Overview

In  this  lesson  I'm  going  to  give  you  an  overview  of  real  estate  and  REIT  modeling,  and  explain  
exactly  what  we're  going  to  cover  in  the  course,  how  we're  going  to  approach  it,  what  some  of  
the  key  differences  are  between  real  estate  and  other  industries,  and  then  some  of  the  key  
challenges  we're  going  to  face,  and  how  we're  going  to  deal  with  them,  and  go  through  
everything  in  this  course.  

So,  to  get  started,  first  we  want  to  define  what  exactly  we  mean  by  real  estate.  What  types  of  
real  estate  we're  going  to  look  at.  What  the  two  major  categories  really  are,  and  then  the  
subcategories  that  we're  going  to  spend  most  of  our  time,  in  this  course  focused  on.  

So,  when  you  talk  about  real  estate,  there  are  two  ways  to  approach  it  from  the  modeling  and  
valuation  angle.  The  first  method  is  to  look  at  individual  properties.  This  is  pretty  
straightforward.  We're  talking  about  things  like;  offices,  hotels,  apartment  complexes,  storage  
facilities,  shopping  malls,  and  then  you  have  more  specialized  properties,  such  as  nursing  
homes,  that  are  in  the  health  care  vertical.  

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So,  these  are  individual  properties,  and  although  they  are  not  companies,  you  can  still  analyze  
them  and  think  about  them,  as  if  they  were  companies,  assuming  that  the  purpose  of  these  
properties  is  to  actually  generate  a  profit.  

So,  within  this  area  we're  really  going  to  focus  on  the  first  three  here;  offices,  hotels  and  
residential  complexes.  In  terms  of  our  focus  in  the  course,  we're  going  to  spend  some  time  
going  over  how  to  construct,  and  develop,  and  then  ultimately  sell  an  office  complex.  Then  
we're  going  to  go  over  how  you  acquire  and  renovate  a  hotel.    

Then  the  residential  properties  are  going  to  come  into  play  when  we  look  at  our  REIT  modeling  
there,  on  our  real  estate  investment  trust  modeling  later  on,  and  we're  going  to  look  at  a  
company  that  aggregates  a  lot  of  individual  residential  complexes.  So,  that's  going  to  be  our  
focus.  

And  within  those  again,  even  though  they're  not  companies,  you  can  still  think  about  them  in  
terms  of  revenue,  expenses,  how  much  in  operating  income  they're  generating  and  other  
metrics  like  that.    

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Even  though  they're  not  companies,  you  may  still  have  to  take  on  debt.  You  may  still  have  to  
raise  equity  to  finance  the  acquisition  or  the  renovation  or  the  construction  of  these  properties.  
So  yes,  they  are  not  companies  but  the  way  we're  going  to  analyze  them  is  through  the  lens  of  
how  they  compare  to  actual  companies,  and  how  they  compare  to  what  you  do  in  corporate  
finance.  

Now  when  you  move  beyond  that,  as  I  just  mentioned,  you  get  into  the  level  of  real  estate  
investment  trusts,  otherwise  known  as  REITs.  Now,  I'm  not  going  to  go  over  all  the  
requirements  here,  and  what's  involved  and  what  constitutes  a  REIT.    

But  the  basic  idea  for  REITs  is  that  they  aggregate  all  these  individual  properties.  So  in  a  sense,  
they're  sort  of  like  private  equity  firms,  but  for  real  estate  rather  than  for  companies.  So,  for  
example,  you  might  have  a  real  estate  investment  trust  that  buys  a  lot  of  office  complexes,  or  a  
real  estate  investment  trust  that  buys  a  lot  of  hotels,  or  a  lot  of  apartment  complexes,  and  then  
they  hold  on  to  these  assets  for  a  while.    

They  develop  new  assets.  They  start  the  construction  of  new  assets,  as  well.  They  improve  the  
assets  they  have,  and  then  over  time  they  sell  them.  And  then  they  go  on,  and  buy  new  assets,  
keep  selling  them,  and  keep  buying  new  assets,  over  time.    

