TOPIC 7

Property risk and risk analysis

P R E PA R E D B Y T I M S P R O AT F O R T H E U N I T T E A M

Contents

Deakin University

Introduction

Key questions

Learning resources
Print readings

2
2

Types of risks
Introduction
Macro risks
Entity risks
Project-specific risks

2
2
2
4
4

Property development

Property investment
Assessment risks

5
5

Analysing risk for an investment property

Identification and discussion of risks
Risk-adjustment techniques
Sensitivity analysis
Scenario analysis
Statistical techniques

5
6
7
8
9
10

Review

11

Further resources

11

Suggested answers

12

Building Project Evaluation

Introduction
All property development and property investment projects are risky. They involve
large capital outlays for long periods of time. In the evaluation of capital projects,
we must make forecasts and predictions which give rise to uncertainty.
Risk is the chance or probability that the investor will not receive the expected or
required rate of return from the capital invested. Return in this context includes
income as well as the ultimate return of the capital. For example, an investment in
government bonds provides interest income for an agreed period at the end of
which the initial investment capital is returned. Similarly, an investment in real
estate provides rental income for a period at the end of which the initial investment
capital is returned by way of:

sale of the property, or

increase in value of the land component so as to amortise the wasting asset in

the building component, or

actual investment in a sinking fund, which will grow during the investment
period to be equivalent to initial capital investment.

The risks are that some or all of the income will not be received and that some or
all of the capital will be lost. The purpose of this topic is to:

establish the nature of the risks involved

consider how the risks may be assessed

identify techniques to manage risk.

What is the nature of risk?

What are the different categories of risk?

What are the risks in:

Key questions

property development?

property investment and facilities management?

How is the risk measured?

What can be done to minimise risk?

What is a risk/return profile?

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Learning resources
Readings
Bajaj, D 2002, Risk management, in R Best, C Langston & G De Valance (eds),
Workplace strategies and facilities management: building in value, ButterworthHeinemann, Woburn, pp. 12845.
Holmes, P 1998, Investment appraisal and the capital-asset pricing model, Investment
appraisal, 1st edn, International Thomson Business Press, London, pp. 93104.
Twyford, J 2002, Risk allocation in construction contracts, in R Best, C Langston &
G De Valance (eds), Design and construction: building invalue, ButterworthHeinemann, Woburn, pp. 18094.
Whipple, RTM 1995, Sensitivity analysis, Property valuation and analysis, Law Book
Co., Sydney, pp. 386402.

Types of risks
Introduction
Risk identification, management and mitigation can be viewed from a macro
approach that looks at the world at large, and from an activity perspective with
individual property development projects and property investments.
When considering risks in property development and property investment it is
essential to separate the two activities, as there are distinctly different approaches
to risk identification and management. In property development the major
approach to risk management is to spread the risks involved to other participants if
possible, while in property investment the major approach is to identify and
minimise risks across all the activities of facilities.
To start, let us look at the sort of risks that are unpredictable and beyond the control
of managers in the property development and investment industry.
R E AD I N G

Please re-read Holmes, Investment appraisal and the capital-asset pricing model
as an introduction to systematic and unsystematic risk.

Macro risks
Traditionally, macro risks have been associated with the economy and while this is
still true, it is important to recognise that in the twenty-first century some new
drivers assume increasing importance in influencing national economies. Terrorist
activity has the potential to change both actual economic activity and business and
consumer sentiment.
Macro risks are always present and are called systematic or market risks. Very
little, if anything, can be done to avoid macro risks although in some cases their
project-specific component can be reduced. Some of the macro risks are:

Building Project Evaluation

Economy: major structural changes are taking place within the world, national
and local economies. Businesses are becoming more competitive at every level
and this is leading many firms to divest themselves of property they own in
order to maximise their resources.

