Lecture 11: Risk Analysis

Question 1

1. Types of risks:
   1.1. ? Risk
   Loss due to changes in economic conditions
   Some properties are affected more than others
   Well-diversified tenant mix =>? business risk
   More lease provisions => ? business risk

Answer 1

1. Types of risks:
   1.1. Business Risk
   Loss due to changes in economic conditions
   Some properties are affected more than others
   Well-diversified tenant mix => less business risk
   More lease provisions => less business risk

Question 2

1.2. Financial Risk
Increases with the amount of ? (i.e., leverage)
Also depends on the ? and ? of debt
e.g., Participation loans: lenders are allowed to “participate” the appreciation of property value => lower monthly payments => less financial risk. The ‘Help-to-Buy’ scheme in the U.K. is a good example

Answer 2

1.2. Financial Risk
Increases with the amount of debt (i.e., leverage)
Also depends on the cost and structure of debt
e.g., Participation loans: lenders are allowed to “participate” the appreciation of property value => lower monthly payments => less financial risk. The ‘Help-to-Buy’ scheme in the U.K. is a good example

Question 3

1.3. ? Risk
Challenges in selling property (it can take from 6-12 months) especially during periods of weak demand & low confidence.
Real estates has a relatively higher degree of liquidity risk

Answer 3

1.3. Liquidity Risk
Challenges in selling property (it can take from 6-12 months) especially during periods of weak demand & low confidence.
Real estates has a relatively higher degree of liquidity risk

Question 4

1.4. Inflation Risk
Unexpected inflation can reduce an investor’s ???
Q: Does income increase enough to offset inflation?
Real estate has historically done well during periods of inflation

Answer 4

1.4. Inflation Risk
Unexpected inflation can reduce an investor’s rate of return
Q: Does income increase enough to offset inflation?
Real estate has historically done well during periods of inflation
=> putting money into real estate investment is a safe bet.

Question 5

1.5. ? Risk
Most real estate investments require management to keep the space leased & maintained to preserve the value of investment.
Returns can depend heavily on the competency of management’s ability to respond to market conditions.

Answer 5

1.5. Management Risk
Most real estate investments require management to keep the space leased & maintained to preserve the value of investment.
Returns can depend heavily on the competency of management’s ability to respond to market conditions.

Question 6

1.6. Interest Rate Risk
Changes in interest rates affect all securities and investments.
Real estate tends to be highly ?, and thus the rate of return can be significantly affected by changes in interest rates
Direct impact on variable rate mortgage: ???
Indirect impact on fixed rate mortgage or no mortgage :by lowering the ? that a ?? is willing to pay)

Answer 6

1.6. Interest Rate Risk
Changes in interest rates affect all securities and investments.
Real estate tends to be highly leveraged, and thus the rate of return can be significantly affected by changes in interest rates
Direct impact on variable rate mortgage (higher monthly repayments)
Indirect impact on fixed rate mortgage or no mortgage (by lowering the price that a subsequent buyer is willing to pay)

Question 7

1.7. ? Risk
Some regulatory changes can adversely affect the profitability of the real estate investment (e.g., stamp duty, tax laws, other restrictions imposed by government).

Answer 7

1.7. Legislative Risk
Some regulatory changes can adversely affect the profitability of the real estate investment (e.g., stamp duty, tax laws, other restrictions imposed by government).

Question 8

Does the investment in income producing property provide a competitive return?

Answer 8

Q: Does the investment in income producing property provide a competitive return?
A: it depends on…
Nature of real estate investments
(apartment, office, hotel, etc.)
Alternative investments that are available (bonds, stocks, commodities, etc.)
Returns and risk on these alternatives

Question 9

Q: How can an investor effectively manage the risks associated with real estate investment?

Answer 9

Q: How can an investor effectively manage the risks associated with real estate investment?

