Alternative Investments - Aide Memoire

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ALTERNATIVE INVESTMENTS AIDE MEMOIRE Section 1 – Real Estate Definition of Alternative Investments: Not very easily defined explicity thus more easily defined by what it is not. Alternative investments are those investments which are non-traditional, i.e. not Bonds, Equities or Cash. Characteristics of Alternative Investments: They are typically (though not exclusively) unlisted. o But commodities and some real estate, as well as complex derivatives are indeed listed o Real estate tends to be listed through Property Groups or through mutual Real Estate Historically rather unregulated though all, as with all things, the lack of regulation is temporary and over time, regulatory control tightens. Nonetheless, they’re still much unregulated relative to traditional asset classes. Generally illiquid (save for Commodities and Currencies, some of the most liquid markets in the world) Risk/Return characteristics differ wildly from those of stocks and bonds Implications for valuation. Investment Universe Investment Universe Traditional Alternative Investments Private Equity ("Angel Investing") Commodities Real Estate - Landlords, Property Developers Modern Alternative Investments Hedge Funds Managed Futures Distressed Securities (Junk Bonds) - (+) Risk Traditional Investments Equities Cash Bonds

description

A summary of various topics in the field of Alternative Investments, namely: Real Estate and listed property, Mortgage Backed Securities, Collateralized Debt Obligations and Hedge Funds as well as credit default swaps.

Transcript of Alternative Investments - Aide Memoire

Page 1: Alternative Investments - Aide Memoire

ALTERNATIVE INVESTMENTS

AIDE MEMOIRE

Section 1 – Real Estate

Definition of Alternative Investments:

Not very easily defined explicity thus more easily defined by what it is not.

Alternative investments are those investments which are non-traditional, i.e. not Bonds,

Equities or Cash.

Characteristics of Alternative Investments:

They are typically (though not exclusively) unlisted.

o But commodities and some real estate, as well as complex derivatives are indeed

listed

o Real estate tends to be listed through Property Groups or through mutual Real

Estate

Historically rather unregulated though all, as with all things, the lack of regulation is

temporary and over time, regulatory control tightens. Nonetheless, they’re still much

unregulated relative to traditional asset classes.

Generally illiquid (save for Commodities and Currencies, some of the most liquid markets in

the world)

Risk/Return characteristics differ wildly from those of stocks and bonds Implications for

valuation.

Investment Universe

Investment Universe

Traditional Alternative Investments

Private Equity ("Angel Investing")

Commodities

Real Estate - Landlords, Property Developers

Modern Alternative Investments

Hedge Funds

Managed Futures

Distressed Securities (Junk Bonds) - (+) Risk

Traditional Investments

Equities

Cash

Bonds

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Other Specialised Investments

Collectables

o Very Inefficient Markets

o Requires the specialised knowledge of pundits or experts

o Very Illiquid

o Types: Art, Coins, Stamps, Cars & Wine

Currencies (more of a traditional market, at least in terms of efficiency)

Carbon Credits – much more of a market than collectables but not as developed as that of

currencies, also falls under the purview of the greater Market for Externalities

Other common Features of Alternative Investments

Relative Illiquidity

o These stocks tend to be assosiciated with a return premium as compensation for

the poor liquidity a “liquidity premium” as it were (NB: Hedge Funds)

o Investors thus tend to have a long investment time horizon to combat this poor

liquidity

o Patience is key

Diversification Potential

o Because of the inefficiencies and peculiarities of these markets, there is quite a bit

of diversification potential

o However, this is hindered by the poor liquidity

Due Diligence

o High Due Diligence Costs

o Again, a function of the idiosyncrasies of the markets in which they operate.

o Implies:

Complex Investment structures and strategies

Pundit knowledge dependent evaluation may draw heavily on asset-

class, business-specific and other expertise

Reporting of results and performance thus often lacks transparency

o Repeatability is difficult, Higher potential for fraud

Benchmarking

o Complex procedures necessary to determine valid benchmarks

o This results in difficult performance appraisal

o I.e. It is difficult to say: “Portfolio Manager A has done well” and thus difficult to

answer the question “Should I invest with him/her?”

Informational efficiency

o As previously stated, Alternative investments are informationally much less

efficient than listed markets

o Theory would then have it that it is possible to “beat the market”

o There is scope for adding value through skill and superior information.

Fees

o Investment management fees are typically higher than that of traditional asset

management.

o This is only really applicable for managed investments:

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Private Equity

Hedge Funds etc.

The role of Alternative Investments (AI) in a portfolio

AI can be broadly classified by the primary role they play in a portfolio

1. Risk Factor Exposure

Investments that provide exposure to risk factors not easily accessible

through traditional (stock/bond) investments

In this way they are exposed to higher potential returns (theoretically)

E.g. Real Estate + Long Only commodities (long futures + long underlying +

rollover)

2. Specialised Investment Strategy exposure

Investments that provide exposure to specialised investment strategies run

by an outside manager

I.e. You’re exposed to the manager’s skill and potential informational

superiority

E.g. Hedge Funds + Managed Futures

3. Combination

Any investments that combine features of the above 2 groups

E.g. Private Equity /Distressed Securities

Who invests in Alternative Investments?

High-net-worth individuals (among the pioneer investors in hedge funds for example)

o Angel Investors

o Venture Capitalists

o Private Equity (unlisted equity) firms

Institutional Investors

o Generally have a huge capital base behind them e.g. Banks, Insurers

o However, banks and insurers tend to face strict regulatory control

o Even other investors might have self-imposed limitations in their investment policy

statements

Broad Reasons for Investing in Alternative Investments

Risk Diversification

Return enhancement (almost counteracts the above aim, if traditional theory is worth

anything that is)

Broadening the investment opportunity set

o Speaks to market efficiency and saturation

o Perhaps investors are looking for a Niche or very specific market?

o Again, tied up with above 2 points.

General Trends and Regulations in the SA market

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Internationally and particularly in the US we find that high-net-worth individuals, trusts and

companies in the US have the bulk of their investments in Alternative Investments

This isn’t currently the trend in SA, at least for the time being

Revised Regulation 28

o Applies to SA pension funds

o AI

Requires that Alternative Investments form up to 15% of a pension fund’s

holdings

Hedge Funds (HF) and Private equity (PE) in particular are capped at 10% of

entire holdings (or at 66% of total alternative investment holdings)

(probably to limit risk)

Moreover specific/individual HF & PE investments are capped at 2.5%

(perhaps with the aim of diversification)

o Property

25% Limit for physical property (of the whole or of the AI portion?)

25% Max for listed, but 15% max for unlisted

o Commodities

Up to 10% invested in commodities

10% Max for investment in Gold but 5% in any other commodity Implies

gold is seen as a safer bet

PROPERTY AS AN INVESTMENT CLASS

Introduction

For most people, Real Estate/ Property is the biggest investment they will ever make.