Interest rates: the cost of capital is a significant component of total project costs.
Interest rates have been low in recent years, a factor that has assisted property
development and investment, particularly residential construction. If interest
rates increase, project feasibility and return to equity decrease. In late 2003 the
Reserve Bank of Australia increased official interest rates in an attempt to
reduce construction activity. While this appears to have been successful in
slowing activity, most analysts are predicting further rises later in 2005.

Inflation: as discussed earlier, property and buildings have always been

considered to be a hedge against inflation; that is, their values tend to increase
as inflation increases. On the other hand, inflation can cause costs to increase
during a development phase which may affect feasibility. In addition, interest
rates tend to increase as inflation increases.

Labour unrest: trade union activity is capable of causing substantial lost time
in the economy in general.

Lifestyle changes: many major social determinants are in a state of flux and
their ultimate outcome will seriously affect the property and building
industries. These include:

household formation: the nuclear family is now only a small percentage of

total households. Other households involve singles, couples without
children, retirees. The configuration and location of accommodation
needed is now much broader than the conventional detached house on a
subdivided lot.

workplace: the definition of the workplace is changing and the major

increase in employment in the past few years has been part-time and
casual work. Currently, an economic rationalism prevails that is likely to
continue to affect the workplace. For instance, there is recognition that
older workers have experience gained from years on the job which can be
an asset to business. In addition federal government policy is now directed
to keeping people working to an older age.

leisure: increased leisure time, greater disposable income and fewer

children will make tourism and leisure activities will increase in scope and
importance.

Obsolescence: all buildings face the onset of obsolescence, effectively

shortening their economic lives. Ongoing capital expenditure is required to
upgrade buildings and replace major components to mitigate against
obsolescence. Some office buildings less than thirty years old in some capital
cities have been demolished. Other buildings, some only twenty years old, are
vacant and require major expenditure. Yet others have had capital sums
expended on refitting which have exceeded initial capital expenditure.

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Legislation: upgrading buildings to comply with new regulations has become a

significant financial burden. Some examples are asbestos removal, fire
sprinkler services, access for people with disabilities and other safety
measures. In addition, revision of acts such as the Retail Tenancies Act 1986,
and restricted trading on public holidays has created havoc with the projected
cash flows for some properties. This has led to pre-agreed rental structures.

Taxation: changes to the Income Tax Assessment Act have also affected
forecast cash flows by changing the expected tax shelter.

Entity risks
Entity risks are those associated with the ownership and management of the
property. The following factors may create or reduce risk:

Type of entity: sole trader, partnership, company, syndicate, joint venture, trust.

Track record: substance, reliability, ability, liability, personality or ego and

independence.

Delegation: who are the individuals who actually manage the entities and
make the decisions?

Equity: how much debt is there and do the principals have their own money
at risk?

Project-specific risks
The project-specific risks are those arising from the specific project or investment.
These are known as unsystematic risks and they can be directly affected by
business decisions and potentially reduced by diversification. An important activity
has developed from identifying the risks associated with property acquisition this
is known as due diligence and results in the buyer obtaining information about
risks which may affect the subject property. Many of these are listed below.

Property development
R E AD I N G

Please read Twyford 2002, Risk allocation in construction contracts.

This reading discusses techniques that developers may use to spread the risks to
other participants. Some of these are:

planning risks permits, zoning, objections or public participation in planning

title boundaries, easements, covenants, adjoining properties

construction risks time, cost, quality, weather, unions, form of building

contract, builder, and consultants

marketing risks timing, demand, competition from other properties, letting

negotiations, sales.

Building Project Evaluation

Property investment
R E AD I N G

Please read Bajaj 2002, Risk management.

This reading discusses some of the investment risks associated with the property
life cycle and facilities management. They include:

tenant identity, likelihood of default

lease expiry date, time taken to find another tenant, nature of rent reviews

nature of rental market, passing, incentive based

outgoings liability for their payment including increases in costs

refurbishment see obsolescence (above, page 3)

disposal rising market or falling market.

