David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Finance Theory and Real Estate

Goal –

Asset Valuation:

Risk vs. Uncertainty

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David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Determinants of Value

1. Amount of after-tax CFs

2. Timing of CFs

3. Risk of CFs

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Risk in the Context of Real Estate

Commercial Property – Real Estate Limited Partnership – Real Estate Investment Trust (REIT) – Residential Mortgage – Mortgage-Backed Security – Collateralized Mortgage Obligations (CMOs) – IO’s and PO’s – Servicing Rights -

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Leverage and Capital Structure

Leverage Defined –

Debt increases shareholder returns…

Irrelevance of Capital Structure…

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Options in Real Estate Markets

Call –

Put –

Intrinsic Value Market Value

Valuation considerations:

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Real Estate Options

Residential Mortgages Prepayment – Default –

Commercial Mortgage Ruthless Default – Protections –

Explicit/Real Options –

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Key Concepts

Financial Intermediation

Portfolio Theory Asset Class Diversification Diversification Within Real Estate

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Market Efficiency

Efficient Market Hypothesis

Levels of Market Efficiency

Conclusions?

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Agency Theory

Agency Relationship

Agency Problem:

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Agency Examples in Real Estate

Property Management -

Loan Officers –

Appraisers –

Agents -

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

An Example Agency Problem

Suppose you’re considering undertaking a real estate development project. You plan to finance the construction of ________ with $25M (face value) of debt. Two methods/strategies exist for developing our __________. First, a safe method is available which produces profits (EBIT) of $40M if the economy is slack and $60M if the economy is robust. Alternatively, a risky process is available which produces profits (EBIT) of $0 if the economy is slack and $80M if the economy is robust. Assuming both states of the economy are equally likely to occur, which development strategy should the firm pursue?

Societal Perspective »

Creditors Perspective »

Owners Perspective »

• Conclusion:

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Mitigating Agency Problems

Threat of Firing

Threat of Takeover

Managerial Labor Markets

Proper Structuring of Managerial Incentives