case study soon after the modeling test. Usually, case studies are provided upon completion of a modeling test as a take-home exercise focused less on testing the mechanics of a financial model and familiarity with Excel and more on using the model as a decision-making tool to analyze a potential investment and support a logical investment thesis.Constructing a case study submission likely to impress the firm will reflect a systematic research-driven process presented in a succinct, compelling pitch that distills the key points that matter. The case study requires performing research on an investment opportunity and submitting a write-up in the form of an investment memo (or an in-person presentation) comprised of the following sections: Investment Property Overview Real Estate Transaction Summary Formal Investment Recommendation (“Invest” or “Pass”) Investment Merits Investment Risks (and Mitigating Factors) Financial Highlights (Summary of Recent Operating Results) Market Analysis (Competitive Positioning, Geographical Trends, Industry Outlook) | Real Estate Technical Interview Guide 12 BEGINNER-LEVEL QUESTIONS Beginner-Level Questions | Real Estate Technical Interview Guide 13 BEGINNER-LEVEL QUESTIONS Q: Why real estate? There is no correct answer to this interview question per se, but there are some guidelines to abide by to ensure the technical interview questions start on the right foot: 1. Personalize Response: The right mentality to answer the question is to view it as an opportunity to craft a unique story and illustrate your interest in pursuing a career in real estate. From a personal perspective, the rationale and factors stated should demonstrate to the interviewer your commitment to a long-term career in the real estate industry. 2. Chronological Order: The structure of your response should flow chronologically to ensure each strategic anecdote is a “step” that builds on top of the prior rather than a disorganized list with no ties to each other. By constructing a thoughtful response with information relevant to the position, the interviewer should be able to see how your past experiences (and values) contributed to your decision. 3. Storytelling Element: The response must mention the events (or people) that piqued your interest in a career in real estate, including the pivotal moments that affirmed your commitment. However, it is critical to allocate the time spent on each point based on priority to refrain from going off on a tangent. The interviewer is more likely to be engaged and find the answer intriguing if the response is kept succinct. Therefore, distill only the central parts and trim the “excess,” sort of like a synopsis (and anticipate follow-up questions). The common pitfall to avoid is offering a bland, “cookie cutter” response, a mistake far too often made. Sample Response – Analyst Role at a Real Estate Development Firm “I’ve been set on pursuing a career in real estate for as long as I can remember because my father worked as an architect at a full-service construction management firm. Growing up in that environment, the idea of managing the construction process seemed intriguing, and that interest has only become more palpable over time. Given my background in finance and completion of past internships at commercial development firms, I’m committed to a long-term career in property development because the job’s responsibilities entail sourcing and analyzing potential investment opportunities, including more hands-on work around coordinating with architects, engineers, and builders to design a viable project plan. Therefore, the day-to-day tasks performed on the job blend analytical and collaborative work, which is the type of environment where I’m certain that I can improve as a professional and contribute toward meaningful projects. Of all the asset classes out there, real estate is by far the most fulfilling to me on a personal level, as the continued development of properties is an irrefutable part of our economy that contributes real, tangible value to society.” | Real Estate Technical Interview Guide 14 BEGINNER-LEVEL QUESTIONS Q: What are the different types of real estate firms? Firm Type Description Real Estate Private Equity REPE firms raise capital from investors – the fund’s limited partners (LPs) – to deploy (REPE) their capital contributions into real estate investments. The REPE strategy is oriented around acquiring and developing commercial properties such as buildings, managing the properties, and selling the improved properties to realize a profit. Real Estate Investment REITs own a portfolio of income-generating real estate assets over various sectors. Trusts (REITs) REITs are exempt from corporate-level income taxes if compliant with the regulatory requirements to qualify, such as the obligation to issue 90% of their taxable income as shareholder dividends. Most REITs are publicly traded entities and are thus subject to strict disclosure requirements per SEC requirements. Real Estate Development Development firms, or “property developers,” construct properties from scratch, Firm whereas other firms participate in acquisitions of existing properties. Since development projects start with purchasing land – i.e., “ground-up development” – the project lifecycle tends to be substantially longer than other projects like acquisitions. Real Estate Investment Real estate investment management firms raise funding from limited partners (LPs) to Management acquire, develop, and manage commercial properties to sell them at a profit later. REPE firms are distinct from investment management firms because REPE firms are generally structured as closed-end funds (“stated end date”), while investment management firms are most often open-end funds (“no end date”). Real Estate Operating REOCs purchase and manage real estate, like REITs, but REOCs are permitted to re- Companies (REOCs) invest their earnings rather than the mandatory distribution to shareholders. The drawback is that REOCs face “double taxation,” where income taxation occurs at the entity and shareholder levels – contrary to REITs. Real Estate Brokerage Brokerage firms serve as intermediaries in the industry to facilitate transactions on both Firms sides. Commercial brokers can be hired to protect the interests of their clients in transactions involving the