Spring 2019 exams and solutions (1)

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Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 1 Sample exams Some notes about the sample exams:  The topics covered and sequence vary from year to year, so you may not be able to do all of the problems from the past exams, or you may be able to do some midterm 1 and some midterm 2 problems, but not all, before the first midterm. I will try to give you guidance before the exams as to what you should expect to be able to do.  The solutions I give are much lengthier than what I expect from you. My solutions are more complete than would be necessary for you because they are designed for you to learn from.  Many of the old exams are time-constrained. You should practice taking them with the clock running so you get a sense of how quickly you need to work.  Also note that the length of the exam varies from year to year. Your exam may not have the same amount of time allotted as in prior tests.  If the tax code has changed over time, old exams may reflect previous tax laws. The midterms without solutions are at the front of this file. The solutions are at the end.

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 2 Real Estate Finance: Investment and Analysis Spring 2019 Midterm Exam I Part I. (33 points total.) Answer whether each of the statements in square brackets is true, false, or uncertain. Your grade depends entirely upon your explanation. Be thorough, address all relevant portions of the statement, and explain why they do or do not influence your answer. Providing only one justification for your answer when several may apply will be insufficient for full credit. Grossly irrelevant information will be penalized with a loss of points. 1) (11 points.) [Percentage rent clauses in retail mall leases are used to ensure that the stores that sell more pay higher rent.] 2) (10 points.) [Because cap rates are equal to NOI/V, when NOI goes up, cap rates rise.] 3) (12 points.) You own an office property in Atlanta, Georgia that you plan to hold for 12 more years, and then sell. The building has five tenants, each occupying 20 percent of the rentable square feet on staggered-five year leases, so one lease expires each year for the next five years. Due to the favorable credit markets, you are currently in the process of obtaining a new mortgage. You have two choices of financing: an interest-only mortgage or a mortgage that amortizes over 10 years. Both loans are 80% LTV, have the same 6.5% interest rate, are non- recourse, require the same fees, and have 8-year loan terms. [The amortizing loan is a riskier choice of financing for you.]

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 3 Part II. (12 points total.) Mortgage calculation question. Please show your work. 4) (12 points.) You own a stabilized apartment property that generated $200,000 in NOI this year. You have an existing mortgage with an outstanding balance of $2,400,000, and you are contemplating refinancing it with a new loan that has a 6.5% interest rate, annual payments, and will amortize over 30 years. The new lender requires 80% LTV/1.25 DSCR and will use a 7.0% cap rate to value properties such as yours. How much would your NOI have to increase before taking out the new loan in order for the new mortgage to generate enough proceeds to pay off the entire existing mortgage?

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Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 4 Part III. (31 points total.) You must show your work in order to receive partial credit. Feel free to re-use calculations from previous questions rather than rewriting them. You are considering purchasing a warehouse property near Philadelphia. The warehouse has 40,000 square feet, 100% occupied by one tenant. The property has a ground lease, so you would be purchasing the leasehold estate. Here is the key information about the property, your financing, and your tax situation:  Investment: $7,000,000 acquisition price. Assume the purchase occurs at the end of 2019 and the first year of positive cash flows is 2020. Assume all cash flows are at the end of the year.  Land lease: There is ground rent of $200,000 per year, no escalations, with 75 years remaining on the ground lease.  Sale: 10-year holding period. Assume the exit cap rate will be 5.0%. There are no sales expenses.  Tenant’s Lease: Rent is $640,000 per year, triple-net, no escalations, with 12 years remaining in the lease term. Market rents are expected to remain flat.  Replacement reserve: $24,000 per year, assume you spend it right before sale.  Financing: $3,500,000 loan amount. 6.0% interest rate, 30-year amortization schedule, 10-year term, annual payments, non-recourse, non-assumable, no fees.  Taxes: 29.6% income tax rate; 20% capital gains tax rate; 25% capital gains depreciation recapture tax rate; 39 year depreciation lifetime. Your tax attorney tells you that the depreciable basis is your full purchase price: $7,000,000. Assume you can offset tax losses against taxable income on other projects. 5) (12 points.) Compute NOI, BTCF, and ATCF during operations in 2020 (show all steps and all your work). 6) (9 points.) Compute BTCF and ATCF at sale at the end of 2029 (show all steps and all your work). 7) (10 points.) Do you think the going-out (exit) cap rate is a reasonable assumption based on the information given in the problem? Why or why not? Now consider two alternative cases: One where market rent is expected to grow over time, and another where the market rent is expected to decline. How does your answer change in each of those two cases, if at all?

