Session Plan

Chapter Six:– The Different Types of Risk– Risk Preferences for Investors– Due Diligence in RE Investment Risk Analysis– Portfolio Considerations of Risk– Partitioning the IRR– Sensitivity Analysis Mini-Case

Types of Risk

Business Risk Financial Risk Liquidity Risk Inflation Risk Management Risk Interest Rate Risk Legislative Risk Environmental Risk

Business Risk

This risk is due to fluctuations in the economy This type of risk is a part of each form of investment

– Whether real estate, stocks, bonds, etc. We have discussed characteristics that impact

business risk– Changes in demand, population changes,

changes in base employment, etc. Risk could be partially alleviated by investing in

multiple geographic areas (or countries)

Financial Risk

This risk is associated with the use of debt financing

Last time we discussed how financial leverage can be either positive or negative in terms of the total return, but also that any time leverage is increased, risk is increased– For both the investor and the lender

Liquidity Risk

This risk is associated with a lack of a deep market with many buyers and sellers, and frequent transactions

The less liquid a market is, the more likely price concessions are offered by the seller

Real estate is a less liquid form of investment when compared with other investments due to the time it takes to buy and sell property– Typically takes up to six months to do so– Could be longer for more specialty use properties

Liquidity Risk Continued

Specialty use properties (nursing homes, restaurants, marinas, etc.) take longer to sell as there are less alternative uses for the property should the property experience vacancy issues

Sometimes liquidity can adversely affect more traditional properties as well:– Assume that there are very few houses in a given town

with a price over $500M. This is a nice problem to have, but could present trouble if you have to sell the property quickly

Liquidity Risk: Sub-Prime Crisis

Sept 15, 2008: Lehman Brothers files for Chapter 11 with $60 billion in bad RE holdings, Merrill Lynch sells to Bank of America for $50 billion, AIG seeks $40 billion bridge loan from Fed.

$70 billion pool of funds created to lend to troubled banks.

– $7 billion each from Citi, BofA, Barclay’s, UBS, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Merrill Lynch, & Morgan Stanley.

As we know, this was only the beginning!

Inflation Risk

The risk here is unexpected inflation. As we discussed in an earlier chapter, prudent

lenders price their loans with expected inflation in mind.

As compared with other investments, real estate performs well here due to step up provisions in leases for revenues and expenses, and since property appreciation has historically kept up with inflation– If have soft markets (high vacancy) it may not

Inflation Risk Continued

Sometimes investors purchase a property hoping that the appreciation will consistently beat inflation

While over the long run this has been the case, it will depend on the strength of the market as to whether a specific property will bring in the expected returns for an investor

– Cap rates had been near 40 year lows in many markets, but prices are starting to decline in many markets as cap rates have risen 150-180 basis points in many markets over last 24 months

Management Risk

Must have competent management in real estate– Less likely to be something the investor has to

handle personally for stocks and bonds Some investors have the ability to keep a

performing property leased, and possibly to lease-up an under-performer, but most investors wind up hiring a property manager– Concept of Absentee Management

Management Risk Continued

There is certainly some variability in the level of property management required for a specific property– Apartment properties require someone on staff full-

time (as do self-storage facilities), but single tenant buildings require very little day to day management

– Leasing activity is higher for larger retail and office properties given the “frictional vacancy” that occurs as tenants move in and out

Interest Rate Risk

This affects all investments– But since real estate is typically highly leveraged,

it has a high impact on this type of investment

As rates rise, investors are less likely to borrow money, and may have more trouble paying their bank debt service if they have a variable rate– This goes back to wanting to have certainty in

business

Determinants of Interest Rates

Whether for residential or investment properties:– Supply and Demand of mortgage funds– As the cost of borrowing rises, the demand for new mortgage funds

typically falls (not always!) Recent rises have slowed refinance requests, and have slowed real estate

development opportunities… The Fed has moved interest rates substantially over the last few years 17 consecutive times from June 2004 to July 2006 Moved Bank Prime rate from 4.00% to 8.25% Recently been going in the other direction (now 3.25%)

– The amount of loan losses & defaults also affects the supply of funds on offer by commercial and investment banks.

