Layer Approach for Real Estate

CFA Level II Alternative Investments
#1

When is the layer approach used? As I understand it the layer approach treats the different leases as perpetuities, where only the excess rent is treated as a perpetuity when it changes.

However, this means that if I have a tenant with an ARY of 5% and a rent of $1000, then that “layer” would be a perpetuity of 1000/0.05 = 20000. Then if next year I were to switch to a tenant who was far less likely to pay and increased the required ARY to 20% as well as increasing rent to $1100, then the value of that new portion of the rent would be 1100-1000 / 0.2 = $500, then discounted back one year at 20% = $416.

That means that the value of the property would increase by $416 dollars by moving to a way way more risky tenant, despite only getting an extra $100 in rent? Shouldn’t additional risk at some point reduce the value of the property? The way I’m doing it, a single dollar of extra rent would always have a positive value, no matter the additional rent incurred.

Am I doing something wrong, or is this model as broken as I think it is?

#2

wouldn’t you also now discount the 1000 at the new 20% - get a much lower 5000$ - so 5416$ in total instead of 20000$?

#3

Ya, so I got $5416. But my confusion comes from the fact that even 1 additional dollar in rent will increase the value of the investment even if it comes with a massive increase in risk.

#4

however when you compare yr 1 = 20000$ vs. year 2 = 5416$ - though you received more rent on the property - your higher risk got reflected in a much lower perpetuity cost - reflective of the higher risk in the investment. year-on-year almost 15000$ got .

#5

Oh I see what you’re saying. But…I thought that since it was a layer approach that first “layer” remained untouched. You determine its value and then add on the value of the next layer. That would make more sense intuitively, but then I wouldn’t see how the layer approach would be any different than the regular DCF approach in this case…