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 5 Real Estate Finance: Investment and Analysis Spring 2019 Midterm Exam II What follows is a mix of calculation questions and True/False/Uncertain questions. In both cases, you must show your work in order to receive partial credit. For the True/False/Uncertain questions, answer whether each of the statements in square brackets is true, false, or uncertain. Your grade depends entirely upon your explanation. Be thorough, address all relevant issues, and explain why they do or do not influence your answer. Providing only one justification for your answer when several may apply will be insufficient for full credit. Grossly irrelevant information will be penalized with a loss of points. Part I: (25 points total.) REITs. You must show your work in order to receive partial credit. 1. (15 points.) Chesapeake Home Apartment REIT (CHAR) is a multifamily REIT. CHAR’s effective gross income is $750 million and operating and capital expenses total $400 million. This year’s depreciation, excluding any depreciation on new capital expenditures, is $382 million. (You can assume that the depreciation lifetime for any new capital spending is 27.5 years.) CHAR is financed with interest-only bonds, and this year’s interest will be $180 million. (No bonds will mature this year.) Assuming CHAR does not want to pay less than 100 percent of net income as dividends and would like to retain at least $100 million dollars of their cash flow this year after paying dividends, what is the most they can spend on capital expenses? Please show all calculations necessary to demonstrate how your answer yields the retained cash goal. 2. (10 points.) [True/False/Uncertain, and why:] [To qualify as a REIT, a company and all its subsidiaries must satisfy the “income test” and the “asset test”.] Part II: (30 points.) CMBS. You must show your work in order to receive partial credit. As the head of the mortgage group at a major commercial bank, you have decided to take advantage of the rebounding CMBS market to originate some mortgages with the intent of securitizing them. You have lined up $1.5 billion of interest-only mortgages with 6 year terms. After consulting the rating agencies and potential bond investors, you have concluded that the profit-maximizing tranching of the CMBS bonds would look like this: Required Tranche Rating Principal yield Coupon Sale value A AAA 420 million 4% 4% B A 855 million 6% 6%

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 6 C B 225 million 14% 11% IO 10% If all mortgages pay debt service according to schedule, each tranche will pay interest-only for 6 years and return principal at the end of the 6 th year. All payments are annual, at the end of the year. 3. (7 points.) What will be the sale prices of tranches A, B, and C? [You need show your full calculations only for tranche C.] 4. (13 points.) What would the weighted average coupon interest rate on the pool of mortgages need to be in order to cover $15 million of CMBS structuring costs and still generate a $45 million profit? 5. (10 points.) [True/False/Uncertain, and why:] Now suppose a mortgage in the pool goes into delinquency – the first mortgage in the pool to do so. The mortgage has a $50 million outstanding principal balance. In this instance, an investor in tranche B [would prefer that the same entity owned both tranche C and the special servicer rather than the alternative of separate ownership.] Here is a reprint of the tranching: Required Tranche Rating Principal yield Coupon Sale value A AAA 420 million 4% 4% B A 855 million 6% 6% C B 225 million 14% 11% IO 10% Part III. (20 points total.) Other topics. Answer whether each of the statements in square brackets is true, false, or uncertain. 6. (10 points.) According to the Smith Model, [when there is any vacancy in a building, the landlord should lower the rent] . 7. (10 points.) You are the CEO of a struggling software firm in the San Francisco Bay area. The firm owns – and occupies 100 percent of – its headquarters building. Your real estate consultant has proposed that you engage in a sale-leaseback with a REIT to free up capital. The REIT has given you two leasing options:

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Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 7 i) One lease would have a 20-year term with a constant nominal rent that reflects your best guess of future rent growth. The penalty for exiting the lease early would be two years of rent, and subleasing would not be allowed. ii) The REIT also offered a “tenant-at-will” lease, where you could cancel at any time with no penalty. That lease would adjust annually based on the market rent. Your consultant has calculated that the present discounted cost of the 20-year lease would be 10% lower than the tenant-at-will lease over the 20-year time period, taking taxes and all other expenses into account. Due to your capital needs, continuing to own the property is not an option. Based on this information, [you should do the sale-leaseback with the 20-year lease.]