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Within  this  category,  there  are  a  couple  of  different  types  of  REITs.  The  first  major  division  is  
between  equity,  mortgage,  and  hybrid  REITs.  Equity  REITs  are  pretty  straightforward.  These  are  
simply  companies  that  simply  buy  and  sell  individual  properties,  also  improving  their  properties,  
renovating  them  over  time.  

Mortgage  REITs  differ  because,  rather  than  investing  directly  in  properties  like  that,  instead  
they  simply  invest  in  mortgages  that  these  properties  have  associated  with  them.  So,  let's  say  
that  you  as  a  homeowner  go  in  and  buy  a  house.  You  take  out  a  mortgage  to  buy  the  house.  
There  might  be  a  real  estate  investment  trust  that  invests  in  mortgages,  and  that's  their  entire  
business  model.    

So,  whereas  an  equity  REIT  will  earn  most  of  its  revenue  from  rent,  from  offices  or  apartments;  
or  in  the  case  of  hotels  from  guests  paying  the  nightly  rate  to  stay  there;  a  mortgage  REIT  by  
contrast,  is  going  to  earn  most  of  its  revenue  from  the  interest,  on  the  mortgages  that  it  has  
invested  in,  also  from  people  paying  back  their  mortgages.  

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Also,  from  possibly  fees  people  pay  on  those  mortgages,  and  so  on.  Then  there's  a  third  
category  which  is  called  hybrid,  and  these  types  of  REITS,  actually  combine  both  equity  and  
mortgage,  and  they  buy  and  sell  individual  properties,  but  then  they  also  buy  and  sell  
mortgages  on  those  properties.  

So,  those  are  the  three  major  categories  of  REITs.  And  then,  within  that  you  can  also  have  
different  categories,  depending  on  what  the  REITs  themselves  actually  invest  in.  So,  some  real  
estate  investment  trusts  invest  only  in  offices,  or  in  industrial  complexes.    

Some  focus  on  hotels,  some  focus  on  residential  complexes,  some  focus  on  storage  facilities,  
some  focus  on  shopping  malls,  some  focus  on  health  care  and  more  specialized  industries.  Like  
the  nursing  home  example,  I  just  mentioned  before.  

So,  you  have  their  investment  strategy  what  type  of  industry  they  want  to  focus  on,  whether  it's  
offices,  hotels,  residential  and  so  on,  and  so  by  combining  these  two  you  can  classify  REITs  by  
whether  they're  equity,  mortgage  or  hybrid,  and  then  by  the  subsector  within  real  estate  that  
they  actually  invest  in.  

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Now  in  this  course,  we're  going  to  be  focused  on  equity  REITs  for  the  most  part.  The  reason  
being  that,  equity  REITs  comprise  the  vast  majority  of  what's  out  there  on  the  stock  market,  in  
pretty  much  any  country  that  actually  has  REITs.    

They're  the  most  common  in  the  US  by  far,  but  they  do  exist  in  many  other  countries  as  well,  
and  no  matter  where  you  look  equity  REITs  tend  to  dominate  what  is  out  there  on  the  public  
markets.  So,  that's  the  one  that  we're  going  to  be  focused  on  in  this  course.  

So  now  that  we've  been  over  the  major  categories  of  real  estate,  how  exactly  is  it  different?  
What  are  the  differences  that  we  look  at  when  we  compare  real  estate  and  REITs  to  normal  
companies?    

So,  on  the  real  estate  development  side,  looking  at  individual  properties,  one  of  the  key  
differences  here  is  that  it's  much  more  granular,  than  what  you  see  for  the  standard  company  
that  you  go  and  model.    

Now  when  you  look  at  a  normal  company,  you  might  look  at  their  revenue  growth,  their  EBITDA  
margins  and  so  on,  their  working  capital  requirements,  and  it's  a  very  high-­‐level  overview,  
because  you  don't  usually  get  into  the  individual  stores  they  have,  or  the  individual  customers,  

http://breakingintowallstreet.com
or  expenses  for  very  granular  items  like  advertising,  or  promotional  materials  or  anything  like  
that.  

