Lecture 21: Sensitivity Analysis

Learning Objectives

  • Explain the objective and means of risk management in real estate investment.
  • Complete a sensitivity analysis to assess investment opportunities.
  • Partition the project IRR (Internal Rate of Return) into its constituent components and incorporate the results into investment decisions.

Risk Management in Real Estate

  • Risk Management Tools:

    • Avoidance and Identification of Risk: Conduct due diligence to identify potential risks before making investments.
    • Financial Tools: Use instruments such as insurance, hedging, and option contracts to mitigate risk.
    • Diversification: Spread investments across different property types or locations to reduce exposure to any single risk.

  • Understanding Investment Risks:

    • Identify main drivers of IRR and assess sensitivity of IRR to variations in underlying assumptions.

Sensitivity and Scenario Analysis

  • Base Case: Establish a reference point for analysis.
  • Sensitivity Analysis:
    • Change one assumption at a time to evaluate the impact on NPV (Net Present Value) or IRR.
  • Scenario Analysis:
    • Alter multiple assumptions simultaneously to create different scenarios.
    • Identify outcomes: likely, pessimistic, and optimistic scenarios; analyze effect on NPV or IRR.

Changing A Single Assumption

  • Example Case Study: Monument Office Building
    • Evaluate how changes in the resale price affect the investment.

How Sensitive is IRR to Changes in Sale Price?

  • Compute cash flows from operations and property sales for each scenario (base case, optimistic, pessimistic).
  • Calculate IRR in every scenario.
  • Derive expected return by multiplying the IRR by the probability of each scenario.
  • Consider the risk (variability of return outcomes) alongside expected return for informed investment decisions.

Return and Risk Across Properties

  • Assess expected return and the variability in potential returns based on defined economic scenarios.
  • Compare risk-return trade-offs across different properties.

Comparing Properties

  • Complete property comparison using a table that includes expected returns and associated risks for each type:
    • Office: Expected Return: 18.52%, Risk: 8.02%
    • Apartment: Expected Return: 15.00%, Risk: 3.61%
    • Hotel: Expected Return: 20.00%, Risk: 10.71%

Risk-Return Trade-Off: Summary

  • Analyze probability and risk (standard deviation) based on scenario analysis to evaluate trade-offs:
    • Identify how expected returns correlate with risk levels across different investments.
  • IRR Illustration: Summarized outcomes:
    • Office IRR: 18% - 25%
    • Apartment IRR: 14% - 20%
    • Hotel IRR: 19% - 22%

Partitioning the IRR

  • Distribution of Total IRR:

    • Assess how IRR is attributed to operating cash flow vs. property sale cash flow:
    • Compute overall IRR.
    • Discount cash flows from operations and property sale using the IRR.
    • Find percentage contributions from each cash flow component.

  • Comparative Analysis of Investments:

    • Even if IRRs are identical, different percentages of returns from operations (e.g., 20%) versus sales (e.g., 80%) can imply differing risk levels.

Example: Ivy Park Building

  1. Compute Present Value (PV) of Cash Flow from Operations.
  2. Compute PV of Cash Flow from Property Sale.
  3. Sum both components to obtain total return.
  4. Calculate share of total PV contributed by each cash flow component.

Concept Checks

  1. What are the three tools employed by real estate investors to manage their exposure to risk?
    a. Avoidance and identification of risk.
    b. Financial instruments (insurance, hedging, options).
    c. Diversification across types or locations.

  2. Difference between changing a single investment assumption and full scenario analysis:
    a. Single assumption changes focus on the effect of one factor while scenario analysis evaluates multiple factors to understand comprehensive risk and return.