Historically it has been seen as the “archetypal investment” ownership is of course

modelled on property

Property Types

Residential

1. Single Family homes (detached/ semi-detached houses)

2. Multi-family homes (flats, apartments etc.)

Non-residential (generally where the bulk of investment falls, particularly in listed property)

1. Office

2. Retail

3. Industrial

4. Hotel/Motel

However, there is a necessary distinction between ownership and

management/ the operation of hotels

Namely, one company might own the hotel and another might manage it

(some companies specialise in the ownership and others in the

management)

5. Recreational – e.g. Gold Course, Stadiums, Theatres, Resorts

6. Institutional/ Special purpose e.g. Hospitals

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Sources of returns

1. Capital Appreciation (the change in the market value of the property over time)

2. Ongoing income - rent (analogous to coupons in the case of bonds and dividends in the

case of equity)

The next question is: How do these streams of income (i.e. coupons vs rent) differ?

Normal Vacancy and Market equilibrium

The normal Vacancy or equilibrium vacancy is as a result of property market structural

features i.e. at any given time, much like the distinction between full employment and

natural unemployment; we find that there is some minimum level of vacancy.

There are many reasons for this namely:

o Churn or rental transition

o Rental appreciation

Equilibrium changes are most often driven by the demand side : for whatever reasons,

demand for property increases rent increases Vacancy rates decrease long lag

more property is built/ repurposed property supply increases rent comes down again

Vacancy rates are thus a key indicator of demand

They can however be driven by the supply side.

Supply Factors

Vacancy rates (what percentage of property available to rent is not currently being rented)

Interest Rates and financing ability (because of the large capital outlay required)

Age, suitability and availability of existing stock of real estate (i.e. as time goes on more

and more properties deteriorate and depreciate – requiring repurposing and/or

reconstruction as well as perhaps additional construction.

o E.g. is the area electrified and is there running water?

o Is it an ageing Victorian property?

Construction costs (labour and legislation plays a large role, as well as commodities)

Land costs and availability (largely a function of the social order, population size and the

legality of ownership)

o E.g. Cape Town and its Geographic restrictions

o

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Demand Factors

1. The Key Demand factor is location

o Location is not fixed i.e. the factors which influence the attractiveness of a location

are always influx (the average wealth of the neighbourhood, the average age of

buildings, transport proximity, the quality of roads, noise, retail available etc.)

o E.g. The Johannesburg CBD , gentrification, urban regeneration

o Nonetheless – you can’t pack up a building (well generally at least), and any existing

building is liable to changes in the quality of its location

2. Demand Factors for Houses and apartments

o The number of households (family size and family development etc.)

o The distribution of ages in the population

o Household incomes

o Housing prices (a little circular this)

o Interest rates (those purchasing houses might need financing)

o Affordability – very broad, perhaps referring to purchasing power or inflation?

3. Demand Factors for offices and commercial properties

o The presence and employment numbers of high office use industries (generally the

services industry or firms of professionals and administration)

4. Demand factors for Warehousing

o The presence and size of warehouse using industries

o Such as:

Wholesaling

Distribution

Assembling

Manufacturing

5. Demand Factors for Retail Space

o Very similar to the demand factors for houses and apartments

o Household incomes

o Demographics (ages, gender, population size, density)

o Trends

General Notes/ Trends

Residential house prices are NOT the best barometer for the capital appreciation of

“institutional investment”

This is because most institutional investors focus on non-residential properties

Average SA Nominal House prices have been rising steadily

Real House prices have fluctuated greatly; nominal house prices have not always kept up

with inflation

More and more black South Africans are owning property, particularly in the luxury and high

value sectors, though growth is slowing

Real Estate Cycle

Generally, Real Estate price growth is cyclical

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The period of this cycle is rather long

Phases of the property cycle

1. Expansion

2. Hyper supply

3. Slump

4. Recovery

Why?

1. This is a function of the normal economic growth pattern

2. The mechanism is the interest rate

3. It is a rather complex dynamic, as it is influenced by general inflation

Factors Affecting the South African Property Cycle

1. Inflation

2. Interest rates

3. The availability of finance

This has most recently been impacted by NCA of 2007

When there is a reduction in the access to credit we see a depression in demand

4. General infrastructure

Eskom

There is very limited available capacity

5. Political Uncertainty

6. Foreign Influences

Other indicators

Recent trends declining emigration and foreign home buyers (some of this is driven by

African foreign home buyers, though the numbers fluctuate)

Household debt to disposable income –household debt as a percentage of disposable

income

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Generally, the higher this value, the weaker the housing market (households are less

able to access credit for housing if already highly leveraged)

Generally speaking (+) Expensive to build than to buy, except during the financial crisis

Generally we see that the number of building plans completed is an indicator of the number

passed (though the number passed < the number completed), also there is a little bit of lag

(admin))

Rental Income

Normally the main source of income derived from property

One measure of potential revenue is the GPRP or the Gross Potential Rental Revenue

It’s the theoretical rent if there was 100% occupancy

𝐺𝑃𝑅𝑃 = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑎𝑠𝑒 𝑟𝑒𝑛𝑡 𝑝𝑒𝑟 𝑚2 × 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑛𝑡𝑎𝑏𝑙𝑒 𝑚2

Rentable area vs. Usable area

Rentable area – the total area available

Useable area – what individual tenants rent

𝐶𝑜𝑚𝑚𝑜𝑛 𝑎𝑟𝑒𝑎 = 𝑅𝑒𝑛𝑡𝑎𝑏𝑙𝑒 𝑎𝑟𝑒𝑎 − 𝑈𝑠𝑒𝑎𝑏𝑙𝑒 𝑎𝑟𝑒𝑎

𝐿𝑜𝑎𝑑 𝐹𝑎𝑐𝑡𝑜𝑟 = 𝑅𝑒𝑛𝑡𝑎𝑏𝑙𝑒 𝐴𝑟𝑒𝑎

𝑈𝑠𝑒𝑎𝑏𝑙𝑒 𝐴𝑟𝑒𝑎> 1

𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑟𝑒𝑛𝑡𝑎𝑙 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 = 𝑈𝑠𝑒𝑎𝑏𝑙𝑒 𝐴𝑟𝑒𝑎 × 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑈𝑛𝑖𝑡 𝑅𝑒𝑛𝑡𝑎𝑙 ×

𝐿𝑜𝑎𝑑 𝐹𝑎𝑐𝑡𝑜𝑟

Why this distinction? Prices are usually quoted per unit of useable area and thus

need to be scaled up

Percentage Rental

In the retail sector: rent is a combination of a base rent and percentage rent

The percentage rent is generally a % of the retail business’s turnover

This percentage rent is also known as overage - and is based on retail sales over a

pre-specified point known as the breakpoint

Implications

i. Landlord has an incentive to have the most successful lessees, should a

business fail to meet their breakpoint may be managed out

ii. Lessee has an incentive to present to the landlord the lowest possible

revenue

In this framework, any proper prediction of rental requires the prediction of:

i. Vacancies

ii. The turnover of the retail lessees

𝑁𝑒𝑡 𝐵𝑎𝑠𝑒 𝑅𝑒𝑛𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑁𝐵𝑅𝑅) = 𝐺𝑃𝑅𝑃 − 𝑉𝑎𝑐𝑎𝑛𝑐𝑦 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐹𝑜𝑟𝑒𝑔𝑜𝑛𝑒

𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑛𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝑁𝐵𝑅𝑅 + 𝑂𝑣𝑒𝑟𝑎𝑔𝑒

The Financial Components of a lease

Definition of a lease: a legal contract between the lessor (the renter) and the lessee (the

person who rents). Typically a 2-5 year term for offices and warehouses (though much

shorter for residential properties).

