PPD 499: The Real Estate Capital StackFall 2013

University of Southern California

Price School of Public Policy

PPD 499: The Real Estate Capital Stack

Fall 2013

General Information

Instructor: Jay Glaubach

Class Meetings: Tuesday 6:00 - 7:50 PM

Location: VKC 258

Office Hours:Tuesday 8:00 - 9:00 PM

Contact:

(310) 734-0888

Course Overview

The purpose of this class is to study the various means of financing real estate. Specifically, we will engage in a review of debt financing and equity financing, which comprise the two general categories of the real estate “capital stack.”

We will begin with an overview of real estate debt. We will first discuss the rights and remedies of lenders, and what distinguishes mortgages from other types of interests in real estate. We will also study typical debt terms, and how these terms are negotiated to provide flexibility to owners while protecting lender downside. Our discussion of debt will include unconventional forms of debt, such as second mortgages, mezzanine loans and even ground leases. We will also discuss the CMBS market, tranches of debt, and the role of each in the global financial crisis of 2008.

The second half of the semester will focus on real estate equity financing. We will distinguish the rights and remedies of equity providers from the rights and remedies of debt providers. We will also discuss the different forms thatreal estate equity investments can take, including preferred and participating preferred equity transactions, and review the terms of joint venture equity investments.

The semester will conclude with a discussion of the interaction between debt and equity in real estate. Why do equity holders in property obtain leverage? What are the relative risks and rewards? And how do real estate owners determine the correct mix of mortgage debt, mezzanine debt, equity and/or preferred equity in the capital stack of any given property?

Course Structure and Requirements

This class will be highly interactive. Class attendance is mandatory. There will be an emphasis on classroom discussion. Participation in discussions is required.

The reading list and homework assignments will be manageable by design. Rather than assigning an overwhelming volume, my objective is to assign readings and case studies that provoke thought and discussion. The time saved on reading should be reallocated towards reflection and preparation for the next class.

Final grades will be awarded 10% on take-home assignments, 15% on each student’s classroom participation, 25% on a mid-term examination and 50% on the final exam. For the participation component of grading, the quality of your comments is far more important than quantity.

Class Materials

Required: Real Estate Principles: A Value Approach (Third Edition), David C. Ling and Wayne R. Archer, McGraw-Hill (2010)

Required: HP12c financial calculator. Please have your calculator in class at all times. Microsoft Excel will also be helpful for certain in-class and take-home exercises.

Course Syllabus

Part I: Debt

Class 1: Introduction to the Capital Stack

Assignment: None

  1. Course introduction and ground rules
  2. Review of capitalization rates
  3. Definition of the capital stack
  4. The trade-off between risk and return

This class will begin with a discussion of the semester ahead, including participation expectations and classroom mechanics. We’ll then have an introductory discussion about the capital stack, the placement of debt and equity within the stack, and what this placement signifies about the risks and returns of each.

Class 2: Introduction to Debt

Assignment:Ling and Archer, Chapter 16

  1. Basic vocabulary
  2. Types of debt: secured/unsecured, acquisition/construction, mortgage/mezzanine
  3. Defining characteristics of debt and debt as “fixed income”
  4. Debt on the risk/return spectrum

This class will provide an introduction to real estate debt, particularly the first mortgage loan. After reviewing the basic vocabulary of debt, we’ll discuss its definitional characteristics, and how these characteristics lead to the notion that debt is a “fixed income” vehicle. Finally, we’ll connect the concept of fixed income to the limitations of debt on the spectrum of both risk and reward.

Class 3: Debt Calculations

Assignment: Ling and Archer, Chapter 15 (pp. 415-422 only)

  1. Interest rates: fixed and floating rate loans
  2. Debt constants
  3. Principal payments and amortization tables

Today we’ll discuss the basic debt calculations used in analyzing real estate loans. We’ll begin with a discussion of interest rates, and distinguish between fixed rate and floating rate structures. We’ll then discuss the concept of amortization, and learn how to calculate a loan’s resultant fixed annual payment.

Class 4: Debt and the Protection of Downside

Assignment: Ling and Archer, Chapter 9 (pp. 220-235 only)

  1. Risk/reward and the protection of lender downside
  2. Mitigation of principal risk
  3. Mitigation of current payment risk
  4. Foreclosure, recourse and the mitigation of total loss

In this class we will discuss the various ways that lenders seek to limit their downside risk. Specifically, we will discuss how lenders size their loans to mitigate the risk of failure, and the tests they use (including DSCR and debt yield tests) to ensure payment compliance. We’ll then discuss lender remedies in case of default, as well as various other tools (such as foreclosure and principal recourse) that lenders seek to limit their loss exposure.

Class 5: Tranches of Debt and the Financial Crisis

Assignment: Ling and Archer, Chapter 17 (pp. 467-472 only); Debt Term Sheet (handout); Debt Calculation Problem Set (handout)

  1. Review debt calculation problem set and sample debt term sheet
  2. The concept of vertical and horizontal tranches in loan structures
  3. Tranches and the risk/reward spectrum
  4. CMBS and the global financial crisis

Today we’ll return to the capital stack to observe how debt can be subdivided through the capital markets to more specifically allocate risk and return. This will lead to a discussion of Commercial Mortgage-Backed Securities, how they function, and the role of tranches and CMBS in the global financial crisis of 2008.