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)

Question 10

To identify and evaluate the riskiness of an investment:
=> ? Analysis (what-if) :
- ? Case (based on the best estimate of the most likely situation e.g., rent, vacancy, etc.) as a benchmark for analysis
- Change a ? assumption
What is its effect on NPV or IRR?
- Change ? assumptions at once (i.e., Scenario Analysis)
- Identify i) ? likely, ii) ? , and iii) ? scenarios; and see how much investment performance is affected by these best-case or worse-case scenarios.

Answer 10

To identify and evaluate the riskiness of an investment:
=> Sensitivity Analysis (what-if):
- Base Case (based on the best estimate of the most likely situation e.g., rent, vacancy, etc.) as a benchmark for analysis
- Change a single assumption
What is its effect on NPV or IRR?
- Change multiple assumptions at once (i.e., Scenario Analysis)
- Identify i) most likely, ii) pessimistic, and iii) optimistic scenarios; and see how much investment performance is affected by these best-case or worse-case scenarios.

Question 11

Return on equity investment in real estate comprises two sources of cash flow: (1) cash flow from ? and (2) cash flow from the ? of the property.

In general, the greater a proportion of IRR is made up of (2) the ? the risk & uncertainty facing the investor.

Answer 11

Return on equity investment in real estate comprises two sources of cash flow: (1) cash flow from operations and (2) cash flow from the sale of the property.

In general, the greater a proportion of IRR is made up of (2) the greater the risk & uncertainty facing the investor.

Question 12

Partitioning the IRR (=> How is the total IRR distributed between ??? and property ? cash flow?):
Compute the IRR
Discount cash flows from operations (using the IRR as the discount rate)
Discount cash flow from property sale (using the IRR as the discount rate)
Compute the percentages

Answer 12

Partitioning 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 as the discount rate)
Discount cash flow from property sale (using the IRR as the discount rate)
Compute the percentages

Question 13

The riskier (more uncertain) portion of the return (between operating cash flow and property sale cash flow) is usually ???.
Because expected returns of price appreciation of property sale is further away in the future => more uncertainty

Answer 13

The riskier (more uncertain) portion of the return (between operating cash flow and property sale cash flow) is usually property price appreciation.
Because expected returns of price appreciation of property sale is further away in the future => more uncertainty

Question 14

II. Variation in Risk and Return:
1. Use economic scenarios:
- compute ?? of each scenario
- compute ?       ##
=> expected return = sum(?* ? of each scenario)

Answer 14

II. Variation in Risk and Return:
1. Use economic scenarios:
- compute cash flows of each scenario
- compute IRR             ##
=> expected return = sum(IRR * probability of each scenario)

Question 15

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

Answer 15

II.

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

Question 16

II. 
2. Coefficient of Variation:
CV = Standard ? / expected ?
- A measure of risk per unit of (expected) return
- Standardized measure

Answer 16

II. 
2. Coefficient of Variation:
CV = Standard deviation / expected IRR
- A measure of risk per unit of (expected) return
- Standardized measure

Question 17

II.

3. Portfolio considerations
   - Reduce risk by combining assets into a portfolio (e.g., office, apartment, hotel)
   - Diversification

Answer 17

II.

3. Portfolio considerations
   - Reduce risk by combining assets into a portfolio(e.g., office, apartment, hotel)
   - Diversification

Question 18

An investor is analyzing the risk of a possible investment by producing three different scenarios. Under a pessimistic scenario, the property would produce a BTIRRp of 10%; a most-likely scenario produces a BTIRRp of 15%; an optimistic scenario produces a BTIRRp of 20%. The investor assigns the pessimistic scenario a 25% chance of occurring, the most-likely case a 50% chance of occurring, and the optimistic scenario a 25% chance of occurring. What is the standard deviation of the returns?

Answer 18

Mean return = .010.25 + 0.150.5 + 0.2*0.25 = 0.15

S.D = Square [0.25 ( (.1-.15)^2 ) + 0.5 *
( (.15-.15)^2 ) + 0.25 ( (.2-.15) ^2]
=> S.D. = 0.03536