Credit Crunch has slowed demand in most areas– Another factor influencing supply is the cost of loan origination

Cost is relative to other investment opportunities This led to outsourcing of some jobs as we discussed last week

The Federal Reserve in Brief

The Fed affects the level of interest rates in the economy by three primary mechanisms

– Open market operations Buying and selling Government Bonds in conjunction with commercial

banks– If desire more money in the economy, the Fed buys Gov’t bonds (to increase

the amount of money in the economy)– If the Fed wants to contract monetary policy, the Fed will sell these same

bonds to banks (to reduce the cash holdings available in the economy)– The discount rate

This has lately been the primary method of affecting the supply of money in the U.S.

Discount Rate (Fed to Banks) is now very low (0.75%) Federal Funds Rate (Banks to Banks) is now close to zero (0.25%)

– Reserve requirements The Fed can mandate that banks increase their level of reserves, which

will reduce the amount of funds that they can lend out. Basel Accord Issues…

Determinants of Interest Rates: Demand Side

Demand for credit (mortgage loans) is determined by the following factors:

– Economic vibrancy of the local & national economy Remember GDP formula: C+I+G+Nx How does education of workforce play a role here?

– # of households or businesses in a given area– Stage of economic cycle of the area

The Southeast and West Coast of the US were still growing (both in population and in economic opportunity) relative to the rest of the country until the recent economic troubles

If geographic area is in mature stage of credit cycle, there will be less borrowing need and less lending opportunity as compared with other areas.

Real Rate of Interest

This is the minimum rate of interest that savers must earn to forego current consumption

– The U.S. ranks at the bottom of the list internationally in terms of savings rates for developed countries

Included in the discussion of real interest rates is the effect inflation will have in the future…

– Real Rate of Interest= nominal interest rate - inflation expectations

– This was first determined by the Yale Economist Irving Fisher (1867-1947) and is known as the Fisher Effect.

Interest Rates and Risk

Now that we have discussed factors that influence the cost of borrowing (interest rate), the next question is who bears the risk when interest rates rise and fall?

Many investment real estate deals are priced on a variable rate of interest or a fixed rate of interest.

– Fixed interest rate loans are more common, but some borrowers prefer to have variable rate loans.

– The borrower (investor) assumes all of the interest rate risk on a variable rate loan.

– A traditional fixed rate loan eliminates the upside risk of interest rate movements during the term of the loan for an investor.

Products such as interest rate swaps allow the bank to earn a fee for providing a fixed rate, and provides “two-way make whole” language that provides the following:

– The investor to make money if rates rise during the term of their loan (when they want to end the swap),

– The investor will incur breakage fees if they wish to unwind a swap when rates have fallen during the term of their loan (and they wish to end the swap).

To Hedge or not the Hedge?

-------------------------------------------- 8% Market Rate of Interest

---------------------------------------------------------------6% Contract Rate of Interest

------------------------------------------- 4% Market Rate of Interest

Rat

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f In

tere

st

Effect of ending interest rate swap over term of loan

Time

Market Movement A

Market Movement B

Breakage Fee

Swap Profit

Ben Bernanke & Your Loan

Whether the rate on a loan is variable or fixed, the monetary policy of the Fed affects your borrowing cost as an investor.

– As the Fed increased the Federal Funds rate, banks passed this onto their customers by increasing their Prime Rate.

– The Prime Rate is a variable rate historically offered to a bank’s best customer. It is now more of a benchmark than the representation of the best lending rate.

– Some banks prefer to tie their variable rate loans to the London Inter-Bank Offering Rate (LIBOR).

– This is a rate that is not necessarily tied to the US economy. If an investor has a variable rate, and rates rise during the term of

the loan, the cost of borrowing rises.– Remember our “ARMs & Sub-Prime Mortgages” discussion?

Variable rates provide flexibility and do not have any penalties for prepayment which are found on many fixed rate loans.

