evaluating risk in property feasibility studies for npv computation year is the time interval...
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Evaluating Risk in Property Feasibility Studies
A component of the research project into:
The Functional Performance of Commercial Buildings
19 June, 2003 CRC CI Project 11
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Evaluating RISK
All property projects are risky
To maximise profits, risk must be:IdentifiedQuantifiedManaged
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Today’s Program
2.00 – 3.30 pm: Cash Flow model accuracyShort tutorialKey variables and the marketBasic risk measurement
3.30 – 3.45 pm: Tea break
3.45 – 5.00 pm: Scenario analysisShort tutorialSimulation exerciseTriple bottom line assessment
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Investment Worth
Standard Measure of Rate of Return:
= END PERIOD – BEGINNING PERIOD + CASH FLOW x 100BEGINNING PERIOD
This is the approach used for property investment and development studies but sometimes we simplify the exercise.
1. Simple (Static) Exercise:Calculation of worth or profit in a single time period - this is the yield or direct capitalisation approach
2. Full (Cash flow) Exercise:Examining the cash flow over time – this is the Discounted cash flow (DCF) approach.
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Property Cash Flow Models
These models:
show the anticipated cash flow ( both income stream and capital change) over a specified time periodare used to determine either
1. Present Value ( or net present value)i.e. the worth today
2. Internal Rate of Returni.e. the total annual return achieved on funds during the time period specified.
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Property Cash Flow Spreadsheets
STRUCTURE: OUTCOME – NPV (or PV)Known:Net income estimate over timeFuture selling price estimateRequired total rate of return (discount rate)
Period 0 Period 1 Period 2 Period 3 Period … Period n PURCHASE
SALE
CASH FLOW
Compute: Net Present Value (Present Value)
N.B. May include or exclude a present value figure
Assumptions: Outcome NPV (or PV)1. Length of study 2. Time interval 3. All net income figures over time 4. Any capital items (input or expense)5. All sale figures6. Required rate of return (target rate)
GROSS INCOMEOPERATING EXPENSESNET INCOMECAPITAL EXPENDITURE
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Property Cash Flow SpreadsheetsSTRUCTURE: OUTCOME - IRRKnown:Present value (purchase price or value)Net income estimate over timeFuture selling price estimate
Compute IRRIRR is the rate of return that makes the future cash flows equal to the present cash flow.
Assumptions: Outcome NPV (or PV)1. Length of study (3, 5 or 10 years…)2. Time interval (monthly, annual…)3. All purchase/present value figures, including costs.4. Net income figures over time including starting and finishing dates and escalation rates of
income and expense5. Any capital expenditure or inputs.6. All sale/terminal value figures, including costs.
Period 0 Period 1 Period 2 Period 3 Period … Period n PURCHASE
SALE
CASH FLOW
GROSS INCOMEOPERATING EXPENSESNET INCOMECAPITAL EXPENDITURE
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Tutorial - Incorporating Loan Finance in a DCF exercise
Study the layout of this Property Investment case flow study and insert the additional headings required in the left-hand column to assess the Internal Rate of Return on Equity.
Will the IRR on Equity be greater or lesser than the IRR on Total Capital (10.51%)?
