Risk in Real Estate Investment

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Chapter 15

• Risk in Real Estate Investment

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Major Risk Elements

• Financial risk
• Insurable risk
• Business risk

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Figure 15.1
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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

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Figure 15.4
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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.

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Controlling Risk

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

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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.

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Controlling Risk

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

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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

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Figure 15.6
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Risk Preferences and Profit Expectations

• Configuration of risk-reward indifference curves
  will depend upon the individual investors
  personal attitude toward risk.

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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

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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

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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

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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

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Measuring Risk

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