Forecasting and Analyzing Risks in Property Investments

Ch 15: Forecasting and Analyzing Risks in Property Investments

Applying Quantitative and Qualitative Forecasting Methods,Together With Risk Analysis, to Evaluate Real Estate Investments.

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Property Investments: Long Term Risky Assets

Property investment analysis requires the full application of all capital budgeting techniques:

Forecasting: quantitative (i.e statistical) from Ch 3 qualitatative ( i.e judgmental) from Ch 4.

Risk Analysis: RADR and CE from Ch7.

Risk Analysis: Sensitivity and

Break-even Analysis from Ch 8.

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Property Investments: Long Term Risky Assets

More Risk Analysis Techniques:

Simulation from Ch 9. Scenario Analysis from Ch 10.

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Cash Flow Forecasting For An Income Producing Property

Forecasting Rent:

(a) rent under the lease- this is detailed in

the lease covenants

(b) market rent – rent may be adjusted under the lease covenants, and on lease expiry. Market rent forecasts combine both qualitative and quantitative techniques.

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Cash Flow Forecasting For An Income Producing Property

Forecasting Operating Expenses :

sometimes current expenses are grown forward using a common inflation index, such as the Consumer Price Index.

Forecasting Vacancy Rates:

a common method is to forecast these rates as an annual average percentage of the lease rental.

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Cash Flow Forecasting For An Income Producing Property

Forecasting The Resale Proceeds:

The “resale proceeds” is equivalent to a

salvage or terminal value in general industrial projects. Its value is critically important to the project’s initial accept or reject decision. Usually the forecast value is the discounted value of future net rentals beyond that point, using the investor's required rate of return for the investment life span of the property.

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Rental Property Investment: A Forecasting Example Typical historical data set, for quantitative forecasting.

% change on previous year

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Gross Rents per Square Metre pa $37.00 $41.00 $44.00 $42.00 $41.00 $42.00 $44.00 $44.00 $47.00 $53.00 $58.00

Time Trend in Rents $37.14 $38.67 $40.21 $41.75 $43.28 $44.82 $46.35 $47.89 $49.43 $50.96 $52.50

Years -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0

10.8% 7.3% -4.5% -2.4% 2.4% 4.8% 0.0% 6.8% 12.8% 9.4%

Difference from Trend -$0.14 $2.33 $3.79 $0.25 -$2.28 -$2.82 -$2.35 -$3.89 -$2.43 $2.04 $5.50

Estimated % vacant 4% 6% 9% 14% 18% 15% 14% 6% 3% 4% 7%

New building (square metres) 27,000 13,000 47,000 58,000 21,000 8,000 15,000 6,000 18,000 24,000 29,000

Rental Property Investment: A Forecasting Example Historical data with a prediction trend. Trend Line of Rents Within Actual Historical Data

$60.00

s t n e r

$50.00

s s o r g

l

$40.00

i

a c p y T

$30.00

9 -

8 -

7 -

6 -

5 -

4 -

3 -

2 -

1 0 -

0 1 -

Gross Rents per Square Metre pa Time Trend in Rents

Years

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Rental Property Investment: A Risk Analysis Example

Typical Sensitivity Analysis: Rental Growth, Vacancy.

Sensitivity Table - changes in net present value arising from different rental growth rates and different vacancy rates: rental growth is across the top row; vacancy pa is down the left column.

$148,835.48 0.00% 3.00% 5.00% 7.00% 10.00%

2.00% ($343,525.25) $3,189.95 $255,709.17 $526,463.76 $969,015.48

4.00% ($402,545.11) ($62,905.72) $184,460.05 $449,689.03 $883,209.09

5.00% ($432,055.03) ($95,953.56) $148,835.48 $411,301.66 $840,305.89

7.00% ($491,074.88) ($162,049.23) $77,586.36 $334,526.93 $754,499.49

8.00% ($520,584.81) ($195,097.07) $41,961.79 $711,596.29 $296,139.57 9

Rental Property Investment: A Risk Analysis Example

Typical Monte Carlo Analysis: Various Data.

M o n t e  Ca rlo  An a lay sis T y p ical D at a  I t e m s t o  b e  T e st ed . I n ve st m e n t :Co n st ru ct in g  an  I n co m e  Pro d u cin g  Bu ild in g

Variable

Probability Distribution

Values

Net Rent

Triangular

Min $110,000 Av $130,000 Max$140,000

Letting Period

Uniform

Min 1 month Max 6 months

Capitalization Rate

Triangular

Min 9.00% Av 9.5% Max 10.5%

Buliding Costs

Normal

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Mean $600,000 Std Dev $50,000

Rental Property Investment: A Risk Analysis Example Typical Monte Carlo Analysis: Several Data, 500 Iterations.

Possible net present values

25%

20%

15%

y t i l i

10%

b a b o r P

5%

0%

$1,000

$48,000

$95,000

$142,000

$189,000

$236,000

$283,000 11

$330,000

$377,000

$(93,000)

$(46,000)

$(140,000)

Property Investments: Summary

Property investment analysis requires the full suite of capital budgeting techniques.

Forecasting is required to establish periodic net rental income, and a final resale value. Risk analysis is required to test the full range of prediction variables : Mature managerial judgment is required to make the right decision based on the analytical outcomes.

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