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But  when  you  look  at  individual  properties,  whether  you're  dealing  with  offices  or  hotels  or  
apartments,  for  example,  you  get  into  very  granular  detail,  here.  You  look  at  how  many  floors  
the  building  has.  You  look  at  how  many  square  feet  or  how  many  square  meters  it  takes  up.    

You  look  at,  for  example,  how  many  parking  spaces  it  has,  how  many  floors  the  parking  
complex  has.  You  look  at  how  many  elevators  it  has,  and  you  look  at  how  much  all  this  costs.  So  
you  get  into  a  lot  of  granular  detail  that  you  just  never  normally  look  at,  in  the  scope  of  normal  
investment  banking  

The  other  difference  on  the  real  estate  development  side  is  that  when  you're  modeling  the  
construction  of  a  new  complex,  a  new  office,  a  new  apartment  complex,  and  so  on  it's  sort  of  
like  a  start-­‐up  meets  an  LBO.  What  I  mean  by  this  is  that  with  a  leveraged  buyout  transaction,  a  
private  equity  firm  goes  in  and  buys  a  company  using  debt  and  equity,  similar  to  buying  a  
house,  a  down  payment,  and  then  taking  out  a  mortgage  on  a  house.  

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Well,  with  real  estate  development  it's  the  same  thing.  You're  always  going  to  use  a  
combination  of  equity  the  down  payment,  and  then  taking  out  debt  from  third  party  investors  
to  finance  the  transaction,  to  finance  the  construction  of  your  new  real  estate  property.    

But  the  difference  is  that  when  you're  making  a  new  property,  when  you're  developing  a  new  
property  like  this,  it's  not  like  a  normal  company  where  when  a  PE  firm  goes  in  and  buys  them,  
they're  already  operational,  they  already  have  revenue,  and  they  already  have  profit.  They  have  
nothing.  You  have  nothing  when  you  first  start  constructing  a  property.    

And  so,  over  time  you're  going  to  attract  tenants.  You're  going  to  attract  customers  if  it's  a  
hotel,  for  example.  And  you're  going  to  build  up  your  revenue  and  your  expenses  over  time.  But  
when  you  first  start  out,  you  literally  have  nothing,  and  it  takes  a  very  long  time  to  actually  
develop  it,  and  to  start  generating  profit,  with  the  property  that  you're  creating.  

So  in  a  sense,  it's  sort  of  like  looking  at  an  LBO,  but  then  applying  it  to  a  start-­‐up,  and  to  assume  
that  the  company  is  really  starting  from  nothing,  and  then  developing  everything,  over  time.  

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Now,  in  the  real  estate  investment  trust  side,  a  couple  of  the  key  differences  here.  First  off,  it's  
asset-­‐centric.  So,  unlike  say,  a  consumer  company  or  a  retail  company  or  a  technology  
company,  those  types  of  companies  are  very  focused  on  individual  product  sales  to  customers,  
for  the  most  part.  So,  the  key  metrics  there  are  usually  not  related  to  the  balance  sheet  of  the  
company.  Usually  you're  looking  more  at  revenue,  at  expenses,  things  like  that.  

But,  with  real  estate  investment  trusts,  remember  they  just  aggregate  all  these  individual  
properties.  So,  you're  not  going  to  be  looking  at  revenue  in  the  sense  of  projecting  a  revenue  
growth  rate.  What  you're  going  to  do  instead,  is  look  at  how  many  assets  they  have.  How  much  
are  they  buying  each  year?  How  much  are  they  selling?  How  much  are  they  disposing  of?    

How  much  are  they  renovating  each  year?  How  much  are  they  developing?  How  much  are  they  
creating  each  year?  So,  you  have  to  look  at  these  types  of  metrics,  and  then  look  at  how  much  
in  profit  all  these  different  types  of  assets,  are  actually  going  to  be  generating  over  time.  And  
so,  that's  how  you  really  go  about  projecting  what  a  real  estate  investment  trust  will  look  like  
going  into  the  future,  unlike  a  normal  company  where  you  get  a  very  high-­‐level  overview  with  
revenue  growth,  margins  and  so  on.    

