Question

How do you calculate the risk assesment during real estate investments? what is it actually called? kurtosis or skewness when graphing ?

Answer 1

In order to cope with risk, it is fundamental to define risk in general and risks related to real estate and property investments. Academics have longly debated on the difference and the relationship between risk and uncertainty.

It is generally agreed that uncertainty is due to the lack of knowledge and poor or imperfect information about the state variables. Furthermore, the further the analysis is taken into the future, the greater is the uncertainty and the more uncertain are the outputs. On this basis, risk is the measure of the difference between the actual and the expected outcomes: the risk of an asset can be completely expressed by considering all possible outcomes and the probability of each.

Focusing on property investments, “as the probability that a target rate of return will not be realized” while uncertainty “denotes situations where outcomes and their probabilities are not known”. In conventional investments and finance, the risk associated with an asset is usually defined as the volatility, quantified through the variance or standard deviation of its returns. Of course, there is no risk in hindsight, but it is reasonable to assume that securities or portfolios with histories of high variability also have the least predictable future performance. Therefore we can use variance or standard deviation to summarize the spread of possible outcomes and these measures can be considered as natural indexes of risk. Other authors, though, suggest that both risk and uncertainty cannot be defined operationally but only intuitively.

the European Group of Valuers’ Associations provided a systematic classification of risks into:

a) market risks;

b) property related risks (location risk, construction related property risk, tenants and leases risk);

c) fiscal and legal risks;

d) financial risks.

Though there has been a long debate in the literature on risk definition and classification, the operators of the real estate market still do not have specific methodologies for measuring risk, differently from other areas of financial investments. This circumstance is not due to lack of interest by real estate operators, but to the difficulties of implementing tools developed for assessing risks in financial investments, which need to be adapted to the specificities of property investments.

Market Risks can be grouped into three main categories: Capital Market risk (CMr); Valuation risk (Vr); Market Growth Rate risk (MGRr). While Real Estate Operating Risks can be subdivided into six categories: Operating risk (Or); Development risk (Dr); Leasing risk (Lr); Leasehold risk (LHr); Leverage risk (LVr); Tax risk (Tr).

Capital Market risk defines the asset’s riskiness with respect to market rates and its measure reveals whether the asset under investigation is priced consistently with capital market prices and rates. It is calculated as the ratio between the average market capitalization rate, MCR, and the asset’s capitalization rate, ACR:

CMr = MCR/ACR

Valuation risk defines whether an asset is overvalued and will earn less than expected when it matures or is sold by the holder.

Vr =

Market Growth Rate risk is related to the probability that the asset value increases over time. This risk measure is used to compare the asset value growth rate to the overall market growth rate. If the asset growth rate outstrips inflation, then the value increase is reliant upon factors such as capturing below market rents, redevelopment of the site, super-heated rental growth projections, etc.

MGRr = (UIRR - ACR)/MGR

Operating risk is related to the probability of incurring losses due to changes in demand, input costs, etc. In order to minimize operating risks exposure, operating and tax expenses should be minimized.

Or = OOR/TOE

Development risk is related to land development. It identifies to some extent the probability that any capital expenditure will earn the required rate of return to compensate the investor for the added risk taken, when additional capital is committed to the asset

Dr = [(NOI - ACR)/CC]/CC

Leasing risk measures the asset’s share of overall market absorption, by comparing the asset performance to the overall market trend. In other words, it is the risk that the vacant space will be absorbed at a rate which is slower than projected during the acquisition underwriting of the asset.

Lr = [LU1y - MA1y]/[BV/MV]

Leasehold risk accounts for the probability that the tenant lease terms are above market and that the purchase price is therefore inflated to reflect both the intrinsic real estate value plus the above market leasehold interest.

LHr = GRI/MR

Leverage risk occurs when the cost of debt exceeds the return on the asset to be acquired. Leverage creates risk as the lender has a priority position in the repayment of the outstanding loan balance, upon sale or liquidation of the asset and it is related to the percentage of equity and debt and the related cost of capital:

LVr = UIRR/KD