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Risk in Real Estate Investment

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... are forced to make assumptions about a venture's ability to ... Risk is often viewed as the possibility of variance between assumptions and actual outcomes. ... – PowerPoint PPT presentation

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Title: Risk in Real Estate Investment


1
Chapter 15
  • Risk in Real Estate Investment

2
Major Risk Elements
  • Financial risk
  • Insurable risk
  • Business risk

3
Figure 15.1
4
Controlling Risk
  • Risk analysis
  • Invest in less risky projects
  • Eliminates opportunities for extraordinary
    profits
  • Financial market assigns appropriate level of
    return to each opportunity, commensurate with
    level of risk perceived
  • In an efficient market, the only way to reduce
    risk associated with single investment ventures
    is to choose a venture with a lower expected
    return

5
Figure 15.4
6
Controlling Risk
  • Real estate markets tend to be somewhat less
    efficient than are organized securities markets.
    Real estate investors who can exploit market
    inefficiencies are able to reap extraordinary
    profits without shouldering commensurately
    greater risk.

7
Controlling Risk
  • Investors can control risk exposure by
    considering the relationship between assets
    already held and potential new acquisitions.

8
Controlling Risk
  • Real estate investors are forced to make
    assumptions about a ventures ability to generate
    income over an extended period. Risk is often
    viewed as the possibility of variance between
    assumptions and actual outcomes.

9
Controlling Risk
  • Lease agreements often permit landlords to shift
    some risk to tenants.
  • Hedging may also reduce risk.

10
Risk Preferences and Profit Expectations
  • Rational investors prefer a higher to a lower
    return for a given level of risk for a specified
    level of return they prefer less risk to more
    risk
  • They accept additional risk only if accompanied
    by additional expected investment rewards

11
Figure 15.6
12
Risk Preferences and Profit Expectations
  • Configuration of risk-reward indifference curves
    will depend upon the individual investors
    personal attitude toward risk.

13
Risk Preferences and Profit Expectations
  • The more risk averse the individual, the more
    steeply sloped the indifference curve showing
    that persons preference
  • The indifference curve of an investor who is
    indifferent toward risk has no curvature at all
  • Some investors may be willing to trade expected
    return for the opportunity to bear greater risk,
    and will therefore have a downward-sloping risk
    reward indifference curve

14
Successful Insurance Firms as Rational Risk Takers
  • Allow insured parties to substitute the certainty
    of a small loss for the uncertainty of a larger,
    possibly catastrophic loss
  • Astute risk management
  • Risk takers by design

15
Measuring Risk
  • Rational investors will seek to determine the
    amount of risk associated with an investment
    opportunity and will decide upon a minimum
    expected return that will justify the perceived
    risk

16
Measuring Risk
  • Traditional approaches to incorporating a risk
    premium have included
  • Using a shorter payback period
  • Higher required rate of return
  • Downward adjustment to projected cash flows

17
Measuring Risk
  • Traditional risk-adjustment techniques share a
    serious shortcomingthey do not permit
    quantification of the risk element.
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