purchase, sale, or leasing of real estate assets. Brokerages can help clients identify a new property to purchase or market and sell a property on behalf of the client or even negotiate the terms of a lease as a formal “tenant representative.” | Real Estate Technical Interview Guide 15 BEGINNER-LEVEL QUESTIONS Q: What are the different property classes in real estate investing? Property Class Description Class A Class A properties are premium, modern properties in prime locations with top-of-the-line amenities, such as 24-7 security and on-site property management. The location of the Class A properties is often conveniently near the workplace, shopping centers, sports venues, universities, and tourist attractions. Class A properties offer the most high-end amenities and services to cater to affluent, high-income tenants (and thus command the highest rental pricing in their respective markets). Class A properties are usually professionally managed and pose the least risk to real estate investors, which comes with the trade-off of a lower return. Class B Class B properties are a marginal step down from Class A properties and tend to be more outdated, yet are built and renovated with high-quality construction material and maintained well. The market demand for Class B properties comes primarily from tenants on the higher end of the middle class concerning income. The architectural design and structural features of the properties are sound but less impressive compared to Class A properties. Class B properties still offer higher yields with upside potential from the value-add opportunities, which appeals to a broad segment of real estate investors. Class C Class C properties are far more outdated (30+ years old) in infrastructure and located in sub-optimal areas regarding the outlook on rent pricing and market demand. The condition of Class C properties can range from fair to poor and normally require urgent repair and renovation work post-move-in. Class C tenants predominately earn low income with poor creditworthiness, causing the risk of default to be a valid concern. Given the risk, there is more upside in returns on Class C properties to compensate investors for the incremental risk. Class D Class D properties constitute the bottom-tier classification of property investments in the real estate market. Class D properties are frequently said to be distressed assets because of their poor condition – not to mention that most Class D properties are located in areas with collapsing market demand, the lowest rent prices, high crime rates, etc. Class D properties require substantial spending on renovations and repairs, such as fixing issues like roof leakages – which, at the risk of stating the obvious – takes precedence over modernizing the property. Most institutional investors, aside from distressed investors, tend to avoid Class D properties because of the spending requirements. | Real Estate Technical Interview Guide 16 BEGINNER-LEVEL QUESTIONS Q: What are the four main real estate investment strategies? Strategy Description Core Core property investments are the most conservative strategy with the least risk, as the acquisition targets are modern properties in prime locations occupied by highly creditworthy, affluent tenants. Core properties appeal to investors prioritizing stable income and consistent returns while protecting against downside risk and ensuring capital preservation. Core-Plus Core-plus property investments are marginally riskier than the core strategy, so the strategy exhibits a low-to-moderate risk profile and aims to obtain income and growth. Core-plus properties are distinct from core properties because of the necessity for capital improvements to increase cash flow and improve operating efficiency. Value-Add Value-add investment properties are growth-oriented and carry a moderate-to-high risk profile, as the properties require considerable capital improvements and are often located in tertiary areas. Value-add strategies aim to implement improvements and renovations to existing properties to create more value, resulting in growth in property values, higher rent pricing, and increased demand from buyers in the market. Opportunistic Opportunistic investments are the riskiest of the real estate strategies and involve the most complicated, time-consuming projects – such as new development or redevelopment – which require substantial spending on resources. Opportunistic properties initially produce minimal or no cash flow on the date of acquisition but can potentially generate significant cash flow from scratch once fully developed. | Real Estate Technical Interview Guide 17 BEGINNER-LEVEL QUESTIONS Q: What is the real estate capital stack? The capital stack, or “capitalization,” describes the different sources of funding used to finance a real estate project. The composition of the capital stack is contingent on the real estate investor and strategies about their risk/return profile. Our illustrative capital stack here – ranked in order of descending risk – describes the most common debt and equity components: Common equity Sits at the top of the capital stack and is considered the riskiest security since equity claims come last in priority in the event of default. Common equity investments offer the most potential upside – which is uncapped in theory – creating the opportunity to earn outsized returns. Preferred equity A hybrid security that blends features of debt and common equity but is only senior to common equity and subordinate to all debt. The structure of preferred equity investments is flexible – e.g., the returns can include fixed interest with the option to participate in the equity upside. Mezzanine debt (“Junior debt”) Bridges the gap between senior debt and equity. The interest rate is higher than senior debt because mezzanine debt is unsecured and of lower priority. Mezzanine lenders can possess the right to take control of a property in the event of default, assuming no conflicts in the inter-creditor agreement. Senior debt Such as the standard mortgage loan, constitutes the most significant piece of the capital stack in most real estate transactions. The interest rate pricing is the lowest since senior debt is a form of secured financing where the borrower pledges collateral as part of the financing arrangement. Senior debt