Final Exam Solutions

BA 280/BA E-280

Spring 1998

Part II

a. Net asset value -- stock prices of REITs -- The stock price of publicly traded Real Estate Investment Trusts (REITs) are frequently sold at a premium to the implied underlying net asset values of the real estate owned by the REIT. First, net asset values of REITs properties are typically determined by appraisal, which may not be accurate or reliable. Appraisals are alleged to have many problems, including the notion that net asset values for parcels are determined as the "sale value" of single properties, not the total portfolio of properties contained in the REIT. The total net asset value for the REIT is the sum of these single sales values. Second, it is argued that real estate owned in a large public REIT issues stock which is significantly more liquid than the real estate itself. In addition, it has been argued that REITs have franchise values relating to development capabilities and management efficiencies. All of these factors would create a value for the REIT, which is greater than the sum of the NAV's.

Also, the stocks of REITs can sell at a discount to NAV's. This may be caused by inefficiencies in the management, and so forth. For thirty of the last forty years, REITS have typically sold at a discount to net asset values; However, during the last five years REITs stocks have frequently sold at a premium to net asset values. One could argue that this is the maturation of the REIT industry.

b. The tilt problem -- high expected inflation. The tilt problem relates to problems of the mortgage borrower in high-expected inflation periods. The nominal interest rate is high when there is high-expected inflation. In such circumstances, the fixed rate, fixed periodic payment, fully amortized mortgage associated with high nominal interest rates will create, because of future expected inflation, a declining real payment. In essence, if inflation follows the expected value, households will face a real payment burden that tilts downward over time. This will cause most households to consume or purchase less housing in the early part of their lifecycle because of affordability caused by the "tilt problem."

Unexpected inflation is not incorporated within nominal interest rates (by definition). If there are unexpected changes in inflation, which in turn are incorporated into future expectations, this will create a readjustment in real and/or nominal interest rates. This will cause potentially both the lender and the borrower to be exposed to additional (risks) uncertainties. Therefore, the solution of the tilt problem by itself without handling the uncertainty of future expected inflation rates is only a partial solution to the borrower and lender problems, etc.

c. Asset-liability mix of real estate lenders -- duration, spread, and option risks -- This question addresses the issue of how do the asset liability portfolio mixes of real estate lenders affect three types of interrelated risks: duration, spread, and options associated with mortgage instruments. Asset liability mix in part refers to the differential duration or duration gap of financial institutions with long duration assets, such as mortgages, and short duration liabilities, such as short-term demand-like deposits. This is the maturity "timing duration" problem of assets versus liabilities. The market value of assets change much more than the market values of liabilities because the duration of the assets is greater than the duration of the liabilities. (See figure 1.)

A change in the relative spread between long interest rates and short interest rates (i.e. a "rotational" shift in the term structure of interest rates) can impact the asset liability mix problem without a major change in the general level of interest rates. As the spread between long and short interest rates become more compact, for example, the profitability of financial institutions, ceteris paribas, will decline, even if the absolute value of long rates are unchanged. (See figure 2.)

Because mortgages provide the borrower with certain put and call options, the lender finds that when interest rates fall mortgages are prepaid (and refinanced) to the lender's disadvantage and vice versa. The default option of the borrower is exercised

when the underlying real estate collateral tends to decline, default risks of mortgages are related to interest rate changes through their effects on the market values, which also tend to engender an option exercised by the borrower to "put" the property to the lender as the loan-to-value ratio declines sufficiently.

All of these risks associated with the options of mortgages, especially the prepay option, will exacerbate the asset liability problem by removing "good" high yield assets as interest rates fall, and vice versa.

d. IO Bonds - PO Bonds -- Bullish and Bearish Bonds -- Abstracting from default risks, POs (principal only bonds) pay only principal, and the value of POs increase when interest rates fall because increased prepayments cause the principal to be paid to the investor sooner. The total principal from the underlying mortgage pool is fixed, therefore, decreasing interest rates through prepayments and lower discount rates increase the present value of the cash flow stream of PO bonds. In this way, PO bonds act as general bonds and mortgages and are considered "bullish." IO (interest only bonds) pay interest only from the mortgage cash flows and, therefore, increase in value when interest rates rise. This is because prepayments decline as interest rates rise causing interest payment streams to increase over the average extended life of the mortgage pool, etc. IO bonds because their values increase with increasing interest rates are considered bearish bonds.

In principle, the sum of the IO bonds and the PO bonds should equal the value of the mortgage pool for each interest rate. (See graph 3.)

Unexpected changes in interest rates cause POs and IOs values to move in opposite directions (see graph 3 again) by changing prepayment speeds for the mortgages in the collateral pool (again abstracting from default risks.)

e. Residential (equity) value of "plain vanilla" CMO -- prepayment speed -- In a "plain vanilla" standard four tranche collateralized mortgage obligation (CMO), there are three serial tranches, a Z tranche, and the residual equity ownership (an unrated piece). The residual value tends to be a bearish interest rate bond-like instrument; that is, its value tends to move opposite to that of normal mortgage-backed securities and bonds. As interest rates rise, the value of the residual rises, and vice versa. This is true because as interest rates rise, prepayments slow down causing total cash flows from the underlying collateral to be larger than expected or needed to pay the other CMO tranches, and reinvestment income increases because of higher interest rate reinvestment opportunities. Hence, the cash flows available to the residual ownership will be greater over time at slower prepayment, and the present value of the residual ownership will increase. This mechanism works in reverse for lower interest rates, etc.

f. FFO -- taxable income -- This refers to REIT taxable income versus available cash flows. REIT taxable income because of depreciation of real estate assets is not usually considered a good measure of REIT cash flow. Funds From Operation (FFO) are the sum of depreciation (a non-cash bookkeeping expenditure) and taxable income. Usually, it is standard to adjust FFO for recurrent capital expense, etc. as well. Adjusted FFO or cash available for distribution (CAD) tends to be a better measure of real cash flow available to the REIT investors than FFO itself, etc.