Base Rent

o The initial rent in R/m2

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o This value depends on the type of property (e.g. the grade of the offices) as well as

the location

Escalation Rent

o Generally the annual rate at which rent will increase over the term of the lease.

o 𝐸𝑠𝑐𝑎𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐵𝑢𝑖𝑙𝑑𝑖𝑛𝑔 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 + 𝑃𝑟𝑒𝑚𝑖𝑢𝑚

Percentage Rent

o Only applicable in the case of retail properties

o As defined above

Rental Reversion

Positive Rental reversion

o When the expected inflation implicit in the escalation rate is much lower than actual

inflation.

o i.e. Actual > Expected

o Upon expiry the new rental contract will have a much higher rent (in line with

current and historical actual inflation)

o Lessee benefits during the term

o Lessor benefits on renewal

Negative Rental reversion

o Actual < Expected

o Lessor benefits during the term

o Lessee benefits on renewal

Effective Rent

An approximation used to compare different leases and leasing alternatives

Used to transform the increasing annuity to a level annuity i.e.

1. Calculate the PV of all future lease cash-flows at the relevant discount rate

2. Calculate the payment of an equivalent level annuity

Operating Expenses (Generally for commercial rentals)

1. Reimbursable expenses

These expenses are usually recovered from the tenants pro-rata to area occupied

no net cash-flow effect

Examples

i. Common Area Maintenance – e.g. hallways, common toilets, security

ii. Property taxes

2. Non-reimbursable expenses – not recovered from the tenants

a) Insurance on the property

b) Management (internal or outsourced)

c) Utilities (though sometimes this entirely managed by the tenant)

3. Tenant Improvements

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Those improvements made such as fixtures, flooring and dry-walling made to make

the rental space suitable for the tenant

Often the landlord bears some or all of this cost (depends on the supply of office

space and the competition for new tenants)

4. Capital Expenditure (Capex)

Some things the owner must bear the cost of, particularly if they wish to improve

the building/ rental features

E.g. Elevators, parking lots

Direct Property Valuation

The appraisal process:

Methods of valuation

o Absolute Valuation (CF’s and discounting)

o Relative valuation (using multiples)

1. Cost Approach (quite subjective)

𝑉𝑎𝑙𝑢𝑒 = 𝐿𝑎𝑛𝑑 + 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

Land = valued using the sales of comparable land

The cost of the structure = based on current building costs (Very accuracy?)

Depreciation = generally to account for the age of the building (what rate to use?)

2. Comparables

𝐺𝑟𝑜𝑠𝑠 𝐼𝑛𝑐𝑜𝑚𝑒 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝐺𝐼𝑀) = 𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒

𝐺𝑟𝑜𝑠𝑠 𝐼𝑛𝑐𝑜𝑚𝑒

The unit of comparison here is the Gross Income (GI) of a similar recently sold

property

𝑃𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝐺𝑟𝑜𝑠𝑠 𝐼𝑛𝑐𝑜𝑚𝑒 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝑃𝐺𝐼𝑀) =𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒

𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑅𝑒𝑛𝑡𝑎𝑙

𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐺𝑟𝑜𝑠𝑠 𝐼𝑛𝑐𝑜𝑚𝑒 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝐸𝐺𝐼𝑀) = 𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒

𝐴𝑐𝑡𝑢𝑎𝑙 𝐺𝑟𝑜𝑠𝑠 𝐼𝑛𝑐𝑜𝑚𝑒 𝑜𝑛 𝑂𝑐𝑐𝑝. 𝑆𝑝𝑎𝑐𝑒

The Sales comparison approach

Unit of comparison: 𝑝𝑟𝑖𝑐𝑒/𝑚2 of the recent sales of similar properties

This is then adjusted upwards/downwards based on factors such as

Location

Physical and Legal Identification - boundaries might get blurred over time, there could also be contestation between the owner and the municipality

Identification of property rights to be valued -There's always the issue of userfracts

Specification of the purpose of the appraisal - Whether its for sale or for the dissolution of an estate

Specification of the effective date of value estimate

Gathering and analysis of market data >> Application of techniques for valuation

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Vacancy Rate

Age of building

3. Cap Rate (best known method)

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 (𝐶𝑎𝑝 𝑅𝑎𝑡𝑒) = 𝑵𝒆𝒕 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 (𝑁𝑂𝐼)

𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒

Yet again, the comparison is based on the sales of similar properties

This is a measure of unleveraged returns i.e. doesn’t account for financing costs/

tax

𝐺𝑟𝑜𝑠𝑠 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 (𝐺𝑂𝐼) = 𝑃𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑣𝑎𝑐𝑎𝑛𝑐𝑖𝑒𝑠 −

𝑐𝑟𝑒𝑑𝑖𝑡 𝑙𝑜𝑠𝑠

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 (𝑂𝐸) = 𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 + 𝑀𝑎𝑛𝑎𝑔𝑒𝑚𝑒𝑛𝑡 𝑓𝑒𝑒𝑠 + 𝑅𝑎𝑡𝑒𝑠 +

𝑈𝑡𝑖𝑙𝑡𝑖𝑒𝑠 + 𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 (𝑁𝑜𝑛𝑟𝑒𝑖𝑚𝑏𝑢𝑟𝑠𝑎𝑏𝑙𝑒 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠)

𝑁𝑂𝐼 = 𝐺𝑂𝐼 − 𝑂𝐸

4. DCF

Requires:

1) Predicted Cashflows (estimation)

2) Discount rate/s (which to use?)

3) Reversion value/ terminal Value (which growth rate to use?)

𝑃𝑟𝑒𝑡𝑎𝑥 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 =

𝑁𝑂𝐼 − (𝐶𝑎𝑝𝑒𝑥 + 𝑡𝑒𝑛𝑎𝑛𝑡 𝑖𝑚𝑝𝑟𝑜𝑣𝑒𝑚𝑒𝑛𝑡𝑠 + 𝑐𝑜𝑚𝑚𝑖𝑠𝑠𝑖𝑜𝑛) −

𝐷𝑒𝑏𝑡 𝑆𝑒𝑟𝑣𝑖𝑐𝑒 (𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡)

𝑁𝑒𝑡 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 = 𝑃𝑟𝑒𝑡𝑎𝑥 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 − 𝑇𝑎𝑥 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠

𝑃𝑉𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 = 𝑁𝑂𝐼1

(1+𝑟)+

𝑁𝑂𝐼2

(1+𝑟)2 + ⋯ +𝑁𝑂𝐼𝑛

(1+𝑟)𝑛 +𝑵𝑶𝑰𝒏(𝟏+𝒈)

𝒓−𝒈 ×

1

(1+𝑟)𝑛

Method Comparison

DCF

a. Implies a long-term perspective

b. Links the value to income generation

c. Robust to “bubble” valuations

Cap Rate

a. Appropriate for short-term valuations

b. Appropriate for less cyclical markets

Property Financing

The 5 Cs of Credit

a. Character

b. Cash flow

c. Capital

d. Collateral

e. Conditions

Elements of property financing

1. Ratios

2. Amortising Loans

3. Risks to lender

Page 12: Alternative Investments - Aide Memoire

4. Refinancing

Loan-to-Value Ratio (LTV)