lenders, such as banks, are first in priority of repayment, so the risk of incurring a capital loss in the event of default is the lowest (and thus, the expected return is the lowest in exchange). | Real Estate Technical Interview Guide 18 BEGINNER-LEVEL QUESTIONS Q: What are the four phases of the real estate cycle? Real Estate Cycle Description Recovery The recovery phase represents the start of the real estate cycle, where the market is at the bottom of the trough. The occupancy rates in the market are near their lowest points, with minimal demand from new buyers and investors. The level of new construction activity is normally near non-existent, with rental pricing growth either trending downward or stagnant (and often outpaced by inflation). The recession might continue with a bleak outlook, yet those who actively track economic indicators to identify signs of a potential near-term shift can get ahead of the curve – but of course, timing the recovery is easier said than done. Expansion In the expansion phase, the economy and real estate market show improvements, such as positive economic indicators like unemployment data that contribute to a more optimistic economic outlook. The general public gradually regains confidence while volume in the real estate market climbs upward and new construction activity and development projects start to return. From a macro perspective, the economy exhibits robust growth and points toward an upward trajectory (and return to normalcy) while occupancy rates continue to improve. The prices of homes and properties rise rapidly because of the shortage of available inventory, where the competition among buyers causes pricing to climb upward. Hyper-Supply In the hyper-supply phase, the prices of properties initially retain their upward momentum before starting to descend downward from the oversupply in inventory. The state of the market soon after reflects a “buyer’s market,” where much of the options belong to the buyers at the expense of the sellers – for example, the lackluster demand in the market for a property can cause a seller to reduce the sale price. The market at this stage is often characterized by rising interest rates and a slowdown in economic growth, indirectly influencing the real estate market. Recession The recession phase marks the end of the cycle, in which the economy undergoes a significant contraction, and the markets incur steep losses. The excess inventory in the real estate market and the limited demand from buyers cause property values to drop. The periodic economic data is discouraging and indicates falling consumer confidence, such as high unemployment rates, contributing to a dim economic outlook. If supply in the market outweighs demand by a sizeable margin, the outcome is more vacancies, declining rent prices, and rising defaults on consumer loan obligations. | Real Estate Technical Interview Guide 19 BEGINNER-LEVEL QUESTIONS Q: What factors influence the real estate cycle? Historically, the real estate markets have continuously undergone a pattern of cycles consisting of four phases: 1. Recovery → Declining Vacancy Rates + No New Construction 2. Expansion → Declining Vacancy Rates + New Construction 3. Hyper-Supply → Increasing Vacancy Rates + New Construction 4. Recession → Continued Increasing Vacancy Rates + Excessive Supply in Market The primary factors that influence the real estate market include the market interest rates, the state of the economy, government intervention, and the trends related to demographics (and consumer income). The real estate cycles periodically occur from the inefficiencies in the market and the time necessary for the supply and market rents to adjust to changes in market demand – or for demand to adjust to changes in rent prices and supply in the market. Given a demand shock – where there is a significant decline in demand from a fixed supply in the market – the vacancy rate expands. In effect, rent starts to decline to balance the supply and demand in the market. The reduction in rent pricing can potentially cause two effects based on the circumstances: 1. Higher Demand → The decline in rent can cause demand in the market to climb upward. 2. Less Development → The investors in the real estate market – namely property developers – can become discouraged from actively participating in the market considering the pessimistic outlook. The vacancy rates in the market – the inverse of occupancy rates – gradually decline until reaching a state of normalization. In theory, the point at which the vacancy rate normalizes is where demand is equivalent to the supply in the market, i.e., the real estate market is in a state of equilibrium. If vacancy rates decline, the demand in the market exceeds supply, causing market rent to rise subsequently – thus, vacancy rates reflect the near-term trajectory of the real estate market. Q: What are vacancy and credit losses? In real estate, vacancy and credit losses are inevitable in the property management business model, irrespective of the measures taken to mitigate the risk. Vacancy Losses → Vacancy losses are determined by the percentage of units available for rent that were left unoccupied in a given period, but since vacant units produce no rental income, the incurred monetary losses reflect the opportunity cost of the missed rent payments. Credit Losses → On the other hand, credit losses are quantifiable monetary losses that come out of the property owner’s pocket from the inability to collect rent from tenants – most often caused by unforeseeable financial circumstances or a tenant’s refusal to uphold the lease. | Real Estate Technical Interview Guide 20 BEGINNER-LEVEL QUESTIONS Loss Type Description Vacancy Loss The vacancy losses are the estimated loss in rental income from unoccupied rental properties since there are no tenants in the vacant units. The expected vacancy loss is determined using historical data as precedence, the vacancy rates of comparable properties, and the current market conditions. In a pro forma real estate financial model, the vacancy loss is normally projected to be around 5.0% to 10.0% of the potential gross income (PGI), but the vacancy rate can be adjusted based on the property type and market factors. Credit Loss The credit losses incurred stem from matters related to collection issues, wherein the