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 8 SOLUTIONS

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 9 Real Estate Finance: Investment and Analysis Spring 2019 Midterm Exam I – SOLUTIONS Part I. (32 points total.) Answer whether each of the statements in square brackets is true, false, or uncertain. Your grade depends entirely upon your explanation. Be thorough, address all relevant portions of the statement, and explain why they do or do not influence your answer. Providing only one justification for your answer when several may apply will be insufficient for full credit. Grossly irrelevant information will be penalized with a loss of points. 1) (10 points.) [Percentage rent clauses in retail mall leases are used to ensure that the stores that sell more pay higher rent.] False. Stores in retail malls that sell more do not necessarily pay higher rent and could even pay lower rent. At first blush, the evidence for this is that 82 percent of mall stores are not in the “percentage” range of percentage rent. How could percentage rent lead to high-sales stores paying higher rent if stores are on the minimum rent portion of the rent schedule? The explanation for this is that stores who bring in foot traffic to a mall are rewarded with lower base rent and low or no percentage rent. That is because percentage rent is a disincentive for a store to increase sales and a mall landlord recognizes that stores that generate foot traffic enhance the entire mall and should not be deterred from that. However, the tenants do want the landlord to have a stake in the performance of the mall, so stores that do not generate their own foot traffic are charged higher base rent and more percentage rent. Sales at those stores are wholly dependent on the foot traffic already at the mall, and so if they pay percentage rent the landlord earns more when the mall is well-run, and deterring effort by those stores is not harmful to other stores at the mall. Thus, a high sales store that generates foot traffic for the mall might pay low rent and a low-sales store that benefits from the foot traffic already at the mall may pay high rent. In fact, the very stores that sell the most might have the lowest rents because they are generating foot traffic. That last point depends on what the store is selling. (For example, high price-point items (such as jewelry) can generate lots of dollars of sales without many shoppers.) The answer to this question followed straight from the class discussion. You got full credit simply by explaining how percentage rent aligns the incentives between landlord and tenant and thus should have an inverse relationship between percentage rent and foot-traffic generation, not a positive relationship between total rent and sales. To get all 10 points, you needed to explain the reasoning, not just assert that there is an incentives issue. You could get up to 8 points by coming up with some other explanation, such as risk-sharing. “Risk sharing” says that in boom times, stores earn outsized returns and thus landlords would get some of that (and vice versa). To get all 8 points, you would need to explain that, because most tenants are in the base rent range, percentage rent means that only the stores that are really successful would pay more rent.

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Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 10 Or you could have asserted that landlords raise the base rent of tenants in the percentage rent range, so percentage rent gets them to reveal. We gave up to 6 points simply for defining a percentage rent contract (there is a base rent and an overage component that is a percentage of sales). To get all 6 points, you needed to demonstrate that you understood that percentage rent increased with sales. 2) (10 points.) [Because cap rates are equal to NOI/V, when NOI goes up, cap rates rise.] False. The cap rate is a valuation tool that relates stabilized NOI to the purchase price (or initial valuation). It is not a measure of current yield. Instead, when NOI goes up, V also goes up (if cap rates are constant). If anything, steadily growing NOI would yield lower cap rates, as property investors would pay more for properties relative to current NOI because they expect growth in future NOI. A clear statement of the full answer got you the 10 points. Many of you noted that other factors besides an increase in NOI can affect cap rates, thus rejecting the second half of the statement. However, if you did not explicitly address the first half (rejecting the word “because”) by saying that V=NOI/c, you could get at most 7 points. (Many answers were of the form: “If NOI goes up and V is constant, then cap rates go up. But many factors affect V, such as interest rates, growth, and risk, so the statement might not be true because we don’t know what the net effect on V will be.” That was a 7-point answer because it did not clearly state that if NOI goes up, V is not going to be constant because V = NOI/c.) Some of you just said that cap rates are determined by i, b, and g. That was good for up to 4 points, depending on the quality of your explanation. 3) (12 points.) You own an office property in Atlanta, Georgia that you plan to hold for 12 more years, and then sell. The building has five tenants, each occupying 20 percent of the rentable square feet on staggered-five year leases, so one lease expires each year for the next five years. Due to the favorable credit markets, you are currently in the process of obtaining a new mortgage. You have two choices of financing: an interest-only mortgage or a mortgage that amortizes over 10 years. Both loans are 80% LTV, have the same 6.5% interest rate, are non- recourse, require the same fees, and have 8-year loan terms. [The amortizing loan is a riskier choice of financing for you.] Answer: Uncertain. The interest-only mortgage has a lower required debt service payment and hence less cash flow risk but it has higher duration risk due to its much higher balloon payment. ‐ Cash flow risk: Because the debt service for the amortizing mortgage includes principal and interest, the debt service payment for an amortizing mortgage is higher than for an