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Diagram for NPV computationYear is the time intervalt1…tn is the length of studytn+1 is the extra year
NPV = (disc rate, CF2…CFn) + CF1
Sale Price = Net Income tn+1Terminal Cap Rate
Known inputs
Key variables
Assumptions
OperatingExpenses
HistoricalOPEX
VacancyAllowance
Net LettableArea
Cash Flow
CapitalExpenditure
NetIncome
GrossIncome
TerminalCap Rate
DiscountRate
RentalGrowthRates
Sale Price
t n + 1
Sale Costs
CurrentMarket Value
PurchaseCosts
t =1...n
NPV(PV)
t = n
CPI Forecast
OPEXBenchmarks
Market RentLevels
RentSchedules
t1 ... tn
t1 ... tn
t1 ... tn
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Diagram for IRR computationYear is the time intervalt1…tn is the length of studytn+1 is the extra year
Sale Price = Net Income tn+1Terminal Cap Rate
IRR = (CF1…CFn)
OperatingExpenses
HistoricalOPEX
VacancyAllowance
Net LettableArea
CapitalExpenditure
NetIncome
GrossIncome
TerminalCap Rate
RentalGrowthRates
Sale Price
t n + 1
Sale Costs
t =1...n
t = n
CPI Forecast
OPEXBenchmarks
Market RentLevels
RentSchedules
t1 ... tn
t1 ... tn
t1 ... tn
Cash Flow
PurchaseCostsIRR
PurchasePrice
Known inputs
Key variables
Assumptions
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Rental Growth Rates
Space perWorker
Rent [R]
o
EquilibriumRent [R*]
s
SpaceDemand [OC*]
Employment [E]
s
s
o
Net SpaceAbsorption [AB]
s
s
DesiredCompletions [C*]
o
OccupiedSpace [OC]
s
o
Vacancy [V]
oo
o
Stock [S]
s o
Demolition ¬Α!
o
Completions [C]
o
s
s
+
+
+ -
Negative Feedback: a discrepancy induces corrective action to return the system to a target state (Equilibrium Rent).
Positive Feedback: growth leads to faster growth or decrease accelerates a collapse (space per worker).
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System Dynamics Concepts
System Dynamics theories, as developed by Forrester (1961) and enhanced by Coyle (1977), offer the opportunity to model complex interrelationships and to observe their dynamic behavior over time.
The use of dynamic models:
Provide more reliable forecasts of short to mid-term trends than statistical models – time-series models and regression models.
Provide a means of understanding the causes of industry behaviour.
Allow the determination of reasonable scenarios as inputs to decisions and policies.
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Property Professional – DCF Market Rent Forecasts
Comparison - DCF - Forecasts Market Rent Growth
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Year
% C
hang
e
Company A Company B Company C Company D Company E Economists
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Brisbane CBD – Historical % Change – Face Rents
Brisbane CBD - Historical % Change - Office Face Rents
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Year
% C
hang
e
Prime SecondarySource - BIS
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Property Professional – Inflation Forecasts
Comparison - ForecastsCPI Growth
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Year
% C
hang
e
Company A Company B Company C Company D Company E Economists
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Brisbane – Historical Inflation - % Change
Consumer Price Index - All Groups - Brisbane - Historical Movement
0.00%2.50%5.00%7.50%
10.00%12.50%15.00%17.50%20.00%22.50%25.00%
1949
-50
1952
-53
1955
-56
1958
-59
1961
-62
1964
-65
1967
-68
1970
-71
1973
-74
1976
-77
1979
-80
1982
-83
1985
-86
1988
-89
1991
-92
1994
-95
1997
-98
2000
-01
Financial Year
% C
hang
e
Source - ABS
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DCF Results Comparison – Alternate Rent & CPI Forecasts
DCF Results Comparison - Alternate Rent & CPI Forecasts
$107
,500
,000
$108
,000
,000
$108
,500
,000
$105
,000
,000
$102
,000
,000
$105
,500
,000
$50,000,000
$60,000,000
$70,000,000
$80,000,000
$90,000,000
$100,000,000
$110,000,000
$120,000,000
Company A Company B Company C Company D Company E Economists
Forecast Source
$
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Economic Factors & Property Variables
Historical Relativity - Property and Economic Factors
0
50
100
150
200
250
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Year
Inde
x
Building Net Income Effective Rents Inflation Vacancies
Construction Employment Gross State Product
Source: ABS, BIS Shrapnel & PCA
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Correlations – Economic Factors & Property Variables
10.750.42-0.360.910.030.83GSP
1.000.66-0.350.81-0.160.76Employment
1.00-0.620.340.350.16Construction
1.00-0.04-0.690.07Vacancies
1.00-0.330.96CPI
1.00-0.43Effect Rents
1.00Net Income
GSPEmploymentConstructionVacanciesCPIEffect RentsNet Income
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Research – Property Market Forecast Models
• Numerous models developed by US and UK Researchers
• Models being tested with Brisbane CBD data• Issue with data availability• Optimum model to provide basis for
forecasting module in DCF software• Aim to generate forecasts for rents, vacancy
rates, construction activity, yields & discount rates
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Property Market Forecast Example Equations
Net Space Absorption
ABt = τ1[α0 + Et[α1 + α2 (Et – Et-1) – α3Rt]] – τ1OCt-1
Et E = office based employmentR = office rentOC = occupied space
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Property Market Forecast Example Equations
Rent
Rt = µ3(µ0 – µ1Vt-1 + µ2 ABt-1 ) – µ3Rt-1
St-1
V = vacancyAB = net absorptionS = stock of spaceR = rent
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Property Market Forecast Example Equations
Construction – Space Supply
Ct = τ2 (β0 + β1St-8 + β2St-8Vt-8 + β3ABt-8) + (1 – τ2)Ct-1
S = stock of spaceV = vacancyAB = net absorptionC = construction
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Risk Identification
What are the crucial inputs of the study?