property owner cannot retrieve rent payments from a tenant on time. The tenant might be granted temporary “relief” in the form of an extension to fulfill the payment because of unforeseeable financial circumstances or opt to default on the lease (and face property eviction). The objective of screening and background checks on tenants is to mitigate the risk of incurring credit losses later on, as factors such as the credit score can bring attention to “red flags.” A property's effective gross income (EGI) in a pro forma model is calculated by subtracting the estimated vacancy and credit losses from the potential gross income (PGI) line item. Effective Gross Income (EGI) = Potential Gross Income (PGI) – Vacancy and Credit Losses Q: How is the vacancy rate of a commercial property determined? The vacancy rate of a commercial property is the percentage of units available for rent that are vacant (i.e., unoccupied) as of a particular date. The vacancy rate is calculated by dividing the number of vacant units in a property by the total number of units available for rent. Vacancy Rate (%) = Number of Vacant Units ÷ Total Number of Units In the commercial real estate market (CRE), the vacancy rate is a widely recognized key performance indicator (KPI) closely tracked to measure the market demand and attrition of existing tenants of a specific property: High Vacancy Rate → Low Market Demand + High Attrition Rate in Existing Tenants Low Vacancy Rate → High Market Demand + Low Attrition Rate in Existing Tenants However, an in-depth analysis must be performed on the property to grasp the underlying drivers of its current vacancy rate – for instance, a property could have a low vacancy rate by offering new tenants significant rent concessions and reducing rent prices. | Real Estate Technical Interview Guide 21 BEGINNER-LEVEL QUESTIONS Occupancy Rate (%) = Number of Occupied Units ÷ Total Number of Units The inverse of the vacancy rate is the occupancy rate, which is the percentage of occupied units in a commercial property. Given the inverse relationship, the sum of a property’s vacancy and occupancy rate must equal 100%. Commercial properties with high occupancy rates are perceived as more appealing investment opportunities because the property generates more predictable, stable rental income, which is attributable to the consistent demand from buyers in the market and high retention rates of existing tenants. Q: What is NOI in real estate? NOI stands for “Net Operating Income” and measures the profit potential of income-generating properties before subtracting non-operating costs. The formula to calculate the NOI of a given property investment is the sum of its rental income and ancillary income, net of the direct operating expenses at the property level. Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses Where: Rental Income: The rental income is the total funds collected from tenants as part of the leasing arrangement. Ancillary Income: The ancillary income is the non-rental income sources of a property earned on the side, such as the proceeds earned from selling parking permits, late fee charges, and access to on-premise amenities. Direct Operating Expenses: The operating expenses are incurred by a property for its day-to-day operations to continue running, such as property management fees, property taxes, property insurance, utilities, and maintenance work. The net operating income (NOI) metric neglects capital expenditures (Capex), depreciation, financing costs, income taxes, and corporate-level SG&A expenses to isolate the operating profitability of real estate properties. Therefore, NOI is capital structure neutral since the formula omits the annual debt service, such as mortgage payments and interest obligations, which fall under the category of financing activities rather than core operating activities. Q: How is the cap rate used to value a property? The cap rate, shorthand for “capitalization rate,” is the expected rate of return on an income-generating investment property. Formulaically, the cap rate is the ratio between a property's stabilized net operating income (NOI) and its current market value, expressed as a percentage. Cap Rate (%) = Net Operating Income (NOI) + Property Value | Real Estate Technical Interview Guide 22 BEGINNER-LEVEL QUESTIONS The income component of the cap rate is the forward NOI – most often projected on a twelve-month basis (or until the property has reached stabilization) – therefore, the implied yield is subject to a margin of error. Cap rates are the primary shorthand by which different investment properties with comparable risk- return profiles can be analyzed side-by-side. One common appraisal method to estimate the value of a property is the Income Approach (or “Direct Capitalization Method”), where the implied value of the property is determined by dividing the NOI of the property by the market cap rate. The market cap rate is estimated by analyzing comparable properties and compiling relevant transaction data to establish parameters to guide pricing. Property Value = Net Operating Income (NOI) ÷ Market Cap Rate Q: Why is the cap rate the inverse of a multiple? The cap rate is the inverse of a multiple because the net income multiplier (NIM) is the reciprocal of the cap rate. Conceptually, the cap rate and net income multiplier (NIM) are virtually identical, as the cap rate is the inverse of a multiple and derived from the amount that a real estate investor is willing to pay to receive $1.00 in NOI. Therefore, one common method to estimate a property's value is multiplying its net operating income (NOI) by the net income multiplier (NIM). Property Value = Net Operating Income (NOI) × Net Income Multiplier (NIM) Suppose we’re tasked with estimating the value of a commercial building expected to generate $200k in NOI at stabilization. Given a market cap rate of 10.0%, the implied property value can be determined by dividing the building’s NOI by the cap rate. Implied Property Value = $200k ÷ 10.0% = $2 million Given the NOI and net income multiplier (NIM), the product of the two metrics should confirm that the property value is indeed $2 million. Implied Property Value = 10.0x × $200k = $2 million | Real Estate Technical Interview Guide 23 BEGINNER-LEVEL QUESTIONS Q: Compare the cap rates for the main property types. Property