Assessment risks
The assessment risks are those involved in property investment analysis. These are
the risks associated with forecasting, adopting variables and making assumptions.
In addition, the use of financial modelling and various assessment methodologies
can affect forecast outcomes. Finally, analysts and others can simply make
mistakes that may cause erroneous decisions.

Analysing risk for an investment property

In this section we will now outline some techniques and apply them to the example
from earlier topics with the main variables restated as:

net income

$350 000

purchase price

$5 000 000

purchase expenses

6%

forecast market rental growth

10% p.a.

rent reviews

two yearly

holding period

ten years

sale price

based on a capitalisation rate of 8%

sales expenses

2%

loan/value ratio

70%

interest rate

12%

term loan (interest only with full loan repayment at end of holding period).

The before-tax cash flows are shown in Table 7.1.

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Table 7.1

Year

Market
rent

Cash flow

Lease rent

Purchase
price

Sale price

$(5 300 000)

Net cash
flow

Loan &
repayment

$(5 300 000)

3 500 000

Interest
only

Net cash
flow
(1 800 000)

$350 000

$350 000

$350 000

(420 000)

(70 000)

$385 000

$350 000

$350 000

(420 000)

(70 000)

$423 500

$423 500

$423 500

(420 000)

3 500

$465 850

$423 500

$423 500

(420 000)

3 500

$512 435

$512 435

$512 435

(420 000)

92 435

$563 679

$512 435

$512 435

(420 000)

92 435

$620 046

$620 046

$620 046

(420 000)

200 046

$682 051

$620 046

$620 046

(420 000)

200 046

$750 256

$750 256

$750 256

(420 000)

330 256

10

$825 282

$750 256

(420 000)

7 950 927

11

$907 810
IRR

17.19%

$11 120 671

$11 870 927

IRR

14.57%

(3 50000)

(Tim Sproat, Deakin University, 2009)

Identification and discussion of risks

A preliminary approach to risk analysis consists of simply listing and discussing
the risks associated with the investment. We now discuss each variable in turn:

initial net income a variable known from the outset and therefore no risk is
attached

purchase price a variable known from the outset and therefore no risk is
attached

purchase expenses a relatively minor expenditure but, in any case, known in

advance and therefore no risk

rental growth a forecast of 10% p.a. has been made. This is the most
significant item of risk as changes in this rate affect the ten-year cash flow as
well as the reversion. (Remember the reversionary value is based on the
projected year 11 net rent.)

rent reviews two-yearly reviews are standard in commercial property. The

rent review cycle should be known in advance, so it represents little risk.
However, changes in economic conditions (macro risks) or management
incompetence (entity risks) cannot be ruled out over a ten-year investment
period

holding period the longer the period of ownership, the greater the risks of
forecasting

sale price the capitalisation rate on sale is a significant risk and will be a
function of obsolescence and economic conditions at that time

sales expenses a minor item with little risk

Building Project Evaluation

loanvalue ratio known from the outset. However, the higher the ratio, the
higher the risk as equity may be completely eroded in a downturn with the
consequent pressure applied by the lender

interest rate fixed at the outset and possibly fixed for the ten years; however,
finance contracts are more often agreed at a variable rate so the borrower faces
risks associated with changes in interest rates over the investment period

term loan in this example, all borrowed funds are repaid at the end of the
holding period. This is a low-risk situation as the proceeds from the sale
should easily cover the outstanding loan monies

taxation the tax regime is known at the outset of an investment but this
regime may change over the holding period. Thus, the size of a tax shelter may
increase or decrease.

Risk-adjustment techniques
Risk-adjustment techniques consist of an assessment of the standard cash flows
with regard to specific measures.
We will discuss six approaches:
1

Target rate: compare the financial analysis outcome with a specific target rate
(sometimes called a hurdle rate). For example, your company requires an IRR
of 12% on total funds, so it would be satisfied with the IRR of 14.57%
provided by the above example (Table 7.1). These target rates change over
time, particularly as inflation increases. Hurdle rates of 15 to 20% and above
were common during the high inflation economies of the 1970s and 1980s.
Other hurdles have also been quoted by various organisations, for example, a
payback period of seven years on the building component of a development.

