Chapter 16 Risk Analysis, Leverage and Due Diligence

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

Chapter 16

Risk Analysis, Leverage and Due Diligence


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


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


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.


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


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 Risks2.Liquidity Risks3. Political-Legal and Environmental Risks4. Business or Management Risks5. Financing Risks


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


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


Cycles and Risk


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


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


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


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


Mechanics of Leverage: Physical Leverage


Mechanics of Leverage: Financial Leverage


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


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


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

Risk and Return: Combining Effects


8%

10%

1.00

2.0 2.5

13%

Total Expected Return

Riskless Mortgage

Unlevered Equity:Underlying property

Levered Equity 60% LTV

L.R.

Rf 8%

Rp 2%

Rp 5%


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

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


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

Cash Return on Equity 13.57% -11.42%

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%)



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


END

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Chapter 16 Risk Analysis, Leverage and Due Diligence