Type Description Hospitality Sector (Hotels) The hospitality sector trades at the highest cap rates because of the cyclicality inherent to the sector, in which demand fluctuates based on external factors such as the current state of the economy and the discretionary income of consumers. Bookings are on a short-term basis, which is an issue for operationally-intensive business models such as hotels, where the staff and amenities, such as food, must be prepared to offer a positive experience to customers. Retail Sector The retail sector is risky because of the secular shifts disrupting the broader market, namely the emergence of eCommerce, which caused the creditworthiness of retail tenants to decline and forced industry participants to adjust to meet the new norm in consumer spending behavior. eCommerce has completely disrupted the traditional retail sector and spending patterns of customers, as confirmed by the bankruptcies of corporations such as J. Crew, J.C. Penney, Brooks Brothers, and GNC. Industrials Sector The industrials sector has become a top performer in the CRE market because of favorable trends such as eCommerce, cloud computing, and big data. The products offered ultimately determine the performance of the individual segments categorized under the industrials sector – hence, fulfillment centers, data centers, and infrastructure are expected to continue generating strong returns. Historically, cap rates in the industrials sector fluctuate substantially, but long-dated commercial leases are quite common. Office Sector The office sector, like the hotel industry, exhibits cyclicality based on the prevailing conditions of the broader economy. An effective strategy to mitigate risk is long-term leases – especially if the tenant is reliable regarding creditworthiness – so securing multi-year contracts and establishing long-term business relationships is paramount to the office sector. Multifamily Sector The multifamily sector, including the market for apartment rentals, is recognized by most real estate investors to be the most stable in terms of consistent demand (i.e., consumers will always need a home to live in). But while the customer base is indeed stable relative to other property types, the economic conditions can have a material impact on demand that reduces occupancy rates, and the short-term lease structure poses further risks. | Real Estate Technical Interview Guide 24 BEGINNER-LEVEL QUESTIONS Q: Explain the relationship between the cap rate and risk. Higher Cap Rate (↑) Lower Cap Rate (↓) Properties with high cap rates are expected to be riskier Properties with lower cap rates correspond to lower risk but offer more upside potential in return. – albeit there are certainly exceptions to the rule. Considering the cap rate is a measure of potential From the perspective of real estate investors, the ideal return, the metric is also a measure of risk since, scenario is the mispricing of property values relative to conceptually, risk and return are two sides of the same their income potential. coin. Conversely, low cap rates can result from unfavorable Cap rates and property prices are inversely related market conditions, an economic contraction, etc. because higher risk coincides with lower pricing. Properties with lower cap rates are perceived as more On that note, a higher cap rate corresponds to a lower secure because the location is near a high-demand, property value – all else being equal. modern area with plenty of market demand, which Higher cap rates often warrant a discount to the sale collectively reduces the risk of investing in such price, i.e., a lower purchase price. properties. Positive growth in NOI contributes to a higher cap rate, Lower cap rates are deemed lower return investments whereas negative NOI growth results in a lower cap rate. because properties trading at low cap rates are often ascribed higher pricing. Q: What is the difference between the cap rate and cash-on-cash return? Conceptually, the cap rate metric is the unlevered cash-on-cash return as of the original date of the acquisition. The cap rate on a real estate investment is determined by dividing the property’s annual net operating income (NOI) by its current market value. Like the cash-on-cash return, the cap rate represents the annual rate of return and is expressed as a percentage. Capitalization Rate → The cap rate measures the return expected on a rental property investment. Contrary to the cash-on- cash return, the capitalization rate neglects the effects of financing (i.e., capital structure neutral). The numerator in the cap rate formula is net operating income (NOI), an unlevered profit metric unaffected by discretionary financing decisions. Hence, the cap rate must also neglect financing costs for the ratio to be practical. Cap Rate (%) = Net Operating Income (NOI) + Property Value Cash-on-Cash Return → The cash-on-cash return, or “cash yield,” measures the annual pre-tax cash flow received per dollar of equity invested. Unlike the cap rate, the cash-on-cash return is a levered metric (i.e., post-financing) because the numerator is the annual pre-tax cash flow. The levered pre-tax cash flow metric is unaffected by taxes but is reduced by the annual debt service, which includes mortgage payments and interest. The equity contribution from the investor is also a direct function of the total amount of debt used to fund the purchase. Cash-on-Cash Return (%) = Annual Pre-Tax Cash Flow ÷ Equity Contribution | Real Estate Technical Interview Guide 25 BEGINNER-LEVEL QUESTIONS Suppose the return on a property investment is centered around value appreciation instead of income generation (e.g., lease-up, renovations). In that case, the cash-on-cash returns should be expected to be on the lower end. However, since the proportion of returns is driven predominately by value appreciation (or price appreciation), the low cash yield is not necessarily a concern. Therefore, the distinction between the cap rate and cash-on-cash return boils down to the treatment of financing costs. Q: How are property values and NOI multiples affected if the market cap rate rises? Higher cap rates coincide with lower property values, for the most part (and vice versa for lower cap rates). Likewise, higher cap rates correspond with lower NOI multiples. Given a higher market cap rate