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 11 interest-only loan with the same interest rate. Since the amortization period for this particular mortgage is so short – only 10 years – the debt service payment for that loan is extra high. Calculations weren’t necessary for this problem, but a quick example calculation would show that the debt service payment for the amortizing mortgage is more than twice as large as the interest-only mortgage. (For example, with a $10mm loan amount, the interest-only debt service would be $650,000/year and the amortizing debt service would be $1,391mm/year). One can reasonably assume that initial NOI would be enough to cover either the debt service payment, but if the real estate market gets weaker and tenants pay ever-lower rents as leases come up for renewal, you are more likely to not have enough NOI to cover the debt service if you chose the amortizing mortgage. ‐ Duration mismatch: Both loans have a 8-year term , but there is a big difference between them in what happens in year 8. The interest-only mortgage has a bullet payment whereas the amortizing loan would have little balance. (Back to the example: If you borrowed $10mm, the interest-only loan would have $10mm due and the amortizing loan would have $2.5mm due.) Hence, if the real estate market gets worse, over the next 8 years, you might not be able to refinance the interest-only mortgage but you almost certainly would be able to come up with enough debt to refinance the amortizing loan. Since you intend to hold the property for 12 years, you have a duration mismatch and could lose the property. (Note: You also could have made a completely valid argument that if the real estate market had taken a permanent turn for the worse, you could reduce risk by having the option to put the property back to the bank for $10mm.) We broke the grading up into four components: Recognizing that amortizing loans required higher debt service than interest-only loans; that the amortizing loan in this problem has a much lower bullet payment at term; that the amortizing loan yields much higher risk of cash flow default if there is cash flow risk (due to temporary vacancy due to tenant turnover or permanently lower cash flow due to tenants leasing at lower rental rates); and that the interest-only loan yields a much higher risk of term default if there is property value risk (that wouldn’t come from temporary vacancy – the explanation would be leases resetting to lower rental rates). 3 points were allocated to each one, and you could get anywhere from 0 to 3 points in each category depending on the quality of your answer.

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 12 Part II. (12 points total.) Mortgage calculation question. Please show your work. 4) (12 points.) You own a stabilized apartment property that generated $200,000 in NOI this year. You have an existing mortgage with an outstanding balance of $2,400,000, and you are contemplating refinancing it with a new loan that has a 6.5% interest rate, annual payments, and will amortize over 30 years. The new lender requires 80% LTV/1.25 DSCR and will use a 7.0% cap rate to value properties such as yours. How much would your NOI have to increase before taking out the new loan in order for the new mortgage to generate enough proceeds to pay off the entire existing mortgage? We gave up to 5 points for each half. For the LTV test, you got 2 points for calculating how much the property value would need to be at the time of refinancing (1 point for trying, the other for getting it right), 2 points for converting that property value to the NOI needed, and the last point for computing growth. For the DSCR test, you got 2 points for computing the mortgage payment on the new mortgage amount, 2 points for using the DSCR to convert that debt service payment to the NOI needed, and 1 point for computing the growth in NOI. The last two points were for choosing the bigger of the two. LTV test: Old mortgage balance: 2,400,000 Property value needed: 3,000,000 (Old balance / LTV) NOI needed to get that valu 210,000 (Property value x cap rate) % Growth in NOI needed: 5.0% $ Growth in NOI needed: 10,000 DSCR test: Old mortgage balance: 2,400,000 New mortgage amount: 2,400,000 (Equals balance on existing mortgage) Debt service: 183,786 (N=30, I=0.065, PV=2,400,000) Required DSCR: 1.25 NOI that covers DSCR: 229,732 (Debt service x DSCR) % Growth in NOI needed: 14.9% $ Growth in NOI needed: 29,732 Since the most limiting condition binds, NOI will need to grow by 14.9%