Interest Rate Movements

00.0%

02.0%

04.0%

06.0%

08.0%

10.0%

12.0%

14.0%

1985 1990 1995 2000 2005 2010

3M LI BOR PRI ME 10Y Treasury

All three indices for last 25 years as of 09/12/2011.

Interest Rate Risk Continued

At the time a loan is made, the interest rate charged reflects (in theory anyway) the lender’s future expectations as to what inflation will be over the term of the loan

Unanticipated inflation hurts all lenders as the actual return on the loan is less than what was initially expected.

There are other risks for the lender…

Other Forms of Lender Risk

Prepayment Risk– If borrowers pay too quickly, will affect lender return

Legislative Risk– Change in regulatory environment could raise costs or

make certain types of lending unattractive for lenders– Patriot Act required more stringent due diligence concerning

getting to know the borrower than before Sept. 11 Default Risk

– Risk of non-payment by borrower due to loss of job, loss of tenants in investment property, or a myriad of other factors

Liquidity Risk– Deals with how easy it is to sell off the loan– If finance too much of the value, could be a problem

Remember: Risk and Return are Directly Related!!!

Legislative Risk

This is a category that affects real estate more than any type of investment

Changes to tax laws, rent controls, zoning allowances, and other restrictions can seriously impact the return that an investor seeks with investment property

A prudent investor will make sure that all of the property permits and zoning are in place for a new construction project, and will verify these same issues for existing properties

Environmental Risk

This is another area that particularly affects real estate as opposed to other investments

Contamination of a property can be a very expensive risk

Most commercial banks have set requirements for which types of environmental risk is acceptable

Investor must estimate total risk for the property and compare with other investments

Environmental Risk

Phase I and Phase II Reports– Investor should pay a qualified environmental inspector to

prepare these reports– Inspector will discuss prior usage of the property and

whether any contamination exists on the site– Report will recommend steps for remediation if problems are

found– If Phase I report is clean, most banks will not require a

Phase II assessment – Phase II assessment includes soil testing, as well as testing

of groundwater, air, etc. if necessary.

Environmental Risk Continued

What are some danger signs for investment property:– Prior use including on-site dry cleaning operation– Manufacture & Disposal of hazardous materials– Presence of underground storage tanks

Gas stations, Auto repair shops, etc.

– Any existing or former use of the property that involved use of chemicals which may have contaminated the land

– In Wetlands/Flood Plain area?

Environmental Risk Continued

Keep in mind that an environmental problem will reduce the appraised value of the property– By the amount of the cost of remediation– Will also reduce a bank’s willingness to finance the

property Environmental problem may cause legal

problems between investor and other property owners– If environmental issue started on your property and

then spread to others (via groundwater, air, etc.)

Why Bother?

With all of these types of risk in investing in real estate, why would anyone purchase an investment property?

Expected returns aside, it is because prudent investors perform due diligence PRIOR to purchasing a property

KNOW YOUR TERRAIN– Then make an assessment if the risk is worth the

expected return.

Risk Preferences

Also keep in mind that different investors have different tolerances for risk

Risk averse investors are more conservative in the properties that they select

Risk Tolerant investors are willing to take gambles in order to obtain a higher return

Either way, all investors make the decision to invest or not invest based on their tolerance for risk– And hopefully their knowledge of the risks involved!!

Sensitivity Analysis

A large part of due diligence for both the investor and the lender is sensitivity analysis.

It is essentially a “what if?” analysis to see how a given property would cash flow the debt and provide the expected return to the investor given movements in certain variables. Namely:– interest rates, vacancy rates, operating expenses,

& the expected resale price

Sensitivity Analysis

The direct capitalization spreadsheets that we discussed last week have a section devoted to sensitivity for the following areas:– Vacancy rates– Loan interest rates– Capitalization rates

Various Iterations

The method to sensitivity analysis is to prepare three possible scenarios – Most Likely Case Scenario– Pessimistic (or Worst Case) Scenario– Optimistic (or Best Case) Scenario

Various Iterations Continued

The lender would compute what the debt coverage ratio would be under the three different scenarios.

The investor would compute what the expected NPV and IRR would be under the three scenarios.