and compression in the NOI multiple, the implied asset value of properties is reduced. Higher Cap Rate → Lower Property Value + Lower NOI Multiple Lower Cap Rate → Higher Property Value + Higher NOI Multiple A higher cap rate causes the value of the property to decline because of the incremental rise in risk, where investors demand a higher rate of return as compensation for undertaking the risk; hence, the reduction in property value (and purchase price). Given the property's increased risk profile, the amount investors in the market are willing to pay for a dollar of NOI produced by the property reduces, as the image below illustrates. NOI in Multiple ($ in thousands) A B C D E Forward NOI $60 $60 $60 $60 $60 (÷) Cap Rate (%). Step: 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% Implied Property Value $1,500 $1,000 $750 $600 $500 NOI Multiple 25.0x 16.7x 12.5z 10.0x 8.3x Q: What does funds from operations (FFO) measure? Originally, Nareit developed the funds from operations (FFO) metric because the traditional U.S. GAAP accounting metrics, such as net income, were not accurate enough to measure the true financial state of REITs. FFO, or “Funds from Operations,” measures the operating performance of real estate investment trusts (REITs) by estimating a REIT’s capacity to continue generating sufficient cash. The calculation of funds from operations (FFO) starts with reconciling net income, the accounting profits per GAAP reporting standards, and the “bottom line” of the income statement. Funds from Operations (FFO) = Net Income + Depreciation – Gain on Sale (net) | Real Estate Technical Interview Guide 26 BEGINNER-LEVEL QUESTIONS The major adjustment applied to FFO is the add-back of the depreciation from real estate assets, followed by adjustments for certain non-recurring items, such as the gain or loss on an asset sale. FFO is a non-GAAP financial measure, yet it is still widely recognized in the REITs market as a standardized metric to measure operating performance among industry practitioners. Contrary to a common misconception, funds from operations (FFO) is not a true measure of cash flow because FFO neglects working capital, capital expenditures (Capex), and other discretionary adjustments. Q: What is the difference between FFO and AFFO? The funds from operations (FFO) metric is formally recognized as a metric to analyze the operating performance of REITs, yet there is much criticism surrounding the shortcomings of the FFO metric. AFFO = Funds from Operations (FFO) + Non-Recurring Items – Maintenance Capital Expenditures FFO reconciles net income to measure the operating performance of REITs more accurately, yet there are some shortcomings, such as including certain non-recurring items and omitting capital expenditures (Capex), which contributed to the adjusted funds from operations (AFFO) metric gaining traction. The original intent of the AFFO metric was to be a more refined version of the traditional FFO metric, in which the common sources of criticism among practitioners were addressed, such as accounting for Capex. The absence of industry-wide standardization impeded AFFO from becoming a formally recognized measure of operating performance within the REIT industry. Certain REITs outright neglect reporting AFFO in their financial filings, whereas others compute the metric using their specific methodology, which reduces the utility of the metric. The more pressing matter soon became the “slippery slope” formed by the discretion afforded to management on which adjustments to apply, akin to the widespread adoption of EBITDA (and now “Adjusted EBITDA”). Like FFO, AFFO neglects working capital adjustments, which are more related to the REIT sector, instead of imperfections in the metric (i.e., the significance of working capital is relatively menial in the real estate industry). | Real Estate Technical Interview Guide 27 BEGINNER-LEVEL QUESTIONS Q: What is the difference between NOI and EBITDA? NOI stands for “Net Operating Income” and measures the operating profitability of properties in the real estate industry, whereby direct operating expenses reduce the income generated by a property. Like EBITDA, NOI excludes depreciation and amortization (D&A), certain non-cash charges, income taxes, and financing costs like mortgage payments. Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses The direct operating expenses subtracted from the NOI metric include property management fees and maintenance fees, such as repairs and utilities. The effects of financing costs, namely mortgage payments and interest expense, and discretionary management decisions like the useful life assumption post-Capex spending (and the depreciation rate), are removed in NOI. On the other hand, EBITDA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization” and is by far the most common measure of core profitability for corporations. EBITDA = Net Income + Taxes + Interest Expense, net + Depreciation + Amortization The calculation of EBITDA and NOI includes only operating items, causing the metrics to be suited for comparability, i.e., analyze the target company side-by-side with comparable peers. But NOI is seldom recognized outside the real estate industry, whereas EBITDA is the most widely used measure of operating performance across various industries. The distinction between NOI and EBITDA boils down to the industry classification because the factors that constitute “operating” and “non-operating” items are contingent on the specific industry. NOI neglects non-operating items like EBITDA from a real estate property perspective, which differs substantially from corporations. Therefore, NOI measures a property's profit potential, whereas EBITDA reflects the operating profitability of an entire corporation. For instance, property insurance, property taxes, and property management fees are subtracted to calculate NOI, which are irrelevant to calculating EBITDA for non-real estate companies. The depreciation concept is rather nuanced in the real estate industry because unlike standard circumstances – where depreciation reduces the carrying value of a fixed asset (PP&E) on the balance sheet to reflect deterioration (“wear and tear”) – properties such as homes can be priced and sold in the open markets at a premium to the original purchase price. | Real Estate Technical