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Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 13 Part III. (31 points total.) You must show your work in order to receive partial credit. Feel free to re-use calculations from previous questions rather than rewriting them. You are considering purchasing a warehouse property near Philadelphia. The warehouse has 40,000 square feet, 100% occupied by one tenant. The property has a ground lease, so you would be purchasing the leasehold estate. Here is the key information about the property, your financing, and your tax situation:  Investment: $7,000,000 acquisition price. Assume the purchase occurs at the end of 2019 and the first year of positive cash flows is 2020. Assume all cash flows are at the end of the year.  Land lease: There is ground rent of $200,000 per year, no escalations, with 75 years remaining on the ground lease.  Sale: 10-year holding period. Assume the exit cap rate will be 5.0%. There are no sales expenses.  Tenant’s Lease: Rent is $640,000 per year, triple-net, no escalations, with 12 years remaining in the lease term. Market rents are expected to remain flat.  Replacement reserve: $24,000 per year, assume you spend it right before sale.  Financing: $3,500,000 loan amount. 6.0% interest rate, 30-year amortization schedule, 10-year term, annual payments, non-recourse, non-assumable, no fees.  Taxes: 29.6% income tax rate; 20% capital gains tax rate; 25% capital gains depreciation recapture tax rate; 39 year depreciation lifetime. Your tax attorney tells you that the depreciable basis is your full purchase price: $7,000,000. Assume you can offset tax losses against taxable income on other projects. 5) (12 points.) Compute NOI, BTCF, and ATCF during operations in 2020 (show all steps and all your work).

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 14 We deducted 2 points for a major conceptual error (not knowing how to compute principal or interest, or missing an item) and 1 point for a calculation error. 1 2020 Tenant NNN rent: 640,000 Ground rent: ‐200,000 Net operating income: 440,000 Replacement reserve ‐24,000 NOI after reserves: 416,000 Debt service ‐254,271 Before-tax cash flow 161,729 Principal repayment 44,271 Depreciation (structure) ‐179,487 Replacement reserve 24,000 Taxable income 50,513 Tax rate 0.296 Tax bill ‐14,952 Before-tax cash flow 161,729 Tax bill ‐14,952 After-tax cash flow 146,777 Calculations: Debt service: Depreciation: [N] 30 Purchase price: 7,000,000 [I] 0.06 Land share: 0 [PV] 3,500,000 Structure value: 7,000,000 push [PMT] ‐254,271 Lifetime: 39 Depreciation amount: 179,487 Amortization: 2020 Principal ‐44,271 Interest ‐210,000

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 15 6) (9 points.) Compute BTCF and ATCF at sale at the end of 2029 (show all steps and all your work). We deducted 2 points for a major conceptual error (not knowing how to compute principal or interest, or missing an item) and 1 point for a calculation error. 7) (10 points.) Do you think the going-out (exit) cap rate is a reasonable assumption based on the information given in the problem? Why or why not? Now consider two alternative cases: One where market rent is expected to grow over time, and another where the market rent is expected to decline. How does your answer change in each of those two cases, if at all? 10 2029 Gross sale price 8,320,000 Deductible sales exp. 0 Net sale price 8,320,000 Mortgage balance ‐2,916,471 BTCF at sale 5,403,529 Tax bill at sale ‐664,718 ATCF at sale 4,738,812 Net sale price 8,320,000 Original cost ‐7,000,000 Capital improvements ‐240,000 Appreciation component 1,080,000 Appreciation tax rate 0.2 Appreciation tax 216,000 Accumulated depreciatio 1,794,872 Depreciation tax rate 0.25 Depreciation tax 448,718 Calculations: Balance remaining in year 10: Sale price: [N] 20 NOI in 2030: 416,000 [I] 0.06 Exit cap rate: 5.0% [PMT] ‐254,271 Gross sale price: 8,320,000 push [PV] 2,916,471

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Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 16 The exit cap rate in 10 years is assumed to be 5.0%. The going-in cap rate (416,000/7,000,000) is 5.9%. Not much is projected to happen between now and a decade from now. Ordinarily, one would expect the cap rate to increase between purchase and sale, simply because of greater uncertainty about the future, or it being an older building, and so on. In this problem, that uncertainty is magnified because the tenant’s lease will be up for renewal shortly after the leasehold estate is sold. That suggests that the buyer will be faced with considerable uncertainty about their cash flows (even though you expect rents to be flat, you cannot be certain) and will reduce their offer price. That would yield a higher cap rate at sale, not a lower one. (Note: Some of you said “sale cap rates should be higher because there is a land lease”. That is true… but the purchase cap rate also should have taken the land lease into account. Hence, the land lease should not affect the change in cap rates between purchase and sale except, perhaps, that the increase in cap rates should be somewhat bigger due to the amplification of the tenant risk due to the ground lease obligation.) However, suppose we expected market rents to trend upwards. To the next buyer, the NOI is not stabilized because the tenant is about to change or renew to a new rent. If market rents had been steadily growing, then this property’s rents will be significantly below-market at the time of purchase. The buyer would pay a low cap rate relative to the in-place rents on the expectation that s/he would quickly reset the rents to the (higher) market level shortly after purchase. That could justify the low exit cap rate assumed in this pro forma. Conversely, if market rents were expected to decline, the assumption of a low exit cap rate is even more unreasonable. Note that the key element here is that the rent will reset to market at the time of lease expiration (2 years), so the current NOI is not reflective of the NOI that is soon to be earned on the property. You received up to 6 points for explaining that, in general, cap rates should increase between purchase and sale, with more points for a better explanation. You received up to 4 more points for your analysis of rent growth and your explanation of how that could justify the decline in cap rate – 3 points for the case of rent growth and 1 point for the case of rent declines. You received no points for saying that cap rates are higher with land leases, unless you got fewer than 3 points otherwise – in which case your land lease explanation could get you 3 points.

