Chapter 13: Risk Analysis McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

13-2 Comparing 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 13-1 Risk and Return (alternative investments)

13-4 Types 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 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

13-6 Types of Risk –Interest Rate Risk  The impact on variable rate debt  The impact of higher rates on residual property value –Legislative Risk  Regulatory 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 Management  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 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 13-7 Probability Distribution of IRRs (office, apartment, hotel)

13-10 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 –Discount cash flow from property sale using the IRR –Compute the percentages

13-11 Partitioning the IRR  Example 13-1 –Equity Invested = $600,000 –BTOCF 1 = $40,000 –BTOCF 2 = $42,000 –BTOCF 3 = $45,000 + $800,000 from sale –IRR = 16.48% –Where BTOCF = Before tax operating cash flow

13-12 Partitioning 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

13-13 Partitioning 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.

13-14 Variation 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

13-15 Variation 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.

13-16 Variation 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

13-17 Lease 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 Risk  Renewal Probability  Market Leasing Assumptions  Market Rent Assumptions  Turnover Vacancy  Leasing Commissions  Tenant Improvements

13-19 Real 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