Chapter 13:

Risk Analysis
McGraw-Hill/Irwin

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

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

13-2

Exhibit 13-1
Risk and Return (alternative investments)

13-3

Types of Risk
Business Risk
Economic Conditions
Tenant Mix
Lease Provisions

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

13-4

Types of Risk
Liquidity Risk
Challenges in selling property

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

Management Risk
Competency of managements ability to
respond to market conditions
13-5

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.
13-6

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)
13-7

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
13-8

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

13-9

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
13-10

Partitioning 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

13-11

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
13-12

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.
13-13

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

13-14

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.

13-15

Variation in Risk & Return

Coefficient of Variation

CV
E (IRR)
Risk per unit of (expected) return
Standardized measure of stand-alone risk

Portfolio considerations
Reduce risk by combining assets into a portfolio
Diversification
13-16

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

13-17

Lease Rollover Risk

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

13-18

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
13-19