Level II Review, Alternative Investments

Study session 13 in the Level II CFA Program curriculum includes four readings (38-39) on alternative investments. The material is quite a bit more detailed and quantitatively focused than that seen in the first exam and worth between 5% and 15% of your total exam score. Most of the readings are fairly conceptual with only some basic valuation calculations.
Private Real Estate Investments
Understand the forms of investment (direct, lending, and public securities) and how they differ. Understand the basics behind REITs and how they differ from normal stocks (tax advantaged structure).
The characteristics of the different ‘alternative’ investments are important throughout the readings. Understand that real estate is not homogeneous (each one differs in size, location, age, quality, etc.), are indivisible and may be prohibitively expensive for smaller investors, are management intensive, subject to depreciation, and have high transaction costs.
Understand the basics behind the different property types, i.e. residential, office, retail, industrial and how they differ. Pay attention to the income approach to valuation and be able to calculate NOI and capitalization rate. Understand that the cap rate is positively related to the discount rate and interest rates, but negatively related to the growth rate.
Publicly Traded Real Estate Securities
Here you will need to get more detail on REITs, the different types,  advantages and disadvantages to privately held real estate. REIT structure (upREITs versus DownREITs) is of secondary importance to basic investment characteristics.
Understand the basic economic drivers and factors for the group and each property type. The Institute does not expect you to become a REIT analyst or Donald Trump from the curriculum. Focus on the basics and don’t get bogged down in detail. Look for advantages/limitations as well as list material.
Pay attention to the NAV approach to valuation.
Pro forma cash NOI = NOI minus non-cash rents plus adjustments for impact of acquisitions
Estimated future expected cash NOI = pro forma NOI plus expected growth in NOI
Est. gross asset value =  estimated value of operating real estate plus BV of cash plus book value of land plus BV of receivables plus BV of prepaid and other assets
Net asset value = estimated gross asset value minus total debt minus other liabilities
NAVPS = NAV divided by shares outstanding
Understand that normal price multiples (P/E) are not appropriate for REITs and know the basic idea behind the FFO multiples.
Private Equity Valuation
Understand the differences between private equity and public equity and the various forms of PE (LBO and VC).
Beyond the vocabulary and general concepts, the NPV method of valuation is fairly testable. To be honest, this is one of the formulas/calculations that I skimmed when I was taking the test. Being that the entire topic area is worth about 10% of the exam and this PE valuation is such a small part of the topic, I didn’t really want to commit the time to get the lengthy process (especially when multiple rounds of financing are used). Unless it comes easily to you or you want to go into PE, I would focus on concepts and vocabulary.
Investing in Hedge Funds: A Survey
The differences between Hedge Funds and other investments is most important here, including fee structure, lock-up periods, and regulation. Understand the basic difference between the types of strategies as well as performance biases.
Self selection bias arises because losing funds simply do not report to a database, skewing average returns upwards.
Survivorship bias occurs because managers with poor performances drop out of the business and the results are removed from databases, overstating average returns.
Study session 14 in the Level II CFA Program curriculum begins the material on fixed income and includes some tough detail on term structure and valuation. Make sure you plan to spend some time on practice problems.
‘til next time, happy studyin’
Joseph Hogue, CFA

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