𝐿𝑇𝑉 = 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐿𝑜𝑎𝑛 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦

a. Generally the balance outstanding decreases over time

b. Generally the market value of the property increases over time

c. Generally, we should see the LTV decrease as time goes on i.e. lim𝑛→0 𝐿𝑇𝑉 =

0 𝑤ℎ𝑒𝑟𝑒 𝑛 𝑖𝑠 𝑡ℎ𝑒 𝑡𝑖𝑚𝑒 𝑙𝑒𝑓𝑡 𝑜𝑛 𝑡ℎ𝑒 𝑙𝑜𝑎𝑛

d. Also, generally the higher the LTV Higher Risk

As a result, we tend to see less credit-worthy individuals with lower initial LTVs (i.e.

requiring a larger deposit, or only financing a smaller portion of the purchase price)

LTV is of importance, particularly w.r.t. refinancing

Coverage Ratios

Interest Coverage Ratio ≡ Debt-to-interest coverage ratio in company analysis

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝑁𝑂𝐼 𝑝.𝑎.

𝐴𝑛𝑛𝑢𝑎𝑙 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑃𝑎𝑦𝑚𝑒𝑛𝑡

Debt Service Ratio – includes both the interest and the principal repayments

1. 𝐷𝑒𝑏𝑡 𝑆𝑒𝑟𝑣𝑖𝑐𝑒 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝑁𝑂𝐼 𝑝.𝑎.

𝑡𝑜𝑡𝑎𝑙 𝑙𝑜𝑎𝑛 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝.𝑎.

Property Expense Ratio (PER) – measures the impact/ magnitude of operating expenses

1. Useful for comparison of different properties

2. 𝑃𝐸𝑅 = 𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑀𝑎𝑛𝑎𝑔𝑒𝑚𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑟 𝑎.𝑘.𝑎. 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

𝑅𝑒𝑛𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒

Amortising Loans

Generally mortgages consist of fixed payments over the term of the loan

The interest portion declines over time as the outstanding balance of the loan diminishes

Variables

1. Capital Amount – capitalised costs (admin) less deposit

2. Interest rate – fixed/ fluctuates with prime

Higher interest rate higher annual repayment

NB: generally quoted as nominal annual rates

3. Term of the loan

Residential – 20 years

Non-residential – 10 years

Loans with long terms only eat into the capital portion after many

repayments larger total amount of interest paid

Renting vs. Owning

The rental vs. ownership decision isn’t as simple as a monthly cash-flow decision

Ownership

1. Entails additional costs such as maintenance, utilities, management & insurance

2. Has taxation implications

Page 13: Alternative Investments - Aide Memoire

3. You’ve the potential for capital appreciation

4. Your long term financing liability is matched/ secured by a very illiquid asset

(namely the property)

Factors reducing equity in a property – the risks of ownership

1. The over-mortgaging of a property

2. Poor maintenance

3. Damage (that’s why insurance is so important)

4. Negative market conditions (House price decreases by loan outstanding remains

constant)

Risks to the mortgage Provider

Default Risk – a function of the credit-worthiness of the borrower, mitigated by certain

covenants which aim to restrict the actions of the borrower (particularly companies)

1. Positive (to-do) Loan covenants

1. Minimum dividend payment levels

2. Insurance Cover: lender requires borrower to insure the property to protect

the lender’s interest (property is used as collateral)

3. Sweep Provision: Lender has the first right to the cash flows generated by

the property - to prevent the borrower collecting all the rent and then filing

for bankruptcy in the case of the loss of a major tenant

2. Negative (no-to-do) Loan covenants

1. Employees not to be fired in the firm

2. Prepayment penalties

Interest Rate Risk – unfavourable movements in the interest rate might induce refinancing

and impact the above and below

Prepayment risk (generally a tie-off between the default risk and the prepayment risk)

1. Higher prevailing interest rates: borrower obtains a loan from you or if he has a loan

defaults on his payments

2. Lower prevailing interest rates: borrower refinances the loan prepayment

3. Preventative methods:

1. Prepayment penalty (negative covenant)

2. Lockout clauses

Refinancing

Borrower’s Perspective

1. An improved credit profile (bolstered my project success) and/or changes in interest

rates might allow for refinancing at a more favourable interest rate.

2. Benefits

1. Lower interest rates lower finance costs

2. The ability to withdraw funds from the project (might be able to get a loan

larger than the current outstanding balance positive cash injection for

other purposes)

3. Costs

1. The appraisal, legal and accounting fees that a new loan application entails

Page 14: Alternative Investments - Aide Memoire

2. Loan origination fees

3. Prepayment penalties (not always the case)

When to Refinance

1. Interest Rates have declined

2. The borrower’s creditworthiness has increased significantly

3. The Lender is better off (i.e. it is better for the lender to allow the borrower to

refinance with them at a lower rate to avoid losing the business to a competitor

with an even lower interest rate)

4. The owner can withdraw capital tax free? (Generally a function of the owner’s

credit-worthiness)

When evaluating the option to refinance: compare the initial cost of refinancing with the

benefits (the decrease in monthly/annual payments) and calculate the IRR

Alternatively: compare the initial cost, with the benefits per month and the savings on

paying out the loan in the case of early market sale.

How to invest in property?

1. Direct Investing

a. Benefits

Customizable leverage

Better selection

More control

Less C/F delay

b. Costs

High cost + High initial capital outlay

Poor diversification

Liquidity constraints

2. Property Syndication (quite direct)

Generally quite costly

Even poorer liquidity constraints

Often difficult to achieve scale

Potential for conflict

3. Listed Property (indirect)

Good liquidity + diversification

Built-in leverage

Less choice + require dividends for cash flows

Layers of costs economies of scale?

4. Collective Investment Schemes, mutual funds and unit trusts (indirect)

Mostly as above, though to a lesser extent \

The benefits of indirect investing

Very little experience is required

Very liquid

Economies of scale

Page 15: Alternative Investments - Aide Memoire

Very accessible – low start-up costs

Listed Property investments

These are listed companies that own and invest in properties and whose shares trade freely

on the exchanges

US, EU, Aus + SA Real Estate Investment Trusts (REITs)

Has generally outperformed the ALSI

Historically in SA there were only: property unit trusts (PUTs) and Property Loan Stocks

(PLSs), with 6 of the former and 20 of the latter on the JSE. Also some PLSs were unlisted.

PUTs

A unit trust (i.e. a collective/ pooled investment fund)

One share is linked to a number of debentures (unsecured loan stock, although this

isn’t really the case) known as “linked units”.

Net income is paid as interest to the debenture holders

PUTs don’t pay tax, but the investor’s “interest income” is taxable at a

marginal rate

Gearing is limited to 30% (quite low)

Governed by the Registrar of Unit Trusts

All income must be paid out

PLSs

A loan stock company

Pretty much the same as a PUT but w/o the governing body.

Also no limitations on gearing.

Also retained income is taxed.