Since risk works to produce variability in return, properties with a higher variation of possible returns are of higher risk than properties with a narrower band of possibilities.

Portfolio Considerations

We can spend the time to find the perfect investment with very limited risk and a great return (not likely!), or we can put together a portfolio of investments in an attempt to diversify the risk.

Diversifiable Risk: unsystematic risk that can be eliminated by holding assets that are less than perfectly correlated.

Portfolio Considerations

Non-Diversifiable Risk: systematic/market risk is the risk remaining in a fully-diversified portfolio.

There are many techniques that investors use to reduce the variability of returns in a portfolio of investments.

Expected Return

Once the investor’s expected returns are computed based on the three “iterations”, the expected return is calculated.

Investor must assign probabilities to each scenario and compute a weighted average expected return. Return Probability R*P

Pessimistic 6.50% 25.00% 1.63%Most Likely 10.75% 50.00% 5.38%Optimistic 14.25% 25.00% 3.56%

10.56%Expected Return:

Variance & Expected Return

Once the weighted average expected return is known, an investor would like to compare the variability of returns between the three scenarios.

The higher the variability, the higher the risk.

Return Probability R*P R-Exp. Ret. P* (R-Exp. Ret)2

Pessimistic 6.50% 25.00% 1.63% -4.06% 0.0413%Most Likely 10.75% 50.00% 5.38% 0.19% 0.0002%Optimistic 14.25% 25.00% 3.56% 3.69% 0.0340%

10.56% Variance: 0.0754%Expected Return:

Variation and Risk

The higher the variation, the more risk in the deal.– This makes intuitive sense doesn’t it?– If there is wide variation between the pessimistic

and optimistic case scenarios, doesn’t it imply that there is an underlying concern with the property’s cash flow or future income stream?

– Possibly something to be gleaned from our QQD framework?

Standard Deviation & Expected Return

Standard deviation is a measure of dispersion about the mean. If we have a normal distribution, the standard deviation can be used to provide a specific range where the actual investment return will fall.– It is the square root of the variance.

If you know the expected return of an investment, you can add and subtract the standard deviation to determine the range of values that, statistically speaking, the actual investment should obtain.

Standard Deviation and Expected Return

By adding and subtracting the standard deviation from our original expected return, we get a range of values that can be expected from the investment.

Return Probability R*P R-Exp. Ret. P* (R-Exp. Ret)2

Pessimistic 6.50% 25.00% 1.63% -4.06% 0.0413%Most Likely 10.75% 50.00% 5.38% 0.19% 0.0002%Optimistic 14.25% 25.00% 3.56% 3.69% 0.0340%

10.56% Variance: 0.0754%Std. Dev. 2.75%

Expected Return:

Range of Expected Returns: 7.81%-10.56%-13.31%

Partitioning the IRR

This is helpful for investors to determine the relative weights of the return components for an investment property and to gauge some idea as to the timing of the receipt of the largest portion of that return.– Is it primarily from cash flow from operations?– Or is the return primarily from the expected future sale

of the property?

Speculative situations rely more heavily on the second component than the first

IRR Partition Problem

Investment A requires an outlay of $110M. Investment B requires an outlay of $120M. A. What is the BTIRR on each investment? B. If the BTIRR were partitioned, which proportions of the BTIRR would be

represented by BTIRRo and by BTIRRs? C. What do these proportions mean?

Year 1 2 3 4 4 (Sale)BTCF 5,000$ 10,000$ 12,000$ 15,000$ 120,000$

Year 1 2 3 4 4 (Sale)BTCF 2,000$ 4,000$ 1,000$ 5,000$ 180,000$

Investment A

Investment B

IRR Partition Problem

A. Using your financial calculator:– Investment A BTIRR is 11.09%– Investment B BTIRR is 12.77%

B. Use the BTIRR results above to discount the cash flows to partition the IRR.

Year BTCF PV1 5,000$ 4,501 2 10,000$ 8,103 3 12,000$ 8,753 4 15,000$ 9,849

4 (sale) 120,000$ 78,792 109,998$

Year BTCF PV1 2,000$ 1,774$ 2 4,000$ 3,145$ 3 1,000$ 697$ 4 5,000$ 3,092$

4 (sale) 180,000$ 111,301$ 120,009$

Investment A

Investment B

IRR Partition Problem

B. The reversion (or sale) portion of the cash flow for investment A is 72%, and is 93% for investment B.

C. Investment B is much more dependent on the reversion. It should be considered more risky as there is more uncertainty concerning the estimated resale price on the property than for the cash flow from operations.– Due to having leases for the operation cash flows.– Due to forecast of cap rates at time of sale.

