{"id":19134,"date":"2021-08-04T23:03:05","date_gmt":"2021-08-04T23:03:05","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=19134"},"modified":"2024-04-11T12:59:27","modified_gmt":"2024-04-11T12:59:27","slug":"describe-the-economic-factors-affecting-investment-in-commercial-real-estate","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/describe-the-economic-factors-affecting-investment-in-commercial-real-estate\/","title":{"rendered":"Commercial Real Estate"},"content":{"rendered":"\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/NFyA0qXHhww\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n<h2>Rental Income<\/h2>\r\n<p><strong>Rental income<\/strong> includes the cash flows that investors in commercial real estate hope to receive. The credit quality of the underlying tenants influences the credit quality of a commercial property portfolio. The higher the credit quality of the tenants, the more likely they are to pay rent on time.<\/p>\r\n<h2>The Equity Component<\/h2>\r\n<p>Upon expiry of property lease, investors (landlords) may decide to redevelop the property for future sale, re-rent the property, or immediately sell the property. These decisions are dependent upon the value of the property at the time.<\/p>\r\n<p>The value of a property is determined by its location and the prevailing state of the economy. Commercial real estate investments are vulnerable to such market forces as the possibility of either making a profit or a loss and the uncertainty related to the redevelopment or sale of commercial real estate. In this respect, commercial real estate investments are like equity investments.\u00a0<\/p>\r\n<h2>Liquidity<\/h2>\r\n<p>Commercial real estate investments are highly illiquid. This is because of the time and effort it takes to sell a property. Additionally, properties incur high transaction costs when liquidating, and it takes a long time to exit a commercial property investment.<\/p>\r\n<p>Since illiquidity reduces commercial properties&#8217; usefulness as a hedge against bad economic outcomes, investors demand a <strong>liquidity risk premium<\/strong>.<\/p>\r\n<h2>Cyclicality<\/h2>\r\n<p>Commercial property prices are pro-cyclical\u2013positively correlated with the overall state of the economy. This implies that investors will demand a high-risk premium in return for investing in this asset class.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>Which of the following statements relating to commercial real estate is <em>most likely<\/em> correct?<\/p>\r\n<ol type=\"A\">\r\n\t<li>The credit quality of the tenants does not affect the value of the property.<\/li>\r\n\t<li>Commercial real estate ownership tends to be counter-cyclical.<\/li>\r\n\t<li>The risk premium for illiquidity and the risk premium for uncertainty in future value is high in commercial real estate as compared to other asset classes.<\/li>\r\n<\/ol>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is C.<\/strong><\/p>\r\n<p>Commercial real estate investments are highly illiquid. Since illiquidity reduces a commercial property&#8217;s usefulness as a hedge against adverse economic outcomes, investors demand a liquidity risk premium. Moreover, as is the case with equities, commercial real estate investments are vulnerable to such market forces as the possibility of either making a profit or a loss and the uncertainty related to redevelopment or sale of a commercial real estate. Therefore, investors require a risk premium for this uncertainty.<\/p>\r\n<p><strong>A is incorrect.<\/strong>\u00a0The credit quality of the underlying tenants influences the credit quality of a commercial property portfolio. The higher the credit quality of the tenants, the more likely they are to pay rent on time.<\/p>\r\n<p><strong>B is incorrect.<\/strong>\u00a0Commercial property prices are pro-cyclical. This implies that investors will demand a high-risk premium in return for investing in this asset class.<\/p>\r\n<\/blockquote>\r\n<p>Reading 43: Economics and Investment Markets<\/p>\r\n<p><em>LOS 43 (l) Describe the economic factors affecting investment in commercial real estate.<\/em><\/p>\r\n","protected":false},"excerpt":{"rendered":"<p>Rental Income Rental income includes the cash flows that investors in commercial real estate hope to receive. The credit quality of the underlying tenants influences the credit quality of a commercial property portfolio. The higher the credit quality of the&#8230;<\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,473],"tags":[216,564],"class_list":["post-19134","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-portfolio-management","tag-cfa-level-2","tag-portfolio-management","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Commercial Real Estate - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Understand the economic factors influencing commercial real estate investments, including rental income, liquidity risks, and cyclicality.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/describe-the-economic-factors-affecting-investment-in-commercial-real-estate\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Commercial Real Estate - 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