For investment studies:What will the future rents be?What will the property sell for?What are the likely capital costs?
For development studies:What are the likely timings for approvals?What will the selling price/s be?What will the development costs be?Other issues…
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Property Investment Crucial Variablesin Cash Flow Study
Rent Escalation Rates
Discount Rate
Terminal Capitalisation Rate
Loan Interest Rates
Purchase PriceIn certain circumstances
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RISK
Is described as the uncertainty surrounding the consequences of actions or decisions.
Definition:“The probability of not receiving what is expected”
PROBABILITY is often described as a deviation from the expected outcomes.
In financial terms the reward for committing funds is the RETURN and the uncertainty of receiving the expected return is the RISK.
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Risk and Return Trade-Off
A higher return must be offered to attract investor’s funds to riskier investments.
Risk and expected returns must be balanced in investment decisions.
EXPECTED RETURN
RISK FREE….RATE
RISK
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Types of Risk
Total investment risk is typically classified as systematic and unsystematic risk.
• Systematic risk – involves pervasive factors that effect all assets, it is unavoidable uncontrollable risk, e.g. inflation, interest rates, market cycles, political events, etc.
• Unsystematic risk - risk that is unique to the asset in question e.g. location, tenancy risk, financial risk, liquidity of asset, etc.
Total Risk = Systematic Risk + Unsystematic Risk
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Basic Measures of Return and Risk
RETURN measure is expected or mean return
RISK measure is the standard deviation from the mean return
The standard deviation is the measure of dispersionfrom expected figure (large standard deviation meanshigh risk, while low standard deviation means low risk)
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Combined Risk/Return Measures
1. COEFFICIENT OF VARIATION (CV)CV = std dev / mean
This is a ratio of the risk to expected return; it can be expressed as a percentage.
2. SHARPE INDEX= (Mean rate of return – risk free rate of return) / std dev of return
This is risk adjusted real rate of return
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Sensitivity Analysis
Sensitivity Analysis : quantifies risk by a process of assigning different values to the inputs considered uncertain in a cash flow model, and then measuring their relative impact on important output variables such as NPV, PV, IRR
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Case Study Example
Equity Study Sensitivity Analysis
17,200,000
17,300,000
17,400,000
17,500,000
17,600,000
17,700,000
17,800,000
17,900,000
18,000,000
18,100,000
18,200,000
18,300,000
18,400,000
18,500,000
18,600,000
-1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5%
Percentage Change
Inve
stm
ent W
orth
Interest Rate Discount Rate OPEX Rate Gross RentalSpider diagramUsed to measures the output change for a realistic change in that variable alone.This method does not take into account the correlation that might exist between the variables, but it is acceptable to determine the degree of sensitivity.
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Tutorial on Sensitivity Analysis
What should you look at to determine the impact of the key variables on the final output?
Which one is the variable that has the strongest impact on the figure?
Which one has the lowest impact?
