1. Fundamentals of Real Estate Lecture 8 Spring, 2002 Copyright © Joseph A. Petry www.cba.uiuc.edu/jpetry/Fin_264_sp02

2. 2 Exam on Wednesday, 2/13 MC, 30-40 questions, similar to homework, class examples. Exam will cover ch. 1-4 & 6. Office hours: Monday, 4-5, Tuesday 9:00-11:00. Web-board questions checked Monday & Tuesday with all questions answered by 5:00pm each day. Homework this week to be checked off, then returned during class. Housekeeping Issues

3. 3 Portfolio Concept of Risk We now can calculate the risk (standard deviation) associated with the returns of specific real estate investments. Most investors however, have more than one asset in their portfolio. Hence they are interested not in the risk of the individual asset, but the implication that adding another asset has on the risk of the overall portfolio. Risk & Real Estate Investment

4. 4 Portfolio Concept of Risk (cont’d) Financial literature generally categorizes risk as either diversifiable (a.k.a. unsystematic, investment specific risk) or nondiversifiable (systematic, or market risk). Diversifiable risk in the real estate market would include management risk, geographic risk, market segment risk (e.g. retail shopping centers). Risk & Real Estate Investment

5. 5 Portfolio Concept of Risk (cont’d) Examples of non-diversifiable risk would include overall economic performance, or major legislative changes. The benefits of portfolio diversification are difficult to overstate. Via proper diversification, the risk of the portfolio can be lower than the risk of any of your investment alternatives with the similar average returns. Diversification benefits can be enjoyed within a real estate portfolio, and between asset classes, such as real estate, stocks and bonds. Risk & Real Estate Investment

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7. 7 Portfolio Concept of Risk (cont’d) Obtaining the benefits of diversification come from combining assets whose returns are uncorrelated. Covariance can range between negative infinity and positive infinity, with a value of zero signifying that the two values move independently of one another, while a large positive number or large negative number suggest a high degree of negative or positive co-movement. Risk & Real Estate Investment

8. 8 Portfolio Concept of Risk (cont’d) Correlation Coefficient is closely related to the covariance, and is even more useful. – It can range from –1 to +1. A value of zero signifies the variables are uncorrelated. –1 indicates perfect negative correlation, and +1 indicates perfect positive correlation. Any correlation coefficient below +1, and there will be diversification benefits. The benefits become more significant the closer to –1. Risk & Real Estate Investment

9. 9 Portfolio Concept of Risk (cont’d) Within real estate, diversification can take a number of forms: – Property type diversification – Geographic diversification – Combining public and private market investments How risky is real estate compared to other investment types, and are there opportunities for diversifying across asset classes? Risk & Real Estate Investment

10. 10 Risk & Real Estate Investment

11. 11 Risk & Real Estate Investment