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Chapter 16Risk 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
- Astute investors are differentiated not by their ability to analyze returns and run cash flow projections, but rather by their ability to understand, avoid or manage and price risk
- Risks that can not be avoided must be priced – a higher return is required

“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
- Then an astute investor will try and avoid potential problems when possible by shifting them to others as discussed in Chapter 10
- 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
- Economic Risks
- Liquidity Risks
- Political-Legal and Environmental Risks
- Business or Management Risks
- 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:
- Cash flow generated from the collected income (rents) less operating expenses and debt service
- Tax shelter and postponement generated from the non-cash deduction of depreciation which lowers, reduces, and postpones taxable income
- Equity buildup from principal reduction on the mortgage loan
- 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

“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

Sensitivity/ Simulation (Contd.)

- Real benefit of such an analysis is the 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
- Investor’s equity is their ownership share and it normally gives them primary control over the underlying asset as long as they fulfill requirements of their debt obligation
- Debt receives the preferred lien on the underlying asset’s cash flow and value

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

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%

Rp 5%

10%

Rp 2%

8%

Rf 8%

0

L.R.

2.5

1.0

2.0

Unlevered Equity:

Underlying property

Levered Equity

60% LTV

Riskless Mortgage

“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
- 1st Mortgage: $150,000 for 25yrs at 8%, i.e. debt service of $13,892.69
- Loan Provided by seller: $50,000 for 5yrs @6.5%, i.e. annual mortgage payment of $3,250
- Down payment (owner’s equity) only $10,000

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Below Market Financing (Contd.)

“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
- 1st Mortgage (75% LTV i.e. $131,250) at 8.0%
- Market rate for 2nd mortgages is 9%, seller offers 6.5% for $50,000 (exceeding market value of property by $6250)
- 2nd Mortgage is interest only and requires annual payments of $3,250
- 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

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