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With  real  estate  it's  all  about  looking  at  the  individual  properties  that  they're  buying,  selling,  
improving,  developing  each  year,  and  then  aggregating  those  together,  to  get  a  picture  of  what  
revenue  and  expenses  look  like,  for  the  real  estate  investment  trust.  

Another  difference  with  REITs  is  that  in  pretty  much  all  countries  they  exist  in,  they  have  a  
requirement  to  issue  a  certain  amount  of  dividends  each  year.  In  the  US,  for  example,  most  real  
estate  investment  trusts  have  to  issue  90.0%  of  their  taxable  income,  taxable  net  income,  as  
dividends  each  year,  in  order  to  continue  qualifying  as  real  estate  investment  trusts.    

What  this  means  is  that  they  save  up  very  little  cash,  over  time.  If  you  think  about  what  a  
normal  company  does  they  may  issue  dividends,  but  there's  no  requirement  that  they  have  to  
issue  a  certain  amount.    

There  is  a  requirement  for  some  industries,  for  example,  commercial  banks  in  the  sense  that  
they  cannot  issue  over  a  certain  amount.  But  in  real  estate,  it's  kind  of  the  opposite  they  have  
to  issue  at  least,  a  certain  amount  in  dividends  each  year.    

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What  this  means  is  that  they  have  very  little  cash  flow  available  to  buy  properties,  to  develop  
new  properties,  and  so  on.  And  so,  they  are  constantly  issuing  debt.  They  are  constantly  issuing  
equity.  They  are  constantly  disposing  of  properties,  and  then  acquiring  new  properties.  
Sometimes  if  they  need  extra  cash  flow,  they  may  have  to  sell  a  property  to  get  it,  if  they  
cannot  issue  debt  or  equity.  

So,  they  are  very  acquisitive.  They  have  a  lot  of  acquisitions  and  dispositions  going  on  each  
year.  They  are  issuing  debt  and  equity  all  the  time.  For  normal  companies  these  are  really  
considered  one-­‐time  events,  but  for  real  estate  investment  trusts  these  are  more  like  recurring  
events  that  happen  each  year.  And  so,  when  you  project  them,  when  you  look  at  them  in  a  
model  you  have  to  take  into  account  all  of  this,  and  assume  that  they're  going  to  be  doing  more  
and  more  of  this  over  time.  

And  then  finally,  a  lot  of  the  terminology  and  the  key  metrics  for  real  estate  investment  trusts  
are  different.  If  you've  been  through  the  other  industry-­‐specific  modeling  courses  on  this  site,  
you're  used  to  this,  and  you're  used  to  some  of  the  other  key  differences  that  you  commonly  
see  here.  But  just  as  with  other  industries,  there's  a  lot  of  jargon  to  get  to  know  with  real  
estate.    

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The  key  metrics  are  all  different.  You  can  look  at  things  like  revenue  growth,  EBITDA  margins,  
and  so  on  for  real  estate  investment  trusts,  but  they  are  not  the  most  meaningful  metrics.  So,  
there's  a  whole  set  of  other  metrics  and  terminology  you're  going  to  need  to  learn,  if  you  want  
to  analyze  both  individual  properties  for  real  estate,  and  then  also  real  estate  investment  trusts.  

So,  what  are  the  key  challenges  we're  going  to  have  to  overcome,  in  order  to  create  this  course,  
and  to  go  through  and  create  models  for  everything  here?  Well,  on  the  real  estate  development  
side,  one  of  the  key  challenges  here,  will  be  to  determine  the  proper  timing  for  everything,  and  
the  proper  cost  of  everything.  I  mentioned  before  that  it's  much  more  granular  than  what  you  
see  for  normal  companies.  

And  so,  what  that  means  is  that  you  have  to  sanity  check  everything,  and  tie  this  together  and  
make  sure  that  your  costs  on  a  per  square  foot,  or  a  per  square  meter  basis  are  correct  and  
reasonable,  given  the  market  that  you're  operating  in.  I  also  mentioned  before  that  it  takes  
time  to  develop  new  properties,  to  renovate  properties.  

