Chapter 16 Risk Analysis, Leverage and Due Diligence

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Chapter 16Risk Analysis, Leverage and Due
Diligence
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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

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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

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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.

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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

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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

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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

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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

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Cycles and Risk
Real Estate Principles for the New Economy
Norman G. Miller and David M. Geltner
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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 lenders 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

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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

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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

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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
  

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Mechanics of Leverage Physical Leverage
Real Estate Principles for the New Economy
Norman G. Miller and David M. Geltner
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Mechanics of Leverage Financial Leverage
Real Estate Principles for the New Economy
Norman G. Miller and David M. Geltner
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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 EL
• Therefore LR V/(V-L)
• LTV (loan to value, L/V) the greater the LR the
  greater the LTV
• Investors 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 assets cash flow and value

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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

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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

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Risk and Return Combining Effects
Total Expected Return
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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
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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

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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 _at_6.5,
  i.e. annual mortgage payment of 3,250
• Down payment (owners equity) only 10,000

Real Estate Principles for the New Economy
Norman G. Miller and David M. Geltner
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Below Market Financing (Contd.)
Real Estate Principles for the New Economy
Norman G. Miller and David M. Geltner
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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
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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

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END