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 17 Real Estate Finance: Investment and Analysis Spring 2019 Midterm Exam II -- SOLUTIONS What follows is a mix of calculation questions and True/False/Uncertain questions. In both cases, you must show your work in order to receive partial credit. For the True/False/Uncertain questions, answer whether each of the statements in square brackets is true, false, or uncertain. Your grade depends entirely upon your explanation. Be thorough, address all relevant issues, and explain why they do or do not influence your answer. Providing only one justification for your answer when several may apply will be insufficient for full credit. Grossly irrelevant information will be penalized with a loss of points. Part I: (25 points total.) REITs. You must show your work in order to receive partial credit. 1. (15 points.) Chesapeake Home Apartment REIT (CHAR) is a multifamily REIT. CHAR’s effective gross income is $750 million and operating and capital expenses total $400 million. This year’s depreciation, excluding any depreciation on new capital expenditures, is $382 million. (You can assume that the depreciation lifetime for any new capital spending is 27.5 years.) CHAR is financed with interest-only bonds, and this year’s interest will be $180 million. (No bonds will mature this year.) Assuming CHAR does not want to pay less than 100 percent of net income as dividends and would like to retain at least $100 million dollars of their cash flow this year after paying dividends, what is the most they can spend on capital expenses? Please show all calculations necessary to demonstrate how your answer yields the retained cash goal. Answer: Solve for the exact amount of capital expenses that would let CHAR retain $100 million. You did a problem very similar to this one in the practice problem set. You manipulate expenses between operating and capital expenses to affect your reported taxable income.

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 18 If you basically set this up correctly and just made calculation errors, we subtracted one point per error. If you missed a line or misunderstood a concept (e.g. didn’t know how to do Capex depreciation), we subtracted two points per error. If you knew how to set up the cash flow lines but didn’t know how to set up and solve in terms of “C”, we started you with 5 points and added back some points for every part you showed you could solve. 2. (10 points.) [True/False/Uncertain, and why:] [To qualify as a REIT, a company and all its subsidiaries must satisfy the “income test” and the “asset test”.] Answer: False. While it is true that, to qualify as a REIT, a company must meet the asset and income tests – have at least 75% of its assets invested in real estate assets, cash, or government securities and at least 75% of its gross income derived from rents, mortgage interest, or gains from the sale of real estate – it is not true that its subsidiaries also have to meet those tests. In particular, a taxable REIT subsidiary does not count against those tests as long as the subsidiary does not exceed 20% of the REIT’s assets. Effective Gross Income: 750 Given. Operating Expenses: -(400-C) Given. Net operating income: 350+C Calculate! Capital expenses: -C Solve for this. Debt service: -180 Given. Before-tax cash flow: 170 Calculate! Principal: 0 Given. Capital expenses: C Solve for this. Depreciation: -382 Given. Current CapEx depreciation: -C/27.5 Lifetime is given. Taxable income: -212+(26.5/27.5)C Calculate! Payout ratio: 100% Given. Dividend payout: 212-(26.5/27.5)C Calculate! Free cash flow: 382-(26.5/27.5)C Calculate! You want to retain: 100 382-(26.5/27.5)C =100 -(26.5/27.5)C =-282 C =292.642 Here are the values you would have found: Maximum capital expenses 292.6 Taxable income: 70.0 Dividend: 70.0 Free cash flow: 100.0