Interview Guide 28 BEGINNER-LEVEL QUESTIONS Q: What are the three methods of appraising a property? Appraisal Method Description Income Approach Under the income approach, or “direct capitalization method,” the property value is estimated by dividing a property’s pro forma, stabilized net operating income (NOI) by the market cap rate. The market cap rate is determined by analyzing the cap rates of comparable properties to arrive at a benchmark to guide the pricing of the property. By dividing the twelve-month forward NOI of the property by an appropriate market cap rate, the income stream is effectively converted into a property valuation. Sales Comparison The sales comparison approach relies on the recent historical sales data of comparable Approach properties to estimate the valuation of a property. The selected transactions provide insights regarding the price per unit or square foot valuations, including the current market cap rate. The sales comparison approach assumes that the attributes of each sold property contributed to its final sale price, so factors such as the floor area, view, location, number of rooms (and bathrooms), property age, and property condition are recorded and applied in the comps analysis. Cost Approach Under the cost approach, or “replacement cost method,” the property value is estimated based on the total cost of replacing the property, i.e., reconstructing the property from scratch. The estimated property value is the total cost incurred if the property were to be hypothetically destroyed and had to be rebuilt. Unlike the income and sales comparison approaches, the cost approach is the only method in which comparable properties are not part of the valuation. Q: Walk me through the income approach to real estate valuation. The income approach, or more specifically, the “direct capitalization method,” appraises the value of a property based on its capacity to generate income, most often projected on a twelve-month time horizon. 1. Project Forward NOI → The initial step is to project the forward NOI of the property, in which the core operating drivers are the vacancy and credit losses rate, along with other operating expense assumptions. 2. Determine Market Cap Rate → The market cap rate is determined by compiling market research and performing comps analysis on comparable properties currently on sale or were sold recently. 3. Estimate Property Value → In the final step, the property value can be estimated under the income approach by dividing the rental property’s forward NOI by the market cap rate. The formula to estimate the property value per the income approach is as follows. Property Value = Forward NOI ÷ Market Cap Rate | Real Estate Technical Interview Guide 29 BEGINNER-LEVEL QUESTIONS The forward NOI of the property must be stabilized, wherein the property is fully functional and generates income on behalf of the property owner or investor. The less equity required to be contributed by the real estate investor, the higher the implied return – all else being equal. Q: What does the cash-on-cash return measure? The cash-on-cash return, or “cash yield,” measures the annual pre-tax earnings on a property relative to the initial equity investment contributed to the purchase, expressed as a percentage. The formula to calculate the cash-on-cash return is the ratio between the real estate investor's annual pre-tax cash flow and equity contribution. Cash on Cash Return (%) = Annual Pre-Tax Cash Flow ÷ Equity Contribution Where: Annual Pre-Tax Cash Flow → The annual NOI of a property subtracted by the annual debt service, such as mortgage payments and interest obligations. Invested Equity → The original equity contribution on the date of property purchase, i.e. the initial cash outlay. Since the annual pre-tax cash flow is NOI subtracted by the debt service – i.e., the cash-on-cash return factors in financing costs – the cash-on-cash return represents a “levered” yield. Therefore, the cash-on-cash return is the percentage of an investment expected to be distributed in cash before income taxes. Q: What is the intuition behind the cost approach? The premise of the cost approach, or “replacement cost,” is the principle of substitution, which states that no rational investor should pay more for a property than the cost of constructing an equivalent substitute. In short, the question answered by performing replacement cost analysis is, “How much would it cost to rebuild the property from the ground up?” The cost approach to appraisal is grounded on the notion that the pricing of a property should be determined by the cost of the land and cost of construction, net of depreciation. Estimated Property Value = Land Value + (Cost New – Accumulated Depreciation) | Real Estate Technical Interview Guide 30 BEGINNER-LEVEL QUESTIONS Estimating the property cost is essentially determining the total spending required to rebuild the property from the ground up, which is then compared to the current asking price: Replacement Cost < Asking Price → Current pricing is potentially reasonable Replacement Cost > Asking Price → Current pricing is not reasonable Therefore, a rational investor should only purchase a property at a lower price relative to the cost of reconstructing a comparable property with similar features and amenities. There are three forms of depreciation recognized in real estate appraisals: 1. Physical Deterioration → The tangible losses in property value from the “wear and tear” starting from the initial date on which the construction was completed. 2. Functional Obsolescence → The loss in the market value of a property because of factors such as subjective consumer preferences, technological innovations, or unfavorable shifts in market standards. 