FINN3061

Real Estate Finance

Epiphany Term

Dr Frankie Chau
1
 Module Team (Term 2)
• Lectures & Seminars
Dr Frankie Chau
Email: h.c.f.chau@durham.ac.uk
Office Hours: Wednesdays 10:30am-11:30am
Room 161, Business School (Mill Hill Lane)

• Associate Professor in Finance, DUBS

• https://www.durham.ac.uk/business/our-people/h-c-f-chau/

• Teaching and Research Interests:

- Behavioural and real estate finance
- Financial derivatives: futures, options, etc.
- Time-series econometrics: VAR, cointegration, GARCH model.
2
 Module Aims
 Understand the risks and rewards associated with
investing in and financing real estate assets.
 Learn concepts and techniques used to value real
estate assets.
 Develop analytical skills useful in careers requiring:
appraising, analysing site locations, consulting, leasing,
managing properties and real estate portfolios.

3
 Term 1 – Progress & Recap
1. Basic legal concepts and asset characteristics
2. House prices and property valuation
3. Fundamental factors and regional house prices
4. Housing bubbles
5. The mortgage contracts
Term 1
6. Fixed rate mortgages
7. Adjustable and floating rate mortgages
8. Buy vs Rent household decisions
9. Buy-to-let investments
10.Online MCQ Test 1 (15% of overall module mark)
4
 Term 2 – Plan & Roadmap
11. Risk analysis I: Types of risks in real estate investments
12. Risk analysis II: Measuring risks in real estate investments
13. Secondary mortgage market I: Market structure and players
14. Secondary mortgage market II: Mortgage-backed securities
15. Real estate investment trusts I: Types of REITs
16. Real estate investment trusts II: Valuation of REITs Term
17. Real estate investment: Performance and portfolio 2
considerations In Term 2 we switch focus to
investments in (residential and
18. International real estate investments commercial) real estate, i.e.
income-producing properties
19. Financing corporate real estate: Lease vs own
20. Online MCQ Test 2 (15% of overall module mark)
5
ECON 3341
Real Estate Finance
Term 2
Lecture 11.
Real Estate Investment: Risk analysis (Part I)

Prof Damian S Damianov

6
 What is Risk?
 The Chinese symbols for risk, reproduced below, give a much better
description of risk

 The first component is the symbol for “danger”, while

 the second is the symbol for “opportunity”,
taking risk isn’t necessarily a bad thing  a mix of danger and opportunity.

7
 Learning objectives
By the end of this lecture, you will be able to:
 Learn how to compare rates of return and risk of a
real estate investment with that of other
investments in real estate and other asset classes.
 Understand the types of risks involved in investing
in income-producing properties.
 Describe the various methods that can be used to
evaluate the riskiness of a real estate investment.

8
 Comparing Investment Returns (1/2)
• Q: Does the investment in a particular income -
producing property provide a competitive return?
• A: it depends on…
– Nature of alternative real estate investments
(apartment, office, hotel, etc.)
– Other investments that are available (bonds,
stocks, commodities, etc.)
– Returns on these alternatives (& their risk
differences)

9
 Exhibit 13-7
Probability Distribution of IRRs (office, apartment, hotel)

Q: Which type of property

shall we invest in?

- Risk-return tradeoff
- Risk attitudes

Expected return for hotel property is the highest, but

the range and variance of its expected returns are ALSO by far the greatest.
10
Comparing Investment Returns (2/2)
Exhibit 13-1
Risk and Return (alternative investments)

Expected return on investment in real estate is considerably

higher than investing in U.S. Treasury bills. WHY?
11
 Risk assessment
• Q: What are the investment characteristics
specific to real estate that make it riskier than,
say, corporate bonds but less risky than stocks?
• We need to understand the sources of risk
(different risk characteristics or types of risk) of
various categories of investments.
• Let’s look at some of the risk that property
investors might have to face…

12
 Types of Risk (1/3)
• Business Risk
– Loss due to changes in economic conditions
– Some properties are affected more than others
• Well-diversified tenant mix  less business risk

• Financial Risk
– Increases with the amount of debt (leverage)
– Also depends on the cost and structure of debt
• e.g., Participation loans: lenders are allowed to “participate” the
appreciation of property value  lower monthly payments  less
financial risk. The ‘Help-to-Buy’ scheme in the U.K. is a good example.

13
 Types of Risk (2/3)
• Liquidity Risk (real estate asset are not liquid)
– Challenges in selling property (it can take from 6-12 months or
longer) especially during periods of weak demand.
– Higher concession if the seller wants to sell quickly.

• Inflation Risk
– Unexpected inflation can reduce an investor’s real rate of return
– Q: Does income increase enough to offset inflation?
– Real estate has historically done well during periods of inflation.