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Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 19 We gave (up to) 10 points for your explanation of the taxable REIT subsidiary point. If you missed that, you could get (up to) 5 points simply by describing the asset and income tests (depending on the quality of the explanation). Part II: (30 points.) CMBS. You must show your work in order to receive partial credit. As the head of the mortgage group at a major commercial bank, you have decided to take advantage of the rebounding CMBS market to originate some mortgages with the intent of securitizing them. You have lined up $1.5 billion of interest-only mortgages with 6 year terms. After consulting the rating agencies and potential bond investors, you have concluded that the profit-maximizing tranching of the CMBS bonds would look like this: Required Tranche Rating Principal yield Coupon Sale value A AAA 420 million 4% 4% B A 855 million 6% 6% C B 225 million 14% 11% IO 10% If all mortgages pay debt service according to schedule, each tranche will pay interest-only for 6 years and return principal at the end of the 6 th year. All payments are annual, at the end of the year. 3. (7 points.) What will be the sale prices of tranches A, B, and C? [You need show your full calculations only for tranche C.] Answer: The A and B tranches are priced to sell at par. Tranche: Coupon: Sale price: A 4% 420,000 B 6% 855,000 The coupon interest rate on the C tranche will be 11.0%. What will be the sale price of tranche C? Interest component: Interest: 6 years of 11.0% coupon, discounted at 14.0% PV(interest): 96,245 Bullet payment: Principal paid back 6 years in the future, discounted PV(principal): 102,507 Total sale price: 198,751

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 20 You lost 1 point for each calculation error and 2 points for a “conceptual” error, with 4 points allocated to getting the PV of the interest correct and 3 points allocated to getting the PV of the principal repayment correct. 4. (13 points.) What would the weighted average coupon interest rate on the pool of mortgages need to be in order to cover $15 million of CMBS structuring costs and still generate a $45 million profit? Answer: The profit is the sale value of the tranches less the structuring costs and principal lent. Thus the total value of all the tranches needs to equal $1.56 billion. Since you now know the value of all the tranches except for the IO, you need to back out the value of the IO as the residual of $1.56 billion less the values of tranches A-C. Then you need to figure out how much interest must be paid to the IO in order to yield that value. Once you have that, you need to figure out how much interest would have to come from the pool of mortgages in order to have enough interest to pay coupon interest to tranches A-C and the IO. Step 1: How much do we need to sell the tranches for? Original loan amount plus costs plus ARB: Goal: 1,560,000 Step 2: Net out A, B, and C tranches. A tranche at par: 420,000 B tranche at par: 855,000 C tranche: 198,751 Total A+B+C: 1,473,751 Goal: 1,560,000 Difference needed: 86,249 This means that we need to sell the IO for 86,249. Step 3: What interest payment makes the IO worth $86,249? 86,249 = PV(IO interest, 6 years, 10.0% discount rate) Solve for the payment: 19,803 Step 4: What interest rate do we need to charge on the principal to generate enough coupon interest? Coupon interest in each tranche: Tranche: Principal: Coupon: Interest: A 420,000 4% 16,800 B 855,000 6% 51,300 C 225,000 11% 24,750 IO 0 19,803 Total interest needed: 112,653 As a percent of collateral: 7.5%

Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 21 You got 2 points for step 1; 4 points for step 2; 4 points for step 3, and 3 points for step 4. (And if what you wrote down did not fit neatly into our rubric, we did our best to match up the concepts.) You lost 1 point for each calculation error and 2 points for a conceptual error. Common errors were: (a) using $60 million as the amount needed to be raised (-3 in Step 2); (b) using 14% instead of 10% for Step 3 (-2); (c) simply adding $60 million to the coupon payments (-10); (d) ignoring the IO strip and increasing the C tranche coupon (-7). 5. (10 points.) [True/False/Uncertain, and why:] Now suppose a mortgage in the pool goes into delinquency – the first mortgage in the pool to do so. The mortgage has a $50 million outstanding principal balance. In this instance, an investor in tranche B [would prefer that the same entity owned both tranche C and the special servicer rather than the alternative of separate ownership.] Here is a reprint of the tranching: Required Tranche Rating Principal yield Coupon Sale value A AAA 420 million 4% 4% B A 855 million 6% 6% C B 225 million 14% 11% IO 10% Answer: True. The potential conflict of interest when the special servicer owns the B-piece is that they will be overly keen to work out bad debt rather than foreclose because they would rather gamble on a successful workout than foreclose with certainty. The reason for their propensity to gamble is that, if the potential loss from a failed workout is great enough, some of the losses will accrue to the higher tranches so the B-piece is gambling with the higher tranches’ money. In this case, the potential loss does not exceed the B-piece slice so a special servicer that owns the C tranche will act as if it held the whole loan and appropriately account for risk. If the special servicer does not own the B-piece, it is compensated on assets under management, and does not have the correct incentives. We allocated 7 points to your explanation of the “typical” conflict of interest; that when the special servicer owns the B-piece, they work out too often. We allocated 2 points to your explanation of why the “typical” conflict of interest does not apply in this situation because the C tranche is not at risk of being wiped out. (Some of you noted that the C-tranche would be closer to being wiped out if the special servicer foreclosed, and so the next default would be riskier, leading them to try to work out. We gave you credit for that answer although it is not actually that cut-and-dry.) The last point was given for the explanation of the special servicer’s incentives if it does not own the C tranche. An incomplete answer received less-than-full points

