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FNCE 333 Lecture 14

FNCE 333 Lecture 14. Risk Analysis Professor C. F. Sirmans. Readings. Brueggeman and Fisher, Chapter 13 Readings 22, 23, 24. Overview. The Risk-Return tradeoff in real estate investing. What are the types of risks in real estate investing? How to account for risks?

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FNCE 333 Lecture 14

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  1. FNCE 333Lecture 14 Risk Analysis Professor C. F. Sirmans

  2. Readings • Brueggeman and Fisher, Chapter 13 • Readings 22, 23, 24

  3. Overview • The Risk-Return tradeoff in real estate investing. • What are the types of risks in real estate investing? • How to account for risks? • How to manage risks?

  4. Investment Strategies alongRisk-Return Tradeoff • Income (Lowest Risk) Strategy Triple-Net Leased Properties Investment-grade CMBS Whole Mortgage Loans • Balanced Investment Strategy Fully-leased Multi-tenanted Properties Large Cap REIT

  5. Investment Strategies • High Yield 1. Subordinated CMBS Tranches 2. Mezzanine Debt 3. REITs • Growth 1. Recovering Market 2. Low Lease-up risk properties 3. Development Oriented REITs

  6. Investment Strategies • Opportunistic (Highest Risk) 1. Turn-around investments 2. High Lease-up risk 3. Redevelopment/Expansion 4. Recovering Markets

  7. Investment Strategies • Any real estate investment strategy requires careful “due diligence” at the acquisition phase of the decision-making process. • Likewise, the investor must constantly reevaluate the risk exposure of an investment during the operations phase.

  8. Due Diligence The process through which the investor confirms and supports the selection of the property to be acquired, develops the investment strategy for the property and identifies how to “add value”.

  9. Due Diligence • What are the risks associated with a real estate investment? • Can the investor create value through risk management? • Any action that a firm takes that investors could take on their own does not create value.

  10. Value Creation How to create/add value to a real estate investment? • Increasing cash flows • Improving the physical design or layout • Changing use/density • Changing the Property Rights/Risk

  11. Market Financial Liquidity Inflation Capital Markets Management Legislative Environmental Other (terrorism, weather) Types of Risks

  12. Property Level Risks • Deferred maintenance • Financially troubled tenants • Is property non-conforming use? • Functional/obsolete factors • Leases below/above market rents? • Development options in property? • New supply in the market • Local governmental constraints • Local government plans, i.e., transportation?

  13. Risk Aspects • Some aspects of the risks in real estate investments: A. Income component for most property types is fairly stable. Why? Long-term lease effect. B. The capital gain component is volatile.

  14. Required Rate of Return 1. Risk-free rate 2. Risk Premium

  15. Risk Premium • The following slide illustrates the changes in the risk premium on “institutional” grade real estate over recent years. • What would cause the premium to decline?

  16. IRR Compression 2001-2005 (Median Ten Year IRR)

  17. Risk Premium • How to calculate the risk premium? • Extracting the risk premium from the market. Example: Overall Cap Rate

  18. NCRIEF cap rates continue to decline despite all expectations that the minimum level has been found. Real Capital Analytics data is similar to the NCREIF data with the exception of showing some categories with cap rate increases such as industrial properties in secondary markets, office properties in primary markets and all apartments. There is no trend of rising cap rates as increases are only over a single quarter. Only expectation leads to a conclusion that cap rate have hit bottom in most property types. Cap rates are still falling in retail and primary industrial markets. Cap Rates Capitalization rates

  19. Total returns for core real estate are still above a sustainable level. NCREIF Returns: End 2006 with 10% return Go to a more sustainable single-digit number during calendar year 2007 Real Estate Returns Total returns: stocks, bonds and real estate

  20. The cap rate spread over Treasuries. As the 3rd quarter evolved, cap rates continued to fall but 10-year Treasuries fell back to the mid 4% level preserving a spread. It is reasonable to expect that this relationship will invert with Treasuries over cap rates, if the long-end of the yield curve responds to the short-end and inflation expectations rise. Cap Rates Capitalization rates and spreads

  21. Despite Lows in Cap Rates, Risk Premium Still Applies

  22. Upturn in Property Valuations Beginning in 2003 • NCREIF total returns in 05 hit 20%. • 12.7% Capital Appreciation • 6.75% Income • More volatility to capital appreciation component • Capital appreciation: • Turned positivebeginning in ‘96, • Peaked at 6.83% in ‘98, • Returned to negative levels in ‘01. • Positive once again in ’03 at 0.96%.

  23. Market Risk • The link between changes in vacancy rates and changes in rents. • What has happened to market fundamentals in the various “food groups” in recent years?

  24. Office: Vacancy and Rental Rates

  25. Retail Vacancy Rates and Rents

  26. Multifamily

  27. Capital Markets Risk • A major category of risk – shifts in supply and demand for debt and equity capital. • Cost of mortgage debt and supply of mortgage debt. • What happens if interest rates rise?

  28. Cost of Mortgage Debt Borrower’s Market Still Low Treasury Rates + Contracting Mortgage Spreads Cheaper Commercial Mortgage Financing Rates • Declines in financing rates driven by: • Strong capital in-flows into CRE • Participation of public capital markets • Conduit lenders inject liquidity • Expanded products

  29. Sensitivity Analysis • How sensitive is IRR or NPV to change in assumptions? • Scenario Analysis Pessimistic, Most Likely, Optimistic • Expected return or NPV for each • Monte Carlo Simulations

  30. Managing Risks • Insurance • Diversification • Hedging

  31. Insurance • Paying a premium to avoid a loss. • Substitute a sure loss (premium) for the possibility of a greater loss. • Retain possibility of a gain

  32. Insurance Examples of Insurance Contracts in Real Estate Investing 1. Fire/Earthquake/Hazard Insurance 2. Mortgage Default Insurance 3. “Insurance-Like” Contracts

  33. Hedging • Reduce exposure to risk but give up possibility of gain • Example: Derivative products • Contract to sell or option to sell

  34. Diversification • How to diversity in real estate A. Property type B. Geographically

  35. Diversification • In Lecture 15 we will discuss different types of real estate equity portfolios and diversification strategies.

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