3. Economic Obsolescence → The losses in property value caused by external factors that pertain to the property's location, such as the local economy and environment Q: What is the gross rent multiplier (GRM)? The gross rent multiplier (GRM) is the ratio between the market value of a property and its expected annual gross rental income. Gross Rent Multiplier (GRM) = Market Value of Property ÷ Annual Gross Rental Income In practice, the gross rent multiplier (GRM) is a “back of the envelope” method to screen potential investments by estimating the profit potential of properties. By comparing the property investment’s current fair value to its expected annual rental income, the total number of years necessary for the property to break even and become profitable can be estimated. Therefore, the GRM estimates the number of years a property must continue operating until its cumulative gross rental income reaches the break-even point and starts to “turn a profit.” The lower the gross rent multiplier (GRM), the more profitable the investment because the property generates more rental income to pay for itself at a faster pace relative to comparable properties. Generally, most real estate investors target a gross rent multiplier (GRM) around 4.0x to 7.0x. The gross rent multiplier (GRM) approach estimates the value of a property by multiplying the annualized rental income of a property by the GRM ratio. Property Value = Gross Rent Multiplier (GRM) × Annualized Rental Income | Real Estate Technical Interview Guide 31 BEGINNER-LEVEL QUESTIONS Q: What is the difference between the yield on cost (YoC) and cap rate? The yield on cost (YoC) is the ratio between a property's stabilized net operating income (NOI) and the total project cost, expressed as a percentage. Yield on Cost (%) = Stabilized Net Operating Income (NOI) ÷ Total Project Cost Unique to the yield-on-cost metric, the ratio measures the risk-return of a property at its core, considering the yield compares the property’s potential earnings and the total project cost. The stabilized NOI of a property is the pro forma NOI on an annualized basis after the new construction and property development work is completed. Conceptually, the yield on cost (YoC) is the forward-looking cap rate on property investments since the computation divides the stabilized, “potential” NOI by the total project cost. The properties that have reached a state of stabilization are fully operational and generate sustainable income, representing their actual run-rate income. The composition of the total project cost varies by the project type: Development Projects → The composition of the total project cost is predominately the purchase price and the developmental costs, such as the spending on construction after purchasing the land. Acquisition Projects → On the other hand, the spending on acquisitions is mostly maintenance, fixtures, renovations, and discretionary upgrades since acquired properties can start operating and generating income relatively quickly, while development projects are long-term commitments. Q: Explain how to calculate net operating income (NOI) from effective gross income (EGI). The effective gross income (EGI) is the pro forma income generated by a property after factoring in vacancy and credit losses. The starting point of calculating a property’s effective gross income (EGI) is the potential gross income (PGI) metric – which is a property’s maximum rental income assuming a 100% occupancy rate and no collection issues, including ancillary income, such as fees from amenities access, vending machines, laundry facilities, parking fees, etc. Once the potential gross income (PGI) is estimated, the next step is to compute the effective gross income (EGI) by subtracting the estimated vacancy and credit losses. Effective Gross Income (EGI) = Potential Gross Income (PGI) – Vacancy and Credit Losses The net operating income (NOI) is the remaining income after subtracting direct operating expenses from the property’s effective gross income (EGI). | Real Estate Technical Interview Guide 32 BEGINNER-LEVEL QUESTIONS Net Operating Income (NOI) = Effective Gross Income (EGI) – Direct Operating Expenses Hypothetically, if a property incurred no losses attributable to vacancies and credit (collection) issues, its effective gross income (EGI) would be equivalent to its net operating income (NOI). The common direct operating expenses deducted from the property’s effective gross income (EGI) include the following: Property Management Fees Property Taxes Property Insurance Maintenance Costs Repairs Utilities To reiterate from earlier – as the point bears repeating – NOI neglects financing costs, federal income taxes, and capital expenditures (Capex). Q: What is the loan-to-value ratio (LTV)? The loan-to-value ratio (LTV) measures the risk of a real estate lending proposal by comparing the requested loan amount to the appraised fair value of the property securing the financing. Loan-to-Value Ratio (LTV) = Loan Amount ÷ Appraised Property Value The loan amount refers to the size of the financing offered by the lender, whereas the appraised property value is the estimated fair value of the property as of the current date. For the most part, the lower the loan-to-value ratio (LTV) of the financing request, the less risk perceived by real estate lenders, resulting in more favorable terms to the borrower. General Rules of Thumb: Higher Loan-to-Value Ratio (LTV) → Greater Credit Risk + Higher Interest Rate Lower Loan-to-Value Ratio (LTV) → Less Credit Risk + Lower Interest Rate Thus, the higher the loan-to-value ratio (LTV), the higher the risk to the lender, reflected via the higher interest rate charged to the borrower to compensate for the incremental risk. Commercial real estate loans are usually capped at around 75% in most cases – i.e., the maximum LTV ratio set by lenders is 75% – in effect, the borrower's minimum equity contribution (or “down payment”) is 25%. | Real Estate Technical Interview Guide 33 BEGINNER-LEVEL QUESTIONS For example, suppose a commercial property with an appraised value of $1 million received a commercial loan for $700k. The loan-to-value ratio (LTV) is 70%, meaning that the lender is loaning 70% of the property's market value. Total Purchase Price = $1 million Loan Size = $700k Equity Contribution (“Down Payment”) = $1 million – $700k = $300k Since most senior lenders, such as banks, are risk-averse and prioritize capital preservation, lower LTV ratios are offered for higher-risk properties, while higher LTV ratios are reserved for low-risk properties. Q: What does the loan to cost ratio (LTC) measure? The e loan-to-cost ratio (LTC) is an underwriting metric used by lenders to analyze credit risk by comparing the total size of a loan to the total development cost of a real esta

Real Estate Technical Interview Guide PDF

Document Details

Tags

Related

Summary

Full Transcript

Upgrade to continue