REITs – possible as from May 2013

Company REITs = PLSs

Trust REITs = PUTs

Requirements

Must own (+) R300 million in property

Gearing < 60%

75% + Earnings from rentals/ other indirect property ownership

75% + Earnings must be paid out to investors

Taxation

All s/h distributions are tax deductible (marginal rates, 0 for pensioners)

No CGT on property sale P/L to stimulate liquidity

No securities transfer tax (STT) on REIT shares

“Interest tax exemption no longer available to shareholders?”

Analogy between Property and Bonds

Both have a relatively constant stream of income

Limited uncertainty

Argument is that the gap between Bond yields and Property yields should be quite stable

Page 16: Alternative Investments - Aide Memoire

Property Earnings yield > Bond Yield (risk-return characteristics require this)

Valuing Listed Property

1. DCF Method

Assumption: NOI will grow at a constant rate

Capitalisation rate = discount rate less growth rate = r – g = 𝐶𝑎𝑝 𝑅𝑎𝑡𝑒

𝑬𝒒𝒖𝒊𝒕𝒚 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂 𝑷𝒓𝒐𝒑𝒆𝒓𝒕𝒚 = 𝑷𝑽𝑪𝒐𝒎𝒑𝒂𝒏𝒚 − 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 𝒅𝒆𝒃𝒕

𝐸𝐵𝐼𝑇𝐷𝐴 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 𝑇𝑎𝑥, 𝐷𝑒𝑝𝑟𝑒𝑖𝑐𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛

𝑆𝑡𝑎𝑏𝑖𝑙𝑖𝑠𝑒𝑑 𝑁𝑂𝐼 = 𝐶𝐹 = 𝐸𝐵𝐼𝑇𝐷𝐴 − (𝐶𝑎𝑝𝑒𝑥 + 𝑇𝑒𝑛𝑛𝑎𝑛𝑡 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑎𝑡𝑖𝑜𝑛𝑠 +

𝑐𝑜𝑚𝑚𝑖𝑠𝑠𝑖𝑜𝑛𝑠)

𝑃𝑉𝐶𝑜𝑚𝑝𝑎𝑛𝑦 =𝑆𝑡𝑎𝑏𝑖𝑙𝑖𝑠𝑒𝑑 𝑁𝑂𝐼

𝐶𝑎𝑝 𝑅𝑎𝑡𝑒=

𝐸𝐵𝐼𝐷𝑇𝐴−(𝐶𝑎𝑝𝑒𝑥+𝑇𝐼+𝐶𝑜𝑚𝑚𝑖𝑠𝑖𝑜𝑛𝑠)

𝑟−𝑔

2. Net Asset Value Method

Active Property Portfolio Management

This entails the ongoing improvement of and trading in properties in order to optimise and

increase in returns

Sometimes: the improvement and reinvestment in existing properties may yield higher

returns than buying new properties.

This sort of management is the cornerstone of property investment and is distinct from

tenant management

Tenant management – the ongoing management and support of tenants

Places a role in all forms of rental real-estate, but mostly in the retail sector

Owner tries to optimise the tenant mix Attract profitable tenants and eliminate struggling

tenants

A rather holistic process – must consider the synergies and mutual interactions between

tenants (a little spirit sciencey eiy?)

The question of Anchor Tenants

o Large, often national tenants, who attract shoppers to the centre but often demand

specific lease terms and exclusivity.

Page 17: Alternative Investments - Aide Memoire

Risks vs. Returns of Listed Property

Returns

o Capital Gains – share prices should increase over time as the value of properties held

by the PLS, PUT or REIT increase over time Lowe volatility relative to equity

o Dividends/Distribution – should (theoretically at least) grow in line with the

increased rent (tied to escalation rates)

Risks

o Very vulnerable to changes in the vacancy rate

o Also impacted by bad property management decisions:

Overpaying for a large property (portfolio management)

Losing key tenants (tenant management)

Redevelopment/ Reinvestment in a property that doesn’t work (portfolio

management)

Reporting for Listed Properties

Distribution per linked unit ≡ Dividends per share

Net asset value per linked unit ≡ NAV/ share

Net Tangible value per linked units = Assets – Intangible assets – liabilities per unit

GLA = Gross Lettable Area

Page 18: Alternative Investments - Aide Memoire

Section 2- Mortgage-Backed Securities

Definition of Mortgage: A mortgage is a loan secured by a real estate property.

The borrower is obliged to make a series of payments according to some pre-specified rules.

The lender has the right to foreclose on the loan if the borrower defaults i.e. the lender can

seize the specified property/ other assets for the loan amount

Participants in the Mortgage Market

Mortgage originator

o Not necessarily the bank

o Often just an outsourced firm which helps you obtain the desired loan (in this case

they are an intermediary Home Loan Brokers)

o It can, however, also be the bank.

o Ultimately the loan originator is the bank

Credit bureau

o Suppliers the would-be borrower with a credit score

Mortgage servicer

1. Collects the monthly payments from the borrowers

2. Maintains the records

3. Manages the PMI (private mortgage insurance)

4. Administers escrow balances (collected money used to pay rates and taxes uprfront)

5. Deals with foreclosure if necessary

Mortgage insurer

o Typically the lender requires that the borrower has private mortgage insurance if

LTV > 0.8

o This is to protect the lender in the case of default

o Cost borne by the borrower

Calculation Notes

Level Payment = Fixed rate mortgages

o 𝑃𝑉𝑓𝑖𝑥𝑒𝑑 𝑟𝑎𝑡𝑒 =

𝐶 ×1−(

1

1+𝑦)

𝑛

𝑦 𝑤ℎ𝑒𝑟𝑒 𝑐 𝑖𝑠 𝑡ℎ𝑒 𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑝𝑎𝑦𝑚𝑒𝑛𝑡, 𝑛 𝑖𝑠 𝑡ℎ𝑒 𝑡𝑒𝑟𝑚 𝑖𝑛 𝑚𝑜𝑛𝑡ℎ𝑠

o Interest rates are quoted as nominal annual rates divide by 12 to get the effective

monthly rate

o Assumes: fixed interest for lender, no prepayment, no default (dependent on

property prices?)

o For MBS – assume that they all have the same mortgage rate and maturity

Interest only mortgage

o Pays interest over the life of the loan

o Pays the principal right at the end

Adjustable rate mortgage

o Interest rate is variable and linked to some reference rate

Page 19: Alternative Investments - Aide Memoire

o Interest rate = reference rate + spread

o The rate is adjusted at periodic reset dates floating peg

o They have safety nets

Periodic cap = limits the amount the rate may jump at reset dates

Lifetime cap = limits the amount the rate may jump over its lifetime

Balloon Mortgages

o Generally involves a variable (low) interest rate and then sum lump-sum

o This lump sum is either paid in cash or is refinanced

The risks of investing in mortgages

1. Default risk

2. Interest rate risk – NB generally we assume the entire pool has the same interest rate

Interest rate increases/decreases are both risks

It has implications for refinancing or a decrease in value of the loans

3. Prepayment risk

All about timing and expectations prepayment affects our cash-flow (in both

directions)

4. Liquidity risk

What happens if we can’t get the mortgage/ MBS off our hands?

MBS often trade at a higher value than that of the underlying loans

Definition of MBS: Mortgage backed securities are tradable bonds or debt instruments which are

backed (secured) by residential mortgage loans.

