ARCHITECTURE

3.2.5
Real Estate Finance & Investments: Risks and
Opportunities
3rd ed. (Philadelphia, PA: Linneman Associates, 2011 [2003]),
498 pages, $135.00
Peter Linneman, principal, Linneman Associates, former founding
chair, UPenn Wharton, Real Estate Development Department;
BA Economics, Ashland University 1973, MA Economics 1976;
PhD Economics University of Chicago 1977.
Assigned at: Columbia Business School, UPenn Wharton
Read by Susanne Schindler
Peter Linneman’s Real Estate Finance & Investments,
in teaching the reader how to become a real estate
developer, emphasizes the importance of judgment.
Though it introduces techniques like modeling; key
metrics like discounted cash flow and net present
value; and legal structures, like bankruptcy and real
estate investment trusts, these in themselves are not
sufficient for success. A great developer learns by
experience.
The book addresses readers as if they were
students unfamiliar with basic financial concepts
like value and rates of return. The first two chapters
describe real estate’s particular risks and opportunities
and outline a typology of real estate properties.
Chapters 3 through 7 teach lease and market analysis.
After describing how to appraise particular developments
and real estate companies, the book
takes us on a tour of debt and equity instruments
in chapters 11 through 18. Going on to consider decision
making and cycles, it concludes in chapter
21 with a discussion of ethics. Appendices provide a
primer on finance fundamentals, case studies, exams,
and a guide to Argus financial software.
Probability of the Return Occuring
A key metric for Linneman is choosing the capitalization
rate, or “cap rate,” of a property, which is
its net present value divided by the projected annual
net operating income, and accordingly is a formula
indicating the relationship of risk to return. “8 cap”
means income is 8 percent of value. Cap rates allow a
developer to estimate the “value creation potential”
of a property. For a building with a given income,
“building to a 10,” but selling “to an 8,” means a 20
percent profit margin. He is not shy about stating
expectations: “[G]ross profit margins . . . are typically
15-25 percent.” 45
But one should pursue financing only after
due diligence verifies basic assumptions concerning
an investment. This kind of careful knowledge
is worlds away from Wall Street. Instead, one learns
the business “from the ground up, one day at a
time.” 46 Linneman finds Manhattan as unsuitable
for a development as it is for a “dairy farmer,” directing
students to “unsexy” but promising locales like
Chester, Virginia. 47
6% decrease relative
to expect gain
6% increase relative
to expect gain
Expected return
is 15%
manage risk
to create
value
For Linneman, the key relationship in real estate is between
value, risk, and opportunity. Done efficiently,
development is handsomely profitable “true value creation;”
it renders the final product, or building, “more
valuable than the ingredients.” 44 But sophistication
in the field means patiently learning to manage risk
while exploiting opportunities in order to create value.
Performance is possible to forecast; one must balance
desired rates of return with allowable risk via pro forma
analysis and financial modeling of the market.
Probability Distribution for Expected Returns on a Sample Investment, Linneman, p. 8.
build
reputation
-3% 3% 9% 15% 21% 27% 33%
Expected Annual Return
Ethics is important because a good reputation is necessary
for long-term success in the business. For this
reason, the development world oscillates between
bounded community and impersonal market. The
developer should know the territory, hear the talk of
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