• Management Risk
– Most real estate investments require management to keep the
space leased & maintained to preserve the value of investment.
– Returns can depend heavily on the competency of management’s
ability to respond to market conditions.
14
 Types of Risk (3/3)
• Interest Rate Risk
– Changes in interest rates affect all securities and investments.
– Real estate tends to be highly leveraged, and thus the rate of
return can be *significantly* affected by changes in interest rates
• Direct impact on variable rate mortgage higher monthly repayments
• Indirect impact on fixed rate mortgage (or no mortgage!). How?
by increasing cost of borrowing  lower the demand for housing
 thus, reduce price that a subsequent buyer is willing to pay

• Legislative Risk
– Regulatory changes can adversely affect the profitability of real
estate investment (e.g., stamp duty, tax laws, other restrictions imposed
by government).

15
 Due Diligence and Risk Management
• Q: How can an investor effectively manage the
risks associated with real estate investment?
• Three primary tools may be employed by investors
to minimize their exposure to risk:
1) identification and avoidance of risk through “Due
Diligence”: research the investor undertakes to assess
whether the investment is suitable.
2) Financial tools such as insurance, hedging, and option
contracts
3) Diversification (either into other product types or different
locations)
16
 Sensitivity Analysis
• BUT…we would need to first measure the degree of
risk involved in investing a real estate project?
• Unfortunately, it is not easy to correctly identify and
evaluate the riskiness of an investment
 Sensitivity Analysis (what-if)
– Base Case (based on the best estimate of the most likely situation e.g.,
rent, vacancy, etc.) as a “benchmark” for analysis.
– Change and relax a single assumption
 Q: What is its effect on NPV or IRR?

17
 Partitioning the IRR (1/4)
• Return on equity investment in real estate comprises two
sources of cash flow: (1) cash flow from operations and (2) cash
flow from the sale of the property.
• In general, the greater a proportion of IRR is made up of (2)
[which is less predictable] the greater the risk & uncertainty
facing the investor.
• A breakdown of each component would be useful to understand
the riskiness of a real estate investment
 Partitioning the IRR  How?
1. Compute the IRR
2. Discount cash flows from operations (CFO) using the IRR as the discount rate
3. Discount cash flow from property sale (CFS) using the IRR as the discount rate
4. Compute the percentages: (PV of CFO) / (Total PV); (PV of CFS) / (Total PV)

18
 Partitioning the IRR (2/4)

• Example 13-1 (BF, 2011)

– Equity Invested = $600,000 at t=0
– CFO1 = $40,000 from rent
– CFO2 = $42,000 from rent
– CFO3 = $45,000 from rent
– CFS3 =$800,000 from sale
IRR = 16.48%

19
 Partitioning the IRR (3/4)
• Present Value of all CFOs = $93,773
– Use the IRR of 16.48% as the discount rate
• Present Value of CFS= $506,229
– Discounting $800,000 at 16.48% for 3 years

• Percent from Operations ≈ 15.63%

– $93,773/$600,000
• Percent from Sale ≈ 84.37%
– $506,229/$600,000
Substantial risk facing the investor as
over 84% of the IRR is made up of expected appreciation of property price in the future.
20
 Partitioning the IRR (4/4)

• This method is also useful for comparing

alternative similar investments.
– e.g., an alternative property may have the same IRR,
but if the percent of return from operations is 70%
and property sale is 30%, there is a significantly
lower risk involved.
• The riskier (more uncertain) portion of the
return is generally understood to be the one
based on property sale / price appreciation.

21
 Variation in Risk & Return (1/3)

• Use economic scenarios (pessimistic, most

likely, and optimistic along with the
probabilities for each of the three outcomes):
– Compute cash flows from operations and property
sale for each scenario.
– Compute the IRR in each scenario.
– Multiply the IRR by the probability of the scenario
to compute an expected return
 Need to consider risk (measured by the standard
deviation of IRR)
22
 Variation in Risk & Return (2/3)
• Variance or Standard Deviation
– The lower the standard deviation, the more likely actual
return is closer to expected return

• Normal Distribution
– Usually, we expect the actual return to fall within 1, 2, and
3 standard deviations 68%, 95.5%, and 99.7% respectively.
23
 Exhibit 13-8
Risk versus Return (office, apartment, hotel)

24
 Variation in Risk & Return (3/3)

• Coefficient of Variation

CV 
E (IRR )
– Standardized measure
– A measure of risk per unit of (expected) return

• Portfolio considerations
– Reduce risk by combining assets into a portfolio(e.g.,
office, apartment, hotel)
– Diversification  a topic for lecture in week 17!

25
 Reading
 Brueggeman, William B. and Fisher, Jeffrey D. Real Estate
Finance and Investments, 14th edition (McGraw-Hill/Irwin,
International Edition 2011). Chapter 13.
 Baum, Andrew and Hartzell, David. Global Property
Investment: Strategies, Structures, Decisions. First edition.
John Wiley and Sons, 2012. Chapter 4.
 Ling, David, and Archer, Wayne. Real Estate Principles: A
Value Approach. Fourth International Edition. McGraw-Hill,
2013. Chapter 7.
 See also the module handbook and ‘Study Schedule’.

26