Assessing Risk

Learning how to determine and manage risk can increase returns on real estate investments.

By Norman Miller

In the commercial real estate investment context, risk is anything that creates volatility in a property or portfolio's expected or actual returns. In addition to analyzing returns and running cash-flow projections, the most astute investors effectively understand risk analysis and management.

To deal with risk effectively, investors must know how to determine and manage its causes, as well as how to mitigate problems or shift risk to third parties, such as other brokers, sellers, tenants, or insurance companies. Pricing risk also is essential in determining acceptable risk premiums that are built into an investment's required returns.

What Causes Risk?
Risk analysis begins by assessing factors that influence an investment's returns. Economic factors as well as industry fundamentals and trends weigh heavily in real estate analyses � unlike the stock market where investors seldom do fundamentals research and instead rely on the assumption that statistics repeat themselves over time. Real estate investing clearly is different: Careful consideration of industry trends, market fundamentals, and the investment's financial statements better reflects the return's true