Transcript Chapter 6 - Extra Materials

Session Plan
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Chapter Six:
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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
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Business Risk
Financial Risk
Liquidity Risk
Inflation Risk
Management Risk
Interest Rate Risk
Legislative Risk
Environmental Risk
Business Risk
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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
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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
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For both the investor and the lender
Liquidity Risk
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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
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Typically takes up to six months to do so
Could be longer for more specialty use properties
Liquidity Risk Continued
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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:
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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
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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.
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$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
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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
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If have soft markets (high vacancy) it may not
Inflation Risk Continued
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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
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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
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Must have competent management in real
estate
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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
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Concept of Absentee Management
Management Risk Continued
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There is certainly some variability in the level
of property management required for a
specific property
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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
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This affects all investments
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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
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This goes back to wanting to have certainty in
business
Determinants of Interest Rates
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Whether for residential or investment properties:
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Supply and Demand of mortgage funds
As the cost of borrowing rises, the demand for new mortgage funds
typically falls (not always!)
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The amount of loan losses & defaults also affects the supply of funds
on offer by commercial and investment banks.
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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%)
Credit Crunch has slowed demand in most areas
Another factor influencing supply is the cost of loan origination
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Cost is relative to other investment opportunities
This led to outsourcing of some jobs as we discussed last week
The Federal Reserve in Brief
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The Fed affects the level of interest rates in the economy by three
primary mechanisms
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Open market operations
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Buying and selling Government Bonds in conjunction with commercial
banks
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The discount rate
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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)
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
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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
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Demand for credit (mortgage loans) is determined by
the following factors:
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Economic vibrancy of the local & national economy
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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
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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
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This is the minimum rate of interest that savers must
earn to forego current consumption
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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…
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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
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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.
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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:
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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?
Rate of Interest
Effect of ending interest rate swap over term of loan
Market Movement A
-------------------------------------------- 8% Market Rate of Interest
Swap Profit
--------------------------------------------------------------6% Contract Rate of Interest
Breakage Fee
------------------------------------------- 4% Market Rate of Interest
Market Movement B
Time
Ben Bernanke & Your Loan
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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.
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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
14.0%
12.0%
10.0%
08.0%
06.0%
04.0%
02.0%
00.0%
1985
1990
1995
3M LIBOR
2000
PRIME
2005
10Y Treasury
All three indices for last 25 years as of 09/12/2011.
2010
Interest Rate Risk Continued
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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
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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
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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
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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
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Phase I and Phase II Reports
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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
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What are some danger signs for investment
property:
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Prior use including on-site dry cleaning operation
Manufacture & Disposal of hazardous materials
Presence of underground storage tanks
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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
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Keep in mind that an environmental problem
will reduce the appraised value of the property
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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
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If environmental issue started on your property and
then spread to others (via groundwater, air, etc.)
Why Bother?
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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
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Then make an assessment if the risk is worth the
expected return.
Risk Preferences
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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
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And hopefully their knowledge of the risks involved!!
Sensitivity Analysis
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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:
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interest rates, vacancy rates, operating expenses,
& the expected resale price
Sensitivity Analysis
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The direct capitalization spreadsheets that
we discussed last week have a section
devoted to sensitivity for the following areas:
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Vacancy rates
Loan interest rates
Capitalization rates
Various Iterations
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The method to sensitivity analysis is to
prepare three possible scenarios
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Most Likely Case Scenario
Pessimistic (or Worst Case) Scenario
Optimistic (or Best Case) Scenario
Various Iterations Continued
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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
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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
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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
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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
Most Likely
Optimistic
6.50%
25.00%
10.75%
50.00%
14.25%
25.00%
Expected Return:
1.63%
5.38%
3.56%
10.56%
Variance & Expected Return
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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
Pessimistic
6.50%
25.00%
Most Likely 10.75%
50.00%
Optimistic
14.25%
25.00%
Expected Return:
R*P
R-Exp. Ret. P* (R-Exp. Ret)2
1.63%
-4.06%
0.0413%
5.38%
0.19%
0.0002%
3.56%
3.69%
0.0340%
10.56% Variance:
0.0754%
Variation and Risk
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The higher the variation, the more risk in the
deal.
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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
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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.
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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
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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.
Pessimistic
Most Likely
Optimistic
Return Probability
6.50%
25.00%
10.75%
50.00%
14.25%
25.00%
Expected Return:
Range of Expected Returns:
R*P
R-Exp. Ret. P* (R-Exp. Ret)2
1.63%
-4.06%
0.0413%
5.38%
0.19%
0.0002%
3.56%
3.69%
0.0340%
10.56% Variance:
0.0754%
Std. Dev.
2.75%
7.81%-10.56%-13.31%
Partitioning the IRR
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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.
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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
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Year
BTCF
Investment A
1
2
3
4
4 (Sale)
$ 5,000 $ 10,000 $ 12,000 $ 15,000 $ 120,000
Year
BTCF
Investment B
1
2
3
4
4 (Sale)
$ 2,000 $ 4,000 $ 1,000 $ 5,000 $ 180,000
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?
IRR Partition Problem
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A. Using your financial
calculator:
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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
1
2
3
4
4 (sale)
Year
1
2
3
4
4 (sale)
Investment A
BTCF
$ 5,000
$ 10,000
$ 12,000
$ 15,000
$ 120,000
$
Investment B
BTCF
$ 2,000 $
$ 4,000 $
$ 1,000 $
$ 5,000 $
$ 180,000 $
$
PV
4,501
8,103
8,753
9,849
78,792
109,998
PV
1,774
3,145
697
3,092
111,301
120,009
IRR Partition Problem
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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.
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Due to having leases for the operation cash flows.
Due to forecast of cap rates at time of sale.
Why Borrow Money?
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Some investors do not have the ability to
purchase investment property with cash
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Sometimes this is feasible with 1031 Exchange
Dollars
Investors may want to use equity in multiple
properties to obtain the benefits of financial
leverage.
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To increase the size of their purchase
To magnify their expected rate of return
Risk & Leverage
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If risk and return are positively related, then it follows
that risk and leverage should also be positively
related, right?
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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
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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
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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
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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
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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
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BTIRRE= BTIRRP+ (BTIRRP-BTIRRD) (D/E)
Where:
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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
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This concept makes sense when you view it
in realistic terms:
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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
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ATIRRE= ATIRRP+ (ATIRRP-ATIRRD) (D/E)
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Same formula as the before tax case
In either case, the effect of increased leverage is:
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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.
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Break Even Interest Rate
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This is the maximum interest rate paid on debt before leverage
becomes unfavorable
Keep in mind the incremental cost of debt
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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
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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
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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
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Quantity
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How much lease income per month (historical/projected)?
Comparison to market rental rates per square foot for similar
properties.
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Quality
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Diversification (number of tenants)
Tenant financial strength (internal information or Business
Credit Report when applicable)
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Durability
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Length of leases relative to term of loan.
Mgmt Experience with property (or similar properties)
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End of Session