A whole group of mortgages is purchased and formalised using an SPV (to ring-fence legally)

Shares are then sold in that SPV, these shares are bonds whose cash-flows are backed by the

cash-flows from the mortgage repayments

Residential Mortgage-backed security types

1. Mortgage Pass-through Securities (pass-through MBSs)

A security created when 1 + holders of mortgages form a pool of mortgages

They then sell participation certificates in the pool (the securitisation of the

mortgage)

2. Collateralised Mortgage Obligations (CMOs)

Created from (1) “derivative mortgage-backed security

3. Stripped mortgage-based securities

Created from (1) “derivative mortgage-backed security

Commercial Mortgage-backed securities (CMBSs)

1. Mortgage Loans are pooled together/ bundled into an SPV (Special Purpose Vehicle)

SPV’s only asset is the loans.

2. SPV sells fixed income securities which have a claim to the loan repayment cash flows

Generally sold to institutional investors

Page 20: Alternative Investments - Aide Memoire

Parties to CMBSs

I. Pool Originator (≠ Loan originator)

Generally an investment bank

Assembles the pool of loans (then transfers them into the SPV)

Markets them to investors (“road show”+ “prospectus”)

All of this is for a fee ($$$)

II. Issuer

Usually the SPV (the legal entity/ pseudo-company which holds the loans)

III. Master Servicer

Generally, the “maintenance” of the CMBS pool is outsourced.

The master servicer is this outsourced manager

Collects debt, distributes the cash-flows to the investor, maintains records

Also responsible for meeting regulatory requirements

IV. Special Servicer

Only deals with the special circumstances of loans in default and/or foreclosure.

Paid on a commission basis once work is done

Advantage to the loan originator of securitization

No need to actually service the loans (all taken care of by the master servicer)

Immediate cash-flow

o When the loans are sold to SPV through the pool originator immediate and full

cash-flow.

Overcomes capital limitations

o By selling the loans off they reduce their outstanding loans (an asset to them)

given their existing capital base/ reserve

o Can therefore lend more/ originate new loans

o They earn origination fees each time they start the loan cycle again

o $$$

Interest rate spread

o CMBSs often sold at a lower average interest rate higher nominal value/ price

than the original loans.

o They thus gain from this “interest rate spread”

Other reasons for MBS creation (primarily residential)

Diverse investor requirements can be satisfied (speaks more to CMOs)

Creates liquidity in mortgage markets – now loans can be moved

Results in the diversification of risks to the investor now able to invest in 50% of all the

loans instead of 5/10 of the actual loans

It created a new investment class in the saturated debt market

Definition of a pass-through: A pass-through security is a type of MBS where the payments of

interest and principal from the underlying pool of mortgages is passed through to the individuals

who own shares in the pool (generally unencumbered and pro-rata)

Page 21: Alternative Investments - Aide Memoire

Pass-through agencies

o Government agencies can guarantee the timely payment of the principal and/or interest

repayments

o As much as they might guarantee the payments of the MBS, they themselves might default.

Types of pass-throughs

Fully modified pass-through

o Timely payment of both the interest and the principal is guaranteed

o This ensure that you get the right amount at the right time

o Relatively low-risk

Modified pass-through

o Only the timely payment of interest is guaranteed by the agency

o The scheduled principal is of course passed through as it is collected

o There is however a guarantee that all principal will be repaid by some specified

date

Pass-through agencies

1. Government National Mortgage Association (Ginnie Mae)

Backed by the full faith and credit of the US Gov

Default risk free

Security = MBS

All Fully-modified pass-throughs

2. Federal National Mortgage Association (Fannie Mae)

Guaranteed by Fannie Mae and not the US gov

Security = MBS

All Fully-modified pass-throughs

3. Federal Home Loan Mortgage Corporation (Freddie Mac)

Guaranteed by Freddie Mac and not the US gov

Security = participation certificates

Offers modified and fully-modified pass-throughs

4. Private Label Pass-through agencies

Page 22: Alternative Investments - Aide Memoire

Some private banks create pass-throughs in much the same way as the government

agencies

No implicit/explicit guarantees from the US gov

(+) Risk

Cash-flow characteristics

The exact CF = f(underlying mortgages) = principal repayments + interest

CF to security holders = Morgage Payments received − (Servicing + Other Fees)

o Other fees include fees by the guarantor or whoever guarantees the issue

For pass-through securities, the overall coupon rate is known as the pass-through rate

Assumptions

o Pass-through MBSs exhibit negative convexity (embedded call option)

o Valued as if there is no reinvestment risk i.e. valued as if cash-flows could be

reinvested at the coupon rate

Weighted Average Coupon (WAC) Rate (NOMINAL ANNUAL – forms the interest part in the PV equ.)

The pool consists of mortgages with

o Various coupon rates

o Various maturities

o Various levels of creditworthiness

There is some overall risk of pre-payment, captured by the prepayment rate (generally

calculated monthly)

An investor in MBS needs to be able to project this rate to project future CFs and to account

for the pre-payment risk

𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒 = 𝑊𝐴𝐶, 𝑀𝑅𝑖 = 𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝑖

𝑊𝐴𝐶 = 𝑤1 × 𝑀𝑅1 + 𝑤2 × 𝑀𝑅2 + ⋯ + 𝑤𝑛 × 𝑀𝑅𝑛

𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 = 𝑊𝐴𝑀, 𝑇𝑖 = 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑜𝑓 𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝑖

𝑊𝐴𝑀 = 𝑤1 × 𝑇1 + 𝑤2 × 𝑇2 + ⋯ + 𝑤𝑛 × 𝑇𝑛

Prepayment Risk

Prepayment Risk = risk associated with the uncertainty of cash-flows inherent in prepayment

patterns.

Types

1. Contraction Risk – “everything is paid faster than expected”

Mortgage Rates Decline relative to coupon rate

MBS has a fixed coupon rate MBS price (+) [Investor ]

Also, because mortgage holders can now refinance at a lower rate More

prepayment than expected MBS price (-) [Investor ]

Prepaid CF to MBS has to be reinvested at the lower mortgage rates

[Investor ]

2. Extension Risk “everything is paid slower than expected”

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Mortgage Rates Increase relative to coupon rate

MBS has a fixed coupon rate MBS price (-) = [ investor]

Also, because mortgage holders now under pressure, no scope for

refinancing Less prepayment than expected MBS price (+)

= [ investor]

There is less prepayment to be reinvested at the desirable higher rates (than

expected) = [ Investor]