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Scenario Analysis
Scenario Analysis : similar to sensitivity analysis but here the input variable values are grouped together at values assigned for different scenarios (e.g. boom, normal, and recession) and then the relative impact of the grouped changes is assessed.Output is most likely, best and worst case scenarios.
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Simulation Analysis
Simulation Analysis : The probability distributions are estimated for each uncertain variable in a cash flow model and the possible combinations of all values for each factor are then simulated to determine the range of possible outcomes and the probability of each outcome.
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Case Study: Simulation Exercise
7.75% 8.00% 8.25% 8.50% 8.75%
terminal cap
9.66% 9.93% 10.20% 10.47% 10.74%
disc rate
1.80% 2.40% 3.00% 3.60% 4.20%
Rental escalation 1
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Simulation Exercise Diagram
Frequency Chart
Certainty is 86.90% from 108,000,000 to 115,000,000 $
.000
.008
.017
.025
.033
0
8.25
16.5
24.75
33
105,300,422 108,270,092 111,239,763 114,209,433 117,179,104
1,000 Trials 992 Displayed
Forecast: Market Value
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Risk Management ProcessesAvoiding Risk1. Study property cycle - enter and exit at correct time.2. Selection property type (less risky).3. Prime location selection.4. Structure of financing - no loan finance.5. Quality tenants on secure leases.
Transferring Risk1. Insurance policies2. ‘Limited’ Company.3. No personal guarantees given.4. Good default clauses (easy, quick return of asset).5. Obtaining guarantees from lessee/buyer.6. Sharing interest in property.
Minimising Risk1. Reducing loan finance or interest burden.2. Lower purchase price, deferred payments.3. Rational diversification.4. Good accounting controls and reporting systems.5. Careful investment feasibility study.6. Improved project and property management.7. Improved tenants - ‘pre-let' situation.8. Prime location.9. Quality building.
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Financial Performance Measures
Most probable return (or value/price)
The ‘standard deviation’ risk measure(or range of possible results)
Most sensitive input variables
What-if results
Financial ratiosLoan interest: net incomeLoan amount: value
Benchmark comparisons(to internal or external benchmarks)
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Triple Bottom Line (TBL)
A valuer’s working definition – the comprehensive qualitative and/or quantitative assessment of social and environmental factors of agiven entity, complimentary to purely economic considerations.
Major principles – Legitimacy; appeal to common sense; longer-term focus (inter-generational equity); workplace equity; moral high ground.
Why value TBL – Reflect changes in the market (attitudes dictating demand & supply); important variables obscured by traditional economic approaches; sounder future value projections.
Major problems – Entity ‘greenwashing’; disclosure; difficult to quantify.
Solutions – Avoid ‘messy’ contingency valuations using an integrative, flexible approach (use $ + stars); pay particular attention to entities at the margins.
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Social Metrics
… Developed from Global Reporting Initiative to suit case study
Working conditions• Disclosure of health and safety records• Level of training and awareness optimizing the use of building features• Provision and monitoring of equal opportunity features/amenities• Provision, if any, of facilities/amenities/lobby space/furniture for the publicSociety impacts• Management of stakeholder interests/impacts in local precinct• Nature of tenant and naming rights businesses• Insurance cover for workers, maintenance crews, and the general publicTransparency• Disclosure of management details, including staff, structure, salaries,
contract agreements, auditsHuman Rights• Details regarding human rights training for security personnel, ect. (if any)
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Environmental Indicators
… Selected from green building codes
• Impact of materials used (LCA Design or similar software)• Energy consumption (savings, efficiency, alternatives, ect.)• Energy consumption footprint (plan - total life cycle)• Water consumption (recycling, capture, wastewater)• Emissions (greenhouse, ozone, particulates ect.)• Wastes and effluents (recycling and/or removal)• Transport for workers and visitors (public transport, carpooling)• Non-compliance with environmental regulations • Quality of built environment (worker satisfaction, aesthetics ect.)
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19 June, 2003 CRC CI Project 11
Questions ???
Evaluating Risk in Property Feasibility Studies