[12:00]  

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And  so,  we're  going  to  have  to  go  into  more  granular  detail  here,  and  look  at  this  in  terms  of  
months  required  to  complete  certain  aspects  of  the  construction  of  the  property.  It's  not  
terribly  difficult  conceptually  to  do  that,  but  it  is  a  lot  more  detail  than  you're  used  to  seeing  in  
normal  models.  

Another  difference  is  that  with  real  estate  development,  debt  and  equity  are  used  a  little  bit  
differently  than  they  are  for  normal  companies,  and  the  way  they  play  out  in  the  model  is  a  
little  bit  different  from  what  you've  seen  if  you've  only  looked  at  corporate  finance,  and  only  
looked  at  leveraged  buyouts,  and  debt  models  for  those,  before.  

What  I  mean  here  is  that  with  real  estate  development,  generally  what  happens  is  that  as  the  
costs  come  up,  so  as  they  have  a  requirement  to  spend  a  certain  amount  to  excavate  or  to  
develop  a  property  or  to  buy  concrete  or  something  like  that,  they  will  draw  on  the  equity  they  
have  first.  After  they've  exhausted  the  supply  of  equity  that  investors  have  given  to  them,  then  
the  developers  are  going  to  start  drawing  on  debt,  and  then  you're  going  to  start  seeing  debt  
being  used  in  the  construction.  

[13:00]  

But  it's  a  little  bit  different  from  normal  companies,  in  an  LBO  for  example,  where  you  draw  on  
100%  of  the  debt  and  equity  all  at  once.  With  real  estate  development,  it's  more  of  a  gradual  
process,  and  you  draw  on  these  over  time,  as  you  need  them,  instead  of  drawing  on  everything,  
100%  of  the  debt  and  equity  all  at  once,  as  you  see  in  a  typical  LBO  model.  

Now,  on  the  real  estate  investment  trust  side,  one  key  challenge  will  be  to  estimate  the  assets.  
What  I  mean  by  this  is  estimating  how  much  they're  actually  buying.  How  much  they're  selling.  
How  much  they're  developing.  How  much  they're  renovating  and  so  on,  each  year.    

This  sounds  straightforward,  but  the  way  that  many  real  estate  investment  trust  filings  are  set  
up,  it  makes  it  very  difficult  to  actually  see  what's  going  on,  and  to  accurately  assess  on  an  
ongoing  basis  about  how  much  of  this  they're  doing  each  year.  

So,  to  estimate  this  we're  going  to  have  to  look  at  not  only  their  filings,  but  also  investor  
presentations  and  equity  research,  and  other  sources,  and  sort  of  triangulate  to  come  up  with  
reasonable  numbers  for  their  assets.    

[14:00]    

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And  then  also  how  much  in  profit  and  how  much  in  terms  of  gains  and  losses  on  sales,  for  
example,  their  assets  and  the  asset  sales  are  actually  generating  each  year.  And  then  finally,  
there's  a  lot  of  tricky  accounting  when  it  comes  to  real  estate  investment  trusts.    

We're  going  to  see  topics  like  discontinued  operations,  for  example,  that  you've  probably  not  
seen  before,  or  at  least  not  been  exposed  to  too  much  in  the  past.  If  you  look  at  even  
something  simple,  like  the  cash  flow  statement  of  a  real  estate  investment  trust,  there  are  a  lot  
of  unfamiliar  items  on  there  that  you've  probably  not  seen  before.    

So  we're  going  to  go  through  that  in  detail,  and  look  at  what  all  these  different  items  mean.  The  
way  that  the  corporate  structure  and  the  legal  structure  of  these  trusts  is  set  up,  also  makes  it  
difficult  to  analyze  what's  going  on  sometimes,  and  also  makes  the  accounting  extra  tricky.  
Because  if  you  have  an  operating  partnership  and  then  a  trust  that  owns  the  operating  
partnership  or  vice  versa,  it  can  get  very  confusing  determining  exactly  how  much  it's  worth,  
and  also  how  the  accounting  for  many  of  these  items  actually  works  for  REITs.  

