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The Effects of Risk. As we know, the cap rate relation is given by: R = NOI/V This relation is also the total return relation when an investor buys an income property for cash (V=AP) and holds it in perpetuity: y = NOI/AP - PowerPoint PPT Presentation
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The Effects of RiskAs we know, the cap rate relation is given by:
R = NOI/VThis relation is also the total return relation
when an investor buys an income property for cash (V=AP) and holds it in perpetuity: y = NOI/AP
Economy, market (regional), and property specific risk factors affect the NOI of a property
One approach to modeling the impact of risks on NOI is by treating NOI as a stochastic variable
NOI Under UncertaintyLet NOI (NOI + , where is “white
noise” with E()=0 and E()=2(NOI). Then,
R = (NOI + /v and, in the previous example, y = (NOI + /AP
The variance on returns is:2
(R) = (1/V2) 2(NOI) = (1/AP2) 2
(NOI) = 2(y)
Risks With Debt FinancingV > AP, when an investor borrows to
finance the purchase of an income producing property
In exchange, the investors assume new market and economic (financial) risks
Relevant cash flows now must account for debt service
Risks With Financing: LeverageBTCF = (NOI – DS) + , where is “white
noise” Assuming loan terms may be extended in
perpetuity (infinite refinancing at the same terms), the risk of a debt financing purchase are higher than that of a cash purchase: 2
(BTCF) = (1/V2) 2(NOI) < (1/AP2)
2(NOI) = 2
(y)
Risks With Financing: Debt Service
BTCF = (NOI + ) – (DS + ), where e and v are uncorrelated white noise, with E()=0, E()=2
(NOI), E()=0, E()=2(DS),
and E() = 0Then, the variance of the total returns
changes to:2
(BTCF) = (1/V2) 2(joint) < (1/AP2) 2
(joint) = 2(y)
Where: 2(joint) = (2
(NOI) + 2(DS) ) > 2
(NOI)
Managing Debt Service Risks
BTCF = (NOI + ) – (DS + ), where and are negatively correlated white noise, with E()=0, E()=2
(NOI), E()=0, E()=2
(DS).And E() < 0Then, the variance of the total returns
changes to:2
(BTCF) = (1/V2) 2(joint) < (1/AP2) 2
(joint) = 2(y)
Where: 2(joint)=2
(NOI) + 2(DS) + 2E(),
which is lower than the joint risk under the assumption of zero correlation
Managing Debt Service RisksParticipation loans, convertible
mortgages, interest only and accrual loans are examples of financing tools that can accomplish the above “negative correlation between debt service uncertainties and income uncertainties. Risks do not disappear, they are shared – to the extent lenders and borrowers have incentives (return) that affect their risk taking decision
Summary
Debt financing augments risks of investing in income properties by reducing the expected cash flows before taxes
Debt financing augments risks of investing in income properties by introducing financing risks that are usually partly correlated with cash flow risks
The net effect of debt financing is to enhance the expected return from an income generating property, at the expense of increasing the assumed risks from investing in debt financed real estate
Summary
Debt financing may be used to accomplish the same risk reduction/sharing that is accomplished by investors choosing alternative ownership structures (partnerships, incorporations, etc.) to spread risks of investing in real estate.
The major difference between decisions about risk versus decisions about ownership structure is that before-tax returns are not augmented by the choice of ownership structure, as they are by the choice of financing terms
Summary
Loan terms (loan amount, amortization schedule, loan term, refinancing terms, nature of interest rate and interest payments, lender participation in cash flows, convertibility of debt instrument, etc.) Are used by the lender and the investor to manage or allocate the financing risks of the income producing property