Prepayment and Asset/Liability management

Pension Funds

o Long term liabilities which will need to be met at some later stage

o Because of the long duration of these investments they want to ensure they get

the necessary cash-flows at the right time, particularly they don’t want to get too

much cash too soon (reinvestment risk)

o Liable to contraction risk

Thrift & Commercial banks

o Short term liabilities which need to be met negative consequences when

payments come slower than expected in the MBS

o Liable to extension risk

Prepayment Rates

Conditional Prepayment Rate (CPR)

o We assume that some fraction of the outstanding principal is prepaid each month

o Conditional on the remaining principal balance in the pool

o An annual prepayment rate needs to be converted to monthly rate for

calculations, called the SMM

Single Monthly Mortality rate (SMM)

o (1 − 𝑆𝑀𝑀)12 = 1 − 𝐶𝑃𝑅 → 𝑆𝑀𝑀 = 1 − (1 − 𝐶𝑃𝑅)1

12

Monthly repayments and prepayments (NB. Monthly annuity repayment must be calculated

each month again)

o 𝑃𝑃𝑡 = 𝑃𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑓𝑜𝑟 𝑚𝑜𝑛𝑡ℎ 𝑡

o 𝐵𝐴𝐿𝑡 = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑓𝑜𝑟 𝑚𝑜𝑛𝑡ℎ 𝑡

o 𝑇𝑃𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑟𝑒𝑝𝑎𝑖𝑑 𝑖𝑛 𝑚𝑜𝑛𝑡ℎ 𝑡

o 𝑆𝑃𝑡 = 𝑆𝑐ℎ𝑒𝑑𝑢𝑙𝑒𝑑 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑜𝑓 𝒑𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍 𝑓𝑜𝑟 𝑚𝑜𝑛𝑡ℎ 𝑡

o 𝑃𝑃𝑡 = 𝑆𝑀𝑀(𝐵𝐴𝐿𝑡 − 𝑆𝑃𝑡)

o 𝑇𝑃𝑡 = 𝑃𝑃𝑡 + 𝑆𝑃𝑡

Public Security Agency (PSA) prepayment benchmarks

The PSA has provided a benchmark for the calculation of prepayment rates (often scaled

up/down) As such the normal benchmark is known as 100% PSA

This specifies the CPR as the mortgage reaches maturity

100% PSA

o 0.2% CPR for the first month

Page 24: Alternative Investments - Aide Memoire

o Increasing by 0.2% for the next 29 months

o 6% CPR from 30th month onwards

Factors affecting prepayment behaviour

A. Prevailing mortgage rate

1. The spread between the contract rate (the WAC) and the prevailing mortgage rate

2. The path of interest rates (whether increasing or decreasing)

B. Seasonal Factors

o People tend to move in spring instead of winter they might prepay and refinance

then etc.

C. Type of Loan

o Balloon mortgages, for example, have very specific prepayment behaviours

D. General Economic Activity

o One might argue that employment (+) prepayment (+)

How to mitigate prepayment risk?

Cash-flows from mortgage payments are directed towards different tranches/ bond classes

Results in Collateralised Mortgage Obligations (CMOs)

This doesn’t eliminate the prepayment risk, but redistributes it amongst the tranches

allowing investors to choose based on their risk profile

Definition of Collateralised debt obligations (CDOs): Bond classes which are created by structuring

asset-backed securities into multiple tranches so as to redistribute risk

Definition of CMOs: MBS pass-throughs which have structured into multiple tranches to redistribute

prepayment and default risk

CMOs vs CDOs

CDOs are more general they can hold “any income producing debt”

o E.g. credit cards, vehicle loans, student loans

CMO is a specific type of CDO

CMOs and Tranches

Page 25: Alternative Investments - Aide Memoire

The security cash-flows are bundled into different tranches

Different tranche different risk profile

Senior tranche (AAA)

First claim on all cash-flows

Lowest default risk lower yield

Highest prepayment risk

Each tranche is assessed and rated via a rating agency based on their default risk

Types of CMO’s

1. Sequential Pay tranches

Each tranche is retired sequentially

There are various rules which specify the distribution of CFs

For example:

i. All principal (+ repayment) payments go to tranche 1 until its balance is 0

ii. Then all to tranche 2

iii. Then to tranche 3

iv. …

Observations

i. Tranche 1 has the highest contraction risk and the lowest default risk and

expansion risk

ii. The monthly coupon “interest” is calculated on the month’s opening

principal balance

2. Accrual tranches

a. Interest is paid to each tranche monthly based on outstanding balance

b. One tranche, the Z-bond/ Accrual tranche receives no interest, no principal, but

simply accrues

c. Otherwise it functions much like a sequential pay tranche

d. Z-bond is repaid right at the end Max default risk, Min prepayment risk

3. Floating Rate tranches

Generally, CMO’s are based on fixed rate mortgages

These fixed cash-flows are then divided into (e.g. tranche B to Tranches B1 + B2) two

tranches via. The coupon rate

i. The floating-rate tranche – generally follows some reference rate e.g. LIBOR

𝐹𝑜𝑟 𝑒𝑣𝑒𝑟𝑦 𝑅1.00 𝑜𝑓 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑎𝑐𝑐𝑟𝑢𝑖𝑛𝑔 𝑡𝑜 𝑡ℎ𝑒 𝑡𝑟𝑎𝑛𝑐ℎ𝑒 𝐵,

𝑅1.00 ×𝐵1

𝐵 𝑡𝑜 𝑡𝑟𝑎𝑛𝑐ℎ𝑒 𝐵1 𝑎𝑛𝑑 𝑅1.00 ×

𝐵2

𝐵 𝑡𝑜 𝑡𝑟𝑎𝑛𝑐ℎ𝑒 𝐵2

Floor of the floater = premium added

Cap of the floater = floater valued at LIBOR associated with the floor

of the inverse

ii. The inverse-floating rate tranche – follows the inverse of the ref. rate

Floor of the inverse = 0%, has a LIBOR associated with it

iii. Rule Interest out = interest In

4. Structured interest-only (IO) strips (Stripped MBS)

This tranche receives all the interest

Page 26: Alternative Investments - Aide Memoire

CMO coupon rate < WAC excess interest is paid to the interest only tranche

Principal is repaid at the end No prepayment risk (at least directly)

i. If r is (+) , less prepayment earn the interest for longer

ii. For a variable rate mortgage (+) r (+) CFs (+) discount rate

indeterminate effect

High default risk

5. Principal-only strips (PO) (Stripped MBS)

This bond class receives all the principal

Principal is received whenever it is paid (it is contingent on prepayment rates etc.)

i. When default occurs – if it is Government backed, you still get principal

just no prepayment

Ideally payment received as soon as possible (higher IRR) we would prefer

higher prepayment would prefer the prevailing mortgage rates to (-)

Analysing a CMO tranche

Higher LTV ratio Higher risk higher yield lower price

Higher debt-service-coverage-ratio lower risk lower yield higher price

Tranching and Credit Enhancement

Credit enhancement – occurs when the MBS/CMO’s credit quality is raised above that of the

underlying mortgage pool.

o Because of this, secondary market investors need not have specialised knowledge of

mortgage risks

o This is outsourced to credit rating agencies

Types of Credit Enhancement

o External

Corporate guarantee

A letter of credit

Pool insurance (Ginnie Mae par example)