Why Borrow Money?

Some investors do not have the ability to purchase investment property with cash– Sometimes this is feasible with 1031 Exchange

Dollars Investors may want to use equity in multiple

properties to obtain the benefits of financial leverage.– To increase the size of their purchase– To magnify their expected rate of return

Risk & Leverage

If risk and return are positively related, then it follows that risk and leverage should also be positively related, right?

– It depends on the cost of debt relative to the expected returns that an investor expects to receive.

Typically, the more leverage, the greater the risk for the lender

– Especially since an investor is more likely to let a bank foreclose on a non-performing property if they have very little of their own money tied up in the form of equity

Financial Leverage

Financial Leverage can be either positive or negative for an investor…

Positive leverage is achieved via borrowing at a rate lower than the expected rate of return on the total funds invested in a property

– Before Tax IRR for equity & debt exceeds Before Tax IRR of debt alone

Negative leverage is when the cost of debt is higher than the expected rate of return on total funds invested

– BTIRRD > BTIRRP

– The more you borrow in this situation, the worse your returns become

– Like a money-losing firm trying to make it up with volume!

Positive Leverage Before Tax

BTIRRE= BTIRRP+ (BTIRRP-BTIRRD) (D/E) Where:

– BTIRRE=Before Tax IRR on Equity Invested

– BTIRRP= Before Tax IRR on Total Investment in the Property

– BTIRRD=Before Tax IRR on Debt

– D/E= Ratio of Debt to Equity

Financial Leverage: Intuitive Sense

This concept makes sense when you view it in realistic terms:– If the cost of borrowing money is higher than what

you expect to earn from those funds, then why would you want to borrow?

– If this concept wasn’t valid, then the Federal Reserve raising interest rates would not curtail investors from wanting to borrow money.

After Tax IRR

ATIRRE= ATIRRP+ (ATIRRP-ATIRRD) (D/E)

Same formula as the before tax case In either case, the effect of increased leverage is:

– Increased financial risk (ceteris paribus)– Increased variability of returns of before and after tax cash

flow and equity reversion Risk (measured by standard deviation) will always increase

with leverage. Whether the expected return increases depends on

whether leverage is favorable or not.

Break Even Interest Rate

This is the maximum interest rate paid on debt before leverage becomes unfavorable

Keep in mind the incremental cost of debt– Figure the cost of borrowing as you move up the loan to value ratio

ladder– Many banks will require a higher interest rate if less investor equity is

required into an investment– As the level of leverage increases, the level of risk rises as well

BTIRRD= ATIRRP ÷ (1-T)

The Before Tax IRR of Debt is equal to the After Tax IRR of the project divided by one minus the investor’s tax rate

Thus, ATIRRP = BTIRRD x (1-T)

Deciding How Much Leverage is Appropriate

Banks look to debt coverage ratios for income producing property as a benchmark for the relative risk on a specific loan opportunity

Banks also have minimum requirements for the amount of equity that is required for an investor to inject into a deal

– Depending on the financial strength of the investor or the specific property, these minimum guidelines could be reduced

– But typically, banks will want some of the investor’s own money at risk and not just the bank’s money

Cash Flow Fundamentals

Quantity How much lease income per month (historical/projected)? Comparison to market rental rates per square foot for similar

properties.

Quality Diversification (number of tenants) Tenant financial strength (internal information or Business Credit

Report when applicable)

Durability Length of leases relative to term of loan. Mgmt Experience with property (or similar properties)

End of Session