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Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 22 in a section; for example, many students received 5 points for their explanation of the “typical” conflict of interest. Part III. (20 points total.) Other topics. Answer whether each of the statements in square brackets is true, false, or uncertain. 6. (10 points.) According to the Smith Model, [when there is any vacancy in a building, the landlord should lower the rent] . Answer: False. Vacancies exist for all sorts of reasons in equilibrium. That is called that the “natural vacancy rate”. For example, properties have vacancy simply due to natural tenant turnover (it takes time to find new tenants), landlords holding back space, or there not being a tenant interested in the size/configuration of space that is available. It’s when vacancies get in excess of the natural rate that it is a sign that landlords should lower the rent. That is one of the points of the Smith model – that vacancies are the information landlords use to tell them when to adjust their rent. Vacancies are the indicator that demand has contracted or supply has grown faster than demand, and the space market is out of equilibrium. Of course, it is hard for a landlord to tell that the vacancy rate is above the natural rate – that makes a landlord somewhat slow to adjust (and one could argue that a landlord should wait until s/he is confident that the vacancy rate is above the natural rate before reducing rent). We allocated up to 5 points for saying that vacancies are the signal for landlords to lower rents and up to 5 more points for your explanation of the difference between the natural vacancy and “any” vacancy. If you explained just the natural rate part, but it was clear from your answer that you implicitly thought that landlords should lower rent at that point, we gave you some but not full credit. To get full credit for the “vacancies are the signal” part, you had to explain why landlords should use vacancy to help them decide whether to lower rent. That meant you had to say that vacancies are the first signs of insufficient demand or too much supply. You lost two points if you did not do that. 7. (10 points.) You are the CEO of a struggling software firm in the San Francisco Bay area. The firm owns – and occupies 100 percent of – its headquarters building. Your real estate consultant has proposed that you engage in a sale-leaseback with a REIT to free up capital. The REIT has given you two leasing options: i) One lease would have a 20-year term with a constant nominal rent that reflects your best guess of future rent growth. The penalty for exiting the lease early would be two years of rent, and subleasing would not be allowed.

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Real Estate Finance: Investment and Analysis Spring 2019 Sample exams 23 ii) The REIT also offered a “tenant-at-will” lease, where you could cancel at any time with no penalty. That lease would adjust annually based on the market rent. Your consultant has calculated that the present discounted cost of the 20-year lease would be 10% lower than the tenant-at-will lease over the 20-year time period, taking taxes and all other expenses into account. Due to your capital needs, continuing to own the property is not an option. Based on this information, [you should do the sale-leaseback with the 20-year lease.] Answer: Uncertain. It depends on the probability of your firm moving over 20 years. Given the information in the problem, probably True. a) Expected cost: The 20-year lease is expected to be less expensive than the at-will lease. [3 points] b) “Cost risk”: The 20-year lease locks in your costs. (You have a guess about future costs, but you are not certain. The 20-year lease eliminates that uncertainty.) The at-will lease has cost risk since rents float with the market. On this basis, you prefer the 20-year lease. [3 points] c) “Quantity risk”: It is expensive to adjust the amount of real estate your firm is using if you take the 20-year lease; it costs two years of rent. It is free to adjust if you take the “at-will” lease. However, over 20 years, the long-term lease is cheaper by two years of rent. So, if your firm cancels the lease at any point before 20 years are up, the 20-year lease will be more expensive (in expectation) than the at-will lease. Of course, you could just suffer through having the wrong size or type of space rather than cancel your lease; you would only do that if the mismatch was less costly than two years of rent. [3 points] Hence, this question boils down to whether you are more willing to take the uncertainty over rental costs or the risk of having a mismatch between your space needs and the headquarters building. [Tradeoff: 1 point] Given that your firm is “struggling” and needs to “free up capital”, the problem is signaling that the quantity risk is significant. Note: We gave partial credit in each category; for example, an incomplete answer might receive 2 out of 3 points.

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