[15:00]  

So,  what's  our  plan  of  attack  for  this  course?  First  off  we're  going  to  start  with  a  few  overview  
lessons.  After  this,  where  we  go  into  the  key  terms  that  you  need  to  know  for  real  estate  
development,  and  also  for  REITs,  we’re  going  to  look  at  some  simplified  financial  statements  for  
REITs,  and  see  how  individual  properties  can  be  aggregated,  and  how  individual  property  sales,  
acquisitions  and  so  on,  can  tie  together  to  form  the  financial  statements  for  a  REIT,  as  well.  

After  that,  we're  going  to  look  at  the  office  development  and  sale.  We're  going  to  go  into  real  
estate  development  modeling  here,  and  look  at  how  you  might  model  out  the  costs  and  the  
timing  associated  with  an  office  development,  and  then  what  kind  of  return  you  can  expect,  
when  you  go  and  sell  this  office  at  some  point  in  the  future.  

Then  on  the  real  estate  development  side  once  again,  we're  going  to  look  at  a  hotel  acquisition  
and  renovation,  and  see  how  much  it  would  cost  to  actually  acquire  a  hotel,  how  much  it  would  
cost  to  renovate  it,  how  to  think  about  the  income  statement,  and  the  profit,  and  the  revenue  
of  a  hotel  versus  what  we  saw  for  the  office  development  and  sale  before.  

[16:00]  

So,  we're  going  to  look  at  that  in  detail  and  again  look  at  the  type  of  IRR,  or  internal  rate  of  
return  that  investors  could  expect  when  they  acquire,  and  renovate,  and  sell  a  hotel.  

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Then,  we're  going  to  get  into  the  REIT  side  and  first  look  at  an  operating  model.  We're  going  to  
look  at  a  company  called  Avalon  Bay,  which  is  a  residential-­‐focused  REIT  that  buys  apartments  
and  multi-­‐family  complexes.    

We're  going  to  see  how  to  estimate  the  assets  in  their  portfolio,  how  to  estimate  how  much  
they're  buying,  selling,  developing,  re-­‐developing  and  so  on  each  year,  how  much  profit  all  that  
is  generating,  and  then  how  to  link  together  and  estimate  the  three  statements,  and  also  how  
the  debt  schedules  for  a  REIT  work.    

Those  can  be  a  little  bit  more  complicated  than  what  you  see  from  normal  companies  as  well,  
so  we'll  spend  some  time  delving  into  that.  And  then  we'll  conclude  with  a  REIT  valuation.  
We're  going  to  look  at  how  to  actually  value  Avalon  Bay.    

We'll  go  through  all  the  different  methodologies  that  you  see  for  REITs.  Public  company  
comparables,  precedent  transactions,  same  as  for  more  normal  companies,  but  you  look  at  
different  metrics  and  different  valuation  multiples.  

[17:00]  

We're  also  going  to  look  at  a  DCF,  a  dividend  discount  model,  something  called  a  net  asset  value  
model,  and  then  also  something  called  a  replacement  value  or  replacement  cost  method,  
specifically  for  valuing  real  estate.  

So  that's  our  plan  of  attack  for  this  course.  As  you  can  see,  there's  quite  a  lot  here.  We're  going  
to  cover  quite  a  few  different  topics  ranging  from  overview,  and  the  high-­‐level  thinking  behind  
REITs,  to  real  estate  development,  real  estate  acquisition,  renovation,  selling  real  estate,  and  
then  looking  at  real  estate  investment  trusts,  which  aggregate  everything  together.    

So  now  that  we've  been  over  that  we're  going  to  jump  into  the  first  topic  here,  which  is  to  go  
over  some  of  the  key  terminology  that  you  need  to  know  for  real  estate  development.  After  
that  we'll  look  at  an  overview  of  real  estate  development,  a  simplified  example  and  then  we'll  
get  into  an  overview  of  REITs,  and  some  of  the  key  metrics  associated  with  them.  

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