Class 6: Unconventional Debt

Assignment: Ling and Archer, Chapter 16 (pp. 435-437 only); Mezzanine Debt Term Sheet (handout)

  1. Second Liens and Subordinate Mortgage Debt
  2. Mezzanine debt
  3. Ground leases as debt
  4. Sale-leasebacks as debt

Our discussions so far have focused on relatively straightforward first-mortgage loans, which are collateralized by real assets. Today’s class will focus on less straightforward forms of property financing. First, we will quickly cover subordinate mortgages such as second liens, and compare and contrast them to the subordinate debt tranches that we discussed last week. We will then focus on three unorthodox forms of real estate financing, each of which has become an increasingly popular alternative (or addition) to mortgage debt. Mezzanine debt is unconventional because it is collateralized by equity rather than real property. We will discuss mezzanine debt in the context of rights, remedies and its place in the capital stack. We will then turn to ground leases. While not a form of financing, ground leases actually function similarly to loans. We will contextualize the concept of a ground lease within our discussion of loan terms, mechanics and remedies, and decide where, if anywhere, these vehicles belong in the capital stack. Finally, we will define and discuss sale-leasebacks, and discuss these structures in the context of more traditional debt vehicles.

Class 7: Debt Wrap-Up and Midterm Review

Class 8: Midterm Exam

Part II: Equity

Class 9: Introduction to Equity

Assignment: Ling and Archer, Chapter 17 (pp. 455-467 only)

  1. Defining equity
  2. Equity in the capital stack and risk vs. returns
  3. Introduction to different equity investors: sponsors, REITs, private funds and individuals
  4. Introduction to forms of equity investment: common, preferred and participating preferred

This class will provide an introduction to equity. We will first define equity by examining its rights and remedies in contrast to the rights and remedies of mortgage holders. We will then discuss various legal forms of equity ownership (including ownership through the public capital markets). We will conclude by discussing the various types of equity structures, including common equity, preferred investments and participating preferred structures.

Class 10: Common Equity and the Equity Joint Venture

Assignment: Review Ling and Archer, Chapter 17 (pp. 460-467 only); Joint Venture Term Sheet (handout)

  1. Common equity
  2. Equity partners and developers/sponsors
  3. The concept of the joint venture
  4. Review and discussion of sample joint venture term sheet

This class is dedicated to common equity and the way it is typically funded in real estate ventures. Specifically, we will explore how various participants in the equity markets can work together to add value to an investment. This is often accomplished through the joint venture, which becomes the borrower under the first mortgage loan. We will discuss the mutual benefit of various equity sources teaming up on certain projects, and discuss the legal and financial arrangements that they employ. Class will conclude with the review of an actual joint venture term sheet between a private equity firm and a development firm.

Class 11: Preferred Equity

Assignment: Preferred Equity Term Sheet (handout)

  1. Definition of preferred equity
  2. Concept of participating preferred equity and risk/return trade-off
  3. Preferred equity vs. mezzanine debt in the capital stack
  4. Review of preferred equity term sheet

Preferred equity is an alternative vehicle for investors to provide equity capital to sponsors. In this class, we will define the mechanics of preferred equity investments (including participating preferred equity investments). We will also compare preferred equity and mezzanine debt and their similar placements in the capital stack. We will conclude with a review of an actual preferred equity term sheet.

Class 12: Equity’s Use of Leverage

Assignment: Ling and Archer, Chapter 19 (pp. 502-514 only)

  1. The concept of “leverage” in the capital stack
  2. Leverage and principal appreciation
  3. Cash-on-cash returns
  4. The effects of mezzanine debt and preferred equity
  5. The detriments of leverage

Today’s class will begin to explore the relationship between equity and debt. We will discuss two ways that leverage leads to higher equity returns: disproportionate principal appreciation and equity “cash-on-cash” returns. We will then discuss how the introduction of “secondary” financing (such as mezzanine debt and preferred equity) affects these calculations. We will also understand how leverage can work in reverse, by discussing examples of principal loss and negative equity cash flows in capital stacks that are “overleveraged.”

Class 13: Determining the Capital Stack

Assignment: Review Ling and Archer, Chapter 16 (pp. 438-449 only)

  1. Lender input: debt sizing and coverage tests
  2. Incremental cost of debt
  3. Cap rates, interest rates and blended returns
  4. Product types and equity’stolerance for risk

In this class, we will consolidate what we’ve learned over the course of the semester by discussing how equity owners and debt providers determine the proper capital stack for a given property. We will first discuss the influence of lenders, both in sizing loans and pricing the incremental cost of additional debt. We will then discuss how these inputs affect mezzanine and preferred equity pricing and sizing. We will conclude our discussion with the most important driver of all: ownership preferences, especially given the cash flow dynamics and risk/return profile of the property at hand.

Class 14: Class Wrap-Up and Final Exam Review

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