Risk-adjusted discount rate: a known long-term rate of return such as the tenyear bond rate is adjusted to reflect the risk associated with real estate (e.g. say
the bond rate is 8%; the adjusted rate becomes 12% after adding, say, 50% to
the long bond rate). The size of the adjustment may be as low as 20 or 25%
usually depending on the current yield gap (or reverse yield gap).
The yield gap is traditionally the difference between yields on ordinary shares
and the yields on bond rates. Shares are normally higher risk than bonds;
therefore, the yields would be expected to be higher.

Partitioning of cash flows: this is sometimes called the sliced income approach
in which difference slices are discounted at different rates reflecting the risks
associated with each slice.
For example, the passing rent associated with an underpinned rent review clause
is a low-risk cash flow whilst projected rental growth is obviously higher risk.
These two cash flows could be discounted separately so that, in the continuing
example referred to above, three separate discount rates could be adopted; first,
for the lease rent of $350 000 p.a. for the ten-year lease term; second, for the
difference between the projected rent and the lease rent; and third, for the
reversion which carries the additional risk associated with reletting the premises.
For further explanation, read (Whipple 1995, pp. 4002).
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Accounting ratios: these may be applied to forecast cash flows to assess

whether a property is becoming more or less risky over time.
The risk ratios are generally related to finance. Other ratios related to
profitability and base assumptions are also used (see Whipple 1995,
pp. 40915).

Risk-absorption ratio: this ratio calculates the buffer between the projected
result and a break-even result. In our continuing example, if the discount rate
is 14.57% (the same as the IRR) the risk absorption ratio is 0.
However, if our target rate of return is say 12%, then the NPV of the net
income is $1 036 058. This amount is the buffer; that is, a reduced rental flow
can be absorbed provided that its NPV does not exceed the buffer amount.
This is usually taken to be the annual equivalent of the NPV (akin to a loan
repayment) which is calculated as follows:
Excess NPV
Annuity worth 1 today for ten years at 15%
Risk absorption

$1 036 058
0.1698
$175 923

Therefore, the risk absorption ratio is:

IRR equity vs IRR total: referring to Table 7.1, the IRR on equity is 17.19%
whilst IRR total is 14.57%, which shows that using borrowed finance provides
another buffer.

Sensitivity analysis
R E AD I N G

Please read Whipple 1995, Sensitivity analysis.

A sensitivity analysis consists of undertaking several runs with a financial model,

in order to gauge the effect of changes in values for the most significant investment
or development variables. As discussed in the example above, the significant
variables are rental growth, sale price as represented by the capitalisation rate on
the reversion at the end of the ten-year holding period and the financial package, in
particular, the interest rate.
Three values for each variable are usually tested, a most likely value, an optimistic
value and a pessimistic value. A study to test the sensitivity of rental growth,
capitalisation rate and interest rate (i.e. three variables) requires
3 3 3 = 27 runs resulting in a range of twenty-seven results.
Applying the model in Table 7.1 on page 5, and considering only the IRR on
equity, a sensitivity study may be carried out using the values in Table 7.2.

