Chapter 16
Risk Analysis, Leverage and Due Diligence
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Major Topics Causes of Risk Versus Statistical Measures Understanding the sources of returns as a way
to understand the causes of risk Partitioning the IRR Changing the required rate of return or discount rate Cycles and Risk Sensitivity Analysis Simulation Analysis Causes of Risk and Risk Management Market Due Diligence Property Due Diligence People Due Diligence Contractual Due Diligence Financial Leverage and Equity Return Risk Positive and Negative Leverage Risks of Below Market Financing. Creative Uses of Financing
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Introduction
In the context of real estate investment,
risk is anything that creates volatility in the expected returns
their ability to analyze returns and run cash flow projections, but rather by their ability to understand, avoid or manage and price risk priced – a higher return is required
Astute investors are differentiated not by
Risks that can not be avoided must be
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Introduction (Contd.)
Investment A and B start and end at the
same place but the volatility of the return pattern is much greater for A than for B thus A has more risk.
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Managing Risk
To “manage risks” means to first do a
thorough job investigating what might influence the cash flow projections potential problems when possible by shifting them to others as discussed in Chapter 10
Then an astute investor will try and avoid
Last, the required rate of return is adjusted
to match the expected overall risk on a property
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Causes of Risk Versus Statistical Measures
Listing below ranked by the degree
of control that an owner has over these risks from least controllable to most controllable
1. Economic Risks 2. Liquidity Risks 3. Political-Legal and Environmental
Risks 4. Business or Management Risks 5. Financing Risks
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Understanding the sources of returns as a way to understand the causes of risk
Sources of Return: 1. Cash flow generated from the collected
income (rents) less operating expenses and debt service 2. Tax shelter and postponement generated from the non-cash deduction of depreciation which lowers, reduces, and postpones taxable income 3. Equity buildup from principal reduction on the mortgage loan 4. Appreciation or depreciation from changes in the value of the property
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Partitioning the IRR
One way to quantify the effect of each
source of return is to examine its impact on the Internal Rate of Return Each return is simply adjusted to see how it affects the IRR
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Cycles and Risk
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Sensitivity Analysis and Simulation Analysis
Techniques for statistical risk analysis In each case the variable of concern
may be a measure of return such as the IRR or the first year cash on equity return or some other variable concerned with risk, such as the lender’s debt coverage ratio Sensitivity Analysis: vary one or more key variables over a range of possibilities Simulation Analysis: Possibility of assigning a probability distribution for every uncertain variable
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Real benefit of such an analysis is the
Sensitivity/ Simulation (Contd.)
examination of the tails of the distribution If the tail is not too fat to the left of the dashed line then the investment might match the risk tolerance of the investors Fat tails to the right do not matter nearly as much as fat tails to the left
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Due Diligence: A chance to Investigate the Causes of Risk
Purpose of DD is to discover in detail any
problems that exist on the property which may affect future returns and liabilities Requires a careful analysis of the entire process of reviewing an investment opportunity, contracting to purchase and pre-closing details Occurs when a tentative purchase contract has been drawn up and buyer has time to affect possible modifications/ adjustments Categories: Market Due Diligence Property Due Diligence People Due Diligence Contractual Due Diligence
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Financial Leverage Risks
The use of debt to finance an equity
investment creates what is called “leverage” in the equity investment, because it magnifies the risk and return performance of the equity “Capital structure” refers to the relative proportion of equity/ debt in the real estate investment, and unlike most risk inducing factors, leverage risk is a decisions over which an investor has control Leverage has a dramatic influence on risk and returns in the real estate industry A good way to understand the effect of leverage on the real estate equity investor or borrower is by analogy to the physical principle of the lever
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Mechanics of Leverage: Physical Leverage
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Mechanics of Leverage: Financial Leverage
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Leverage Definitions
Leverage Ratio is defined as the total value
of property divided by the value of equity investment LR = Value / Equity = V/E Value = Equity + Loan = E+L Therefore LR = V/(V-L) LTV (loan to value, L/V): the greater the LR the greater the LTV and it normally gives them primary control over the underlying asset as long as they fulfill requirements of their debt obligation underlying asset’s cash flow and value
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Investor’s equity is their ownership share
Debt receives the preferred lien on the
Effect of Leverage on Return to Equity
In this example, the increase in expected
return has come entirely in the form of an increased appreciation component, with no change in the income component In general, wisely applied leverage will always increase the expected total return to the equity investment
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Effect of Leverage on Risk
Leverage always increases the risk of the
equity investment We cannot influence total property value through the use of debt Default Risk: Arises from possibility of the borrower defaulting on their loan obligations and ultimately losing the property to the lender through foreclosure The Equity Perspective: On the equity side leverage increases the volatility of the returns
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Risk and Return: Combining Effects
Total Expected Return 13%
10% Rp 5%
Rp 2% 8%
Rf 8%
0 Riskless Mortgage
1.0
2.0
2.5
L.R.
Levered Equity 60% LTV
Unlevered Equity: Underlying property
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Positive and Negative Leverage
Condition for positive leverage:
Whenever the return is higher for the property than the cost of the mortgage loan Positive cash flow leverage: Whenever the cap rate or return on the total asset is greater then the annualized mortgage constant Condition for negative leverage: Whenever the property return is lower than the costs of the debt If the total expected returns exceed the cost of the debt we have positive financial leverage and if the current returns in terms of the current cap rate exceed the annual cost to carry the debt then we have positive cash flow leverage as well
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Below Market Financing
Example of a risky deal:
Sellers asking price for property $210,000 NOI with external management $16,000
and without external management $18,500 debt service of $13,892.69
1st Mortgage: $150,000 for 25yrs at 8%, i.e. Loan Provided by seller: $50,000 for 5yrs
@6.5%, i.e. annual mortgage payment of $3,250
$10,000
Down payment (owner’s equity) only
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Below Market Financing (Contd.)
With No Management With Professional Management
NOI Debt Service 1st Mortgage Debt Service 1st Mortgage Annual Cash Flow Cash Return on Equity
$18,000 (13,893) (3,250) $1,357 13.57%
$16,000 (13,892) (3,250) $1,142 -11.42%
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Below Market Financing (Contd.)
Example of an “almost fair” deal:
Sellers asking price for same property
$175,000 8.0%
1st Mortgage (75% LTV i.e. $131,250) at Market rate for 2nd mortgages is 9%, seller
offers 6.5% for $50,000 (exceeding market value of property by $6250) annual payments of $3,250
2nd Mortgage is interest only and requires At market rates 2nd mortgage yields $4,500 NPV to Seller due to below market
financing is $1398 ($6250 minus PV of $1250 for 5 years at 9%)
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
100% Leverage as a Way to Control Real Estate Without Owning It
When an institution wants to invest in real
estate but does not want to hold title Alternative to direct ownership is simply to find someone willing to own and manage the property as a highly levered partner and provide a 100% participating mortgage
Creative Partnering & Return Allocation
Mortgages can be used to help provide
preferential returns to various partners in an investment Example: one investor has capital but wants low risk investment, other investor has less capital but is ready to take risk
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
END
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner