Transcript Chapter 16 Risk Analysis, Leverage and Due Diligence

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
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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
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
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
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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
Riskless
Mortgage
1.0
2.0
2.5
Unlevered
Equity:
Underlying
property
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
L.R.
Levered
Equity
60% LTV
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.)
With No
Management
With
Professional
Management
NOI
$18,000
$16,000
Debt Service 1st Mortgage
(13,893)
(13,892)
Debt Service 1st Mortgage
(3,250)
(3,250)
Annual Cash Flow
$1,357
$1,142
13.57%
-11.42%
Cash Return on Equity
“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