Bond insurance

o Internal

Subordination

Overcollateralization = + tranches than the principle

Credit Rating

o 3 Major rating industries: Fitch, Moody’s, S&P

o They analyse each tranche to determine the credit rating

o This is done using statistical models (built on historical loan data)

o Each tranche and its creditworthiness are considered individually

Subordination

Underlying mortgage quality

Priority of CF

o Senior tranches higher credit rating

Page 27: Alternative Investments - Aide Memoire

Subordination and Credit Rating

Definition of subordination: The subordination of a tranche is the amount of the total pool’s

principal that disappears before the tranche loses principal size of the principal cushion

below it

Adjusted default probability

Desired Rating Adjustment

AAA 100%

AA 80%

A 60%

BBB 40%

Loss severity (a rate, not an amount)

o Measure of the loan balance vs. property value (like the LTV) in the case of default

o 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑉𝑎𝑙𝑢𝑒 = 𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 − 𝑟𝑒𝑝𝑜𝑠𝑠𝑒𝑠𝑠𝑖𝑜𝑛 𝑐𝑜𝑠𝑡𝑠 − 𝑐𝑎𝑟𝑟𝑦 𝑐𝑜𝑠𝑡𝑠 = 𝑅𝑉

o 𝑝 = 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑢𝑛𝑑𝑒𝑟 𝑠𝑡𝑟𝑒𝑠𝑠𝑒𝑑 𝑐𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛𝑠

o 𝛼 = 𝑎𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡 𝑡𝑜 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑝𝑟𝑜𝑏.

o 𝑙 = 𝐿𝑜𝑠𝑠 𝑆𝑒𝑣𝑒𝑟𝑖𝑡𝑦

o 𝛽 = 𝐿𝑜𝑎𝑛 𝑏𝑎𝑙𝑎𝑛𝑐𝑒

o 𝑙 =𝛽−𝑅𝑉

𝛽

Required subordination

o 𝑅𝑆 = 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑠𝑢𝑏𝑜𝑟𝑑𝑖𝑛𝑎𝑡𝑖𝑜𝑛

o 𝐸(𝐿𝑜𝑠𝑠) = 𝑝 × 𝑙 × 𝛽

o 𝑹𝑺 = 𝑬(𝑳) × 𝜶

o = 𝑝 × 𝑙 × 𝛽 × 𝛼

o = 𝑝 ×𝛽−𝑅𝑉

𝛽 × 𝛽 × 𝛼

o = 𝑝 × (𝛽 − 𝑅𝑉) × 𝛼

Page 28: Alternative Investments - Aide Memoire

Section 3- Credit Risk

Definition of Credit Risk: This is the risk of default, the risk of counterparty not paying back

Who cares about credit risk?

Suppliers (who supply on credit)

Creditors

Investors (i.e. you care about whether you get your bond coupon payments)

YTM is an indicator of this risk

Expected value of discounted CF’s under Q

𝑃𝑟𝑖𝑐𝑒 𝐴𝑠𝑠𝑒𝑡 = 𝐸𝑄[𝑃𝑉 (𝑢𝑠𝑖𝑛𝑔 𝑟𝑖𝑠𝑘𝑙𝑒𝑠𝑠 𝑟𝑎𝑡𝑒) 𝑜𝑓 𝑎𝑙𝑙 𝑎𝑠𝑠𝑒𝑡 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑠]

𝐶 = 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒

𝑃 = 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑

𝑅 = 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 (% 𝑜𝑓 𝑝𝑎𝑟)

𝑃𝑉𝐷𝑡 = 𝑃𝑉 𝑜𝑓 𝐶𝐹𝑠 𝑖𝑠 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡

o 𝑒. 𝑔. 𝑃𝑉𝐷1.5 = 𝑠𝑒𝑚𝑖−𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛

(1+𝑟

2)

+𝑠𝑒𝑚𝑖−𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛

(1+𝑟

2)

2 + 𝑅×𝑃

(1+𝑟

2)

3

o 𝐻𝑒𝑟𝑒 𝑟 = 𝑟𝑓 = 𝑟𝑖𝑠𝑘𝑙𝑒𝑠𝑠 𝑟𝑎𝑡𝑒 = 𝐵𝐸𝑌 (𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙)

𝜋 = 𝑢𝑛𝑐𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑟𝑖𝑠𝑘 𝑛𝑒𝑢𝑡𝑟𝑎𝑙 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡

𝑃𝑉𝐷𝑁 = 𝑃𝑉 𝑜𝑓 𝐶𝐹𝑠 𝑖𝑓 𝑛𝑜 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 = Bond formula (remember principal)

𝑃𝑟𝑖𝑐𝑒 = ∑ 𝜋 × 𝑃𝑉𝐷𝑡 + (1 − ∑ 𝜋) × 𝑃𝑉𝐷𝑁𝑛𝑡=1

o Price and PVDs and PVDN can all be immediately calculated

o From this we can calculate the risk neutral probability 𝜋

Default Rates

The conditional default rates of good credit rated companies increase over time. Why?

o If you’re at 0 it can only get worse?

o You’re only rated at the beginning forecasting is only valid for the immediate

future

The conditional default rates of bad credit rated companies decrease over time. Why?

o Informational asymmetries at the beginning all people in the CCC are regarded

as the same sort of borrower, but some are in fact good and others are bad.

o As time goes on only the good remain default prob. Decreases

Credit Default Swaps (CDS)

This can be seen as an insurance product which insures against the risk of default of a bond

(known as the reference obligation) issued by a particular company (the reference entity).

A kind of credit derivative

Credit Events

The firm goes bankrupt

The firm fails to pay a coupon

Page 29: Alternative Investments - Aide Memoire

The firm restructures the terms of the debt

Structure of a CDS

The protection seller increases their exposure to credit risk (the event in the underlying)

Payoff Methods

o Delivery – the protection buyer swaps the defaulted bond with the protection seller

for its par value

o Cash Settlement – the protection buyer keeps the defaulted bond

Gets a cash settlement of (1 − 𝑅) × 𝑃 from the protection seller

Assumption: the buyer pays his periodic payment even at the moment of

the credit event (default) but not after

Payment

o CDS spread = periodic payment = 80 bps (basis points) x Par Value

NB: annualized amount (nominal)

o 100 bps = 1 percent

o Dealer buy-at-the-bid, Dealer sells-at-the-ask

o Bid/ask e.g. 50/70

USE of CDSs

Shift credit risk – e.g. buy protection

Diversify credit risk – e.g. Buy protection on one loan (the one that you have) and sell on

another (not necessarily one you have a loan on)

Setting the spread

𝐸𝑄[𝑃𝑉𝑟𝑓 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠] = 𝐸𝑄[𝑃𝑉𝑟𝑓 𝑜𝑓 𝑝𝑎𝑦𝑜𝑓𝑓𝑠 ]

𝑃𝑎𝑦𝑜𝑓𝑓 = (1 − 𝑅) × 𝑃

𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑤 × 𝑃

Under the equation we drop 𝑃

∑ 𝜋𝑡𝑤 ×

1−( 1

1+ 𝑟𝑓2

)

𝑡

𝑟𝑓2

𝑛𝑡=1 + 𝜋𝑛𝑑𝑤 ×

1−( 1

1+ 𝑟𝑓2

)

𝑛

𝑟𝑓2

= ∑ 𝜋𝑡1−𝑅

(1+𝑟𝑓2

)𝑡

𝑛𝑡=1

o 𝑤ℎ𝑒𝑟𝑒 𝑡, 𝑛 & 𝑤 𝑎𝑟𝑒 𝑠𝑒𝑚𝑖 − 𝑎𝑛𝑛𝑢𝑎𝑙 , 𝑟𝑓 = 𝐵𝐸𝑌