Building Project Evaluation

Table 7.2

Investment variables

Pessimistic

Most likely

Optimistic

Rental growth

8%

10%

12%

Capitalisation rate

9%

8%

7%

14%

12%

10%

Interest rate

(Tim Sproat, Deakin University, 2009)

The twenty-seven results are in Table 7.3. The loanvalue ratio for all results is
70%; it is not a random variable as it would be based on a decision made by the
investor.
Table 7.3

Sensitivity analysis IRR on equity

Rental
growth
rate
Interest
rate

8%

10%

12%

14%

12%

10%

14%

12%

10%

14%

12%

10%

7%

13.44

15.55

17.74

17.20

19.13

21.15

20.63

22.44

24.32

8%

11.19

13.44

15.77

15.14

17.19

19.32

18.71

20.60

22.58

9%

9.11

11.50

13.99

13.28

15.44

17.69

16.99

18.98

21.04

Cap rate

(Tim Sproat, Deakin University, 2009)

The most likely result is an IRR of 17.19%, which lies within a range of 9.11 to
24.32%. A sensitivity study does not provide an assessment of the likelihood that
the most likely result will occur and the wide range of results is only partially
helpful. Moreover, many of the results are potentially unrealistic. For example, a
high capitalisation rate and a high interest rate are unlikely to occur together with a
high growth rate, and a high capitalisation rate is unlikely to occur together with a
low interest rate.
Scenario analysis
R E AD I N G

Now read Whipple 1995, Cash flow approaches to price estimation for an
explanation of this approach.

Scenario analysis is used in an attempt to remove the unrealistic outcomes and also
to reduce the number of runs using the financial model. Rather than adopting
three estimates of value for each variable, the process involves the formulation of,
usually, three realistic scenarios, again most likely, optimistic and pessimistic. The
scenarios may relate to forecast states of the economy or of a specific property
market in the context of this unit. Returning to our example, scenarios may be
adopted as shown in Table 8.2, where the suite of values for the three variables
describes the scenario.
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The three scenarios provide the same range of results as the sensitivity study but
they give no assistance as to the likelihood of either of the results occurring.
Table 7.4

Scenario

IRR on equity

Pessimistic

9.11%

Most likely

17.19%

Optimistic

24.32%
(Tim Sproat, Deakin University, 2009)

AC T I V I T Y 7 . 1

Continuing with an example from a previous topic a property that was recently
sold for $1 million.

The annual net rental is $100 000.

The lease contains provision for two-yearly rent reviews and rental growth is
expected to be 5% p.a.

Assume a holding period of ten years.

The revisionary capitalisation rate is forecast to be 9%.

Conduct a sensitivity analysis and write a brief review of the investment drawing
attention to the risks associated with:

interest rates

forecast rental growth

reversionary capitalisation rate

combination of the above (scenario).

Note: If you have not already done so, you will need to construct a computer
spreadsheet model.
Statistical techniques
So far, we have established a range of possible results; that is, we have established
the nature of the risks, but they are not yet fully assessed. We need an assessment
of likelihood or probability of outcome. The application of statistical methods is
usually based on the assumption that the values of investment variables and the
financial results are normally distributed.
The average implied in a normal distribution becomes the expected value, whether it
is investment value or NPV or IRR. The variance or spread of possible results
around the average (the standard deviation) provides the wherewithal to calculate
probabilities in respect of outcome or results. However, the analyst must assess input
probabilities in respect of the scenarios. This process extends beyond the scope of
this unit. For further discussion of statistical methods, see Robinson (1989) in
Further resources, where he describes a typical application of statistical method.
The assessment of investment risks has, since the 1950s, led to the development of
modern portfolio theory, which is built on the adage that investors should not put
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Building Project Evaluation

all their eggs in one basket. The result is diversification where investments are
selected so that the risks in one are offset by the risks in another.
This is assessed by correlation coefficients where after time-series analysis it may,
for example, be shown that increases in investments of one type occur at the same
time as decreases in investments of another type.
A portfolio built up of the two types of investment can maintain the same combined
rate of return of the two investments, but their negative correlation reduces the
total risk.
AC T I V I T Y 7 . 2

Identify the major risks in your assignment using the risk ranking and risk
mapping techniques as discussed in the Risk Management reading by Deepak
Bajaj and develop a risk action schedule for each.

