Chapter 13: Risk Analysis

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

13-2

Comparing Investment ReturnsComparing Investment Returns

Does the income producing property provide a competitive return?– Nature of alternative real estate investments– Alternative investments that are not real

estate– Returns on alternatives– Risk differences

13-3

Exhibit 13-1Exhibit 13-1Risk and Return (alternative investments)Risk and Return (alternative investments)

13-4

Types of RiskTypes of Risk

Business Risk– Economic Conditions– Tenant Mix– Lease Provisions

Financial Risk– Increases with the amount of debt– Cost and structure of debt

13-5

Types of RiskTypes of Risk

Liquidity Risk– Challenges in selling property

Inflation Risk– Unexpected inflation– Does income increase enough to offset

inflation? Management Risk

– Competency of management’s ability to respond to market conditions

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Types of RiskTypes of Risk

– Interest Rate RiskThe impact on variable rate debtThe impact of higher rates on residual property value

– Legislative RiskRegulatory changes

– Environmental Risk In general, in the United States environmental risk

applies to anyone in the chain of title. If you buy a property with an environmental issue, you are generally taking on that liability regardless of whether or not you caused the problem.

13-7

Due Diligence and Risk Due Diligence and Risk ManagementManagement

Three primary tools may be employed by investors to minimize their exposure to risk:– Avoidance and identification of risk through

due diligence– Financial tools such as insurance, hedging,

and option contracts– Diversification (either into other product types

or different locations)

13-8

Sensitivity AnalysisSensitivity Analysis

Base Case– Frame of reference for analysis

Change a single assumption– What is effect on NPV or IRR?

Scenario Analysis– Change multiple assumptions at once– Identify most likely, pessimistic, and optimistic

scenarios

13-9

Exhibit 13-7Exhibit 13-7Probability Distribution of Probability Distribution of IRRIRRs (office, apartment, hotel)s (office, apartment, hotel)

13-10

Partitioning the IRRPartitioning the IRR

How is the total IRR distributed between operating cash flow and property sale cash flow?– Compute the IRR– Discount cash flows from operations using the

IRR– Discount cash flow from property sale using

the IRR– Compute the percentages

13-11

Partitioning the IRRPartitioning the IRR

Example 13-1– Equity Invested = $600,000

– BTOCF1 = $40,000

– BTOCF2 = $42,000

– BTOCF3 = $45,000 + $800,000 from sale

– IRR = 16.48%

– Where BTOCF = Before tax operating cash flow

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Partitioning the IRRPartitioning the IRR

Present Value of BTOCF = $93,773– Use the IRR of 16.48% as the discount rate

Present Value of BTCF(sale) = $506,229– Discounting $800,000 at 16.48% for 3 years

Percent from Operations ≈ 15.63%– $93,773/$600,000

Percent from Sale ≈ 84.37%– $506,229/$600,000

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Partitioning the IRRPartitioning the IRR

This is useful for comparing alternative similar investments.

For example, an alternative property may have the same IRR, but if the percent of return from operations is 20% and property 80%, there might be significant risk differences.

The riskier portion of the return is generally understood to be that which is based on property price appreciation.

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Variation in Risk & ReturnVariation in Risk & Return

Use economic scenarios:– Compute cash flows from operations and

property sale for each scenario.– Compute the IRR in each scenario.– Multiply the IRR by the probability of the

scenario to compute an expected return– Need to consider risk

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Variation in Risk & ReturnVariation in Risk & Return

Variance Standard Deviation

– The lower the standard deviation, the more likely actual return is closer to expected return

Expect the actual return to fall within 1, 2, and 3 standard deviations 68%, 95.5%, and 99.7% respectively.

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Variation in Risk & ReturnVariation in Risk & Return

Coefficient of Variation

– Risk per unit of (expected) return– Standardized measure of stand-alone risk

Portfolio considerations– Reduce risk by combining assets into a portfolio– Diversification

)(IRRE

CV

13-17

Lease Rollover RiskLease Rollover Risk

Uncertainty of renewal by existing tenants– Tenants may not renew leases– Possible lengthy vacancy– New tenant may require money for tenant

improvements– Commissions are an additional cost for new

tenants

13-18

Lease Rollover RiskLease Rollover Risk

Renewal Probability Market Leasing Assumptions Market Rent Assumptions Turnover Vacancy Leasing Commissions Tenant Improvements

13-19

Real OptionsReal Options

Defined– Purchase land, but wait to develop

The Option– Construct or not construct in the future

Additional Uses and Strategy– Excess land purchased for possible future

development– Multiple phases to a development– Building renovation

The real option approach to land valuation implies a higher land value than the traditional approach