hello friends, today, article we see the bond real estate from Security analysis book chapter 10, Specific standard for bond Investment ( continued). In this chapter, we see Criteria 6: Relation of the Value of property to the funded debt. so let’s see the bond of real estate.
As discussed soundness of bond investment depends on the oblique corporation to take the core of its depts, rather than the value of the property on which the bond has a lien.
so we say before that if a company fails, then their properties value also decreases.
so New York Statutes Recommend that the properties value is more than the 66.67% of bond issues.
let’s see an example to understand it
if Bond issued $100 million of any company, then properties value is about $167 million dollars.
so the author explains some special cases in that we have to consider the value of properties.
Some Special Cases:-bond real estate
1 ) Equipment Trust Obligations:
These issues issued by the railroad and also called as equipment trust certificate
In this case, we kept some mortgage for this valuation so railroad companies kept the locomotive like the engine of the railway and their parts as a mortage.
this type of investment company kept and then, they issue the debt.
so in this, we have to consider the Value Because, this instrument, that companies kept as a mortgage, and they are movable and they have their sellable price ( value) because any other companies railway use this type of assets.
If company fail, then does affect on that, because we can see this to other company and get the money.
2) Collateral-Trust Obligation:-bond real estate
In this, company issue, the debt and kept as mortgage as a security purpose, that company, buy that security
means, those are investment trusts, that trust company buy the security of other company and kept their security as mortgage and issue the debt for himself.
In this companies portfolio, we know the market value of the company and we can give them loans while considering their value.
3) Real- Estate bond:
In this case, the main criteria is that how much properties value.
The company gives loans, only 66.67% of the Properties value.
so property fair value matters
so let’s see how we get the property fair value from earning power.
For this, the author gives simple examples, how do we give the loan on properties?
A home cost is about = $10,000
Rental Value is about = $1200
On the rent, you have to pay the Tax and whatever operation cost, you have to pay
so after this by paying tax and operation cost from $1200
your net income is about = $800
5% mortage, you get on that house, up to 60% of the value of properties, i.e. $6000
so 5% of $6000 = $300
so your coverage ratio is = $800 / $300 = 2.67 X
but any industrial plant they want to issue debt by they want from us
for this, we have to keep more coverage ratio, because, on that plant, this much rental value does not get us.
so after these special cases, the author gives the 7 things on Real Estate bond
Things to consider when dealing with these bonds:
1 ) Properties value increases, then rental value Increases:
If properties value decreases, then rental value also decreases
if this does not happen, then people directly buy the house instead of staying in rent, because properties value decrease but rental value increases
so Properties value increases, then rental value Increases.
2) Misleading character of Appraisals:
If sometimes, the real-Estate boom comes, then properties prices ( value) Increases.
so you have to consider those values of experienced buyers and lenders instead of the booming price of properties.
That experienced buyer wants to buy on the price, that price we have to consider instead that, we can think that if that much price is on booming time is have, then we can buy this property or not if the answer is no then don’t buy on that price.
or you can ask your friends, that price of booming time and they are comfortable to buy that price.
so let’s understand with examples
e.g. the building making cost is about $1 million and in boom time, their price increases after building full develop up to $1.5 million,
so 50% profit on making time of that building.
so let’s see a third thing or bond real-estate
3) Abnormal rental, used as a basis for Valuation:-bond real estate
let’s understand this thing, from previous examples, so property value increases 50% means, Original value is $ 1 million and in boom time is about $1.5 million
so your properties rental is abnormally high, so you have to correct them and adjust to the downside.
so in this problem is
If you get a high return i.e. 50% increase so people, try to make the building. and more and more building is developed then supply increases then all building prices suddenly goes down,
so abnormal rental, used as a basis for valuation.
4) Debt based on excessive construction cost:
in boom time, the company can issue more debt, in this boom time
because, properties construction cost is higher because, the demand for making houses is increased, so construction suppliers also increase the rate.
suppose, a cost increase of making houses is about $100 million
so now boom time, their cost is about $200 million
so you can give a loan as per the 60% rule, which is about $130 million
while properties value in boom time is $200 million but their actual price is about $100 million
so $100 million is 60% is about $60 million and you give the loan on that properties is about $130 million means your debt given that properties are not safe, and logically they did not come in 60% rule of properties.
Because, when the value of properties comes to their original fair price, then you are already paying more loan than their fair price of whole properties and loan criteria is up to 60% but you give the $130 million means more 113% of properties.
so debt is based on excessive construction costs, you have to consider this.
5) Weakness of specialized buildings:
In this people make the mistake is that the apartment house, office, storehouse, clubs, the church building
so in this people make the mistake is, they don’t differentiate between them but they have different values.
so in this, you have to treat differently because in this we can not dispose of easily while considering same value
this value depends on those companies they have it and they become successful, or not depends on their own value.
those are apartment buildings, they do not depend on that company, because this any can use.
for this, you have to ask for the maximum margin of safety
so for this is good that 50% margin of safety on properties on the loan amount,
in this, you have to ask for a 100% margin of safety.
so this is important is that you have to consider the weakness of specialized buildings.
6) Value-Based on initial rental misleading:
At some time, we take the initial rent for valuing properties, but those are new building their rental obviously is more
so instead of that we have to think like that while considering the new building rent instead that we have to consider after this building is old, what are the rent of this building and that rent we have to consider.
and we can approve.
because initial rent is not for the long term.
7) Lack of financial Information:
In real estate financing, the main character is, they sell the bond to the public but, they hold the stocks privately.
so companies issue, the bond, then they forgot about the bond and bondholders.
and they do not offer any financial data to the bondholder.
so this end some exception and some special case
after that author give their own suggestions
The Author suggestion:
- The amount of loan is never over 66.675 of the value of the property (2/3)
- Value of property must not reflect recent speculative inflation ( booming value consideration not allowed, what come after long term that only allowed)
or you can see, how much you pay for buying that or any other experience buyer and lender, how much pay for that
- the property value is more than 50% of the loan value.
- Income account you have to see in that you know when vacancy is available and what is losses or rental rate decline what happen building when they become old.
- The income coverage ratio is twice and income is after consideration depression.
- You have to consider depression, because, the property becomes depressed or not any reason like this does not charge or they firstly spend on that so this is not considered the reason. so this type of stupidity doesn’t do.
- buy when bond, then borrower must agree to supply bondholder with regular operating and financial statement.
If those are company that deals with the hotel, garage
so for this, you have to provide loan when this hotel is running well. if they are new so don’t make the deal
if they have a successful record then only give.
- Investor should be satisfied with the location and type of building
These are the most important things, the large loss probability in unfavorable conditions.
for this point, understanding the author gives the example
In 1933 after conditions going to improve, but those are a financial district of new york, their activity is less and that reason people gets loses and rental rate also decline so location matters most.
- the author also talks about financial instruments i.e. first leasehold Mortage
In this, the land has another owner and we build the building on that land.
but we pay regular payment to the landowner
so those companies build the building on that land, this land is the first mortage bond for that company.
but this is not actually the first mortage for you because first mortage of ground to the company is not for you and ground rent this company have to pay
interest coverage ratio = ground rent + interest expenses of the building increases the cost
so this is all bout the bond real estate and also chapter 10 of the security analysis book.