Review
In this topic we have briefly discussed the various risks associated with investment
generally and with building projects in particular. We have also assessed risks using
some of the simpler techniques in everyday use. This field is growing in
importance and will continue to do so in the search for the ideal investment vehicle
and portfolio. However, one cannot lose sight of the fundamentals of sound
property investment and these should always be present when making a decision
after undertaking building project evaluation.
REVIEW
AC T I V I T Y

Identify the fundamentals of building projects as investments and assess risks

associated with each.

Further resources
Robinson, J 1989, Property valuation and investment analysis: a cash flow approach, Law
Book Co., Sydney, ch. 9, pp. 96118.
Rowland, P 1993, Property investments and their financing, Law Book Co., Sydney,
ch. 8, pp. 175205, ch. 9, pp. 20625 & ch. 10, pp. 22649.

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Suggested answers

AC T I V I T Y 7 . 1

A sensitivity study requires results for at least three values for each selected
variable. If three variables require testing, twenty-seven separate results are
generated.
For example:

The interest rate is 11%, test 10% and 12%

Forecast rental growth of 5%, test 4% and 6%

Reversionary capitalisation rate is 9%, test 8% and 10%.

Sensitivity table

Internal rate of return (IRR) per cent

10%

Interest rate

11%

12%

4%

5%

6%

4%

5%

6%

4%

5%

6%

8%

20.711

22.34

13.92

19.69

21.36

22.97

18.68

20.40

22.05

9%

9.32

20.99

22.60

18.24

19.96

21.61

17.18

18.95

20.64

10%

18.07

19.78

21.43

16.93

18.71

20.40

15.82

17.65

19.38

Rent growth
Cap rate

(Tim Sproat, Deakin University, 2009)

In the pessimistic scenario, the return on equity decreases to 15.82% and the
optimistic increases to 23.92%.
The IRRs increase as the reversionary capitalisation rates and/or interest rates
decrease and as growth rates increase as expected.
Sensitivity analysis does not draw a relationship between interest rate and
reversionary capitalisation rate, so several of the IRR scenarios in the chart may be
unrealistic.

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Building Project Evaluation

REVIEW
AC T I V I T Y

As the property is viewed as an existing investment the development risks are

irrelevant. Your answer should include the following:
The fundamentals of property are:

Supply and demand there must be real demand for the product without being
in a market in which speculative development competition causes an
oversupply. This means that a substantial component, possibly at least 50% of
the total area, should be pre-committed by a tenant. There are macro risks such
as an economic downturn that reduces rental demand.

Resources optimum use of resources should be promoted. A wildly

speculative development boom is wasteful. Macro risks again when the
bubble bursts, supply will exceed demand driving rental prices down.

The relationship between market value and investment value should be

understood.

Decisions should be based on investment value. Properties should be bought,

or held, if investment value is greater than market value and sold if vice versa.

Finance properties should be geared up (or leveraged) to a reasonable level

(probably no more than 70 to 80% of value) to ensure that some equity is
present. Borrowers and lenders would be well advised to restrain themselves in
this regard. An increase in interest rates is a risk.

Taxation the effect of tax shelters should be considered, but they should not
be the sole reason for proceeding with a development proposal. There is a risk
of changes to taxation law.

Long term property is a long-term proposition. The sale of one property in

order to buy another requires ownership for three to four years just to break
even (assuming a modest growth in value). There is a risk that the owner may
be forced to sell.

Outgoings the extent of owning and operating costs is significant and must
be considered particularly during periods of development, refurbishment or
vacancy where outgoings may not be offset by at least some income. There is a
risk that costs increase beyond budget and/or income is less than budget.

Obsolescence the building component of a property is a wasting asset.

Economic, financial, technical and social change can reduce the functional life
of a property substantially. Most buildings require major refurbishment within
15 to 20 years of their original construction. Buildings need to be flexible and
adaptable. There is a risk that new buildings will attract tenants away from
yours.

Occupants if not owner-occupied property, buildings need to attract and

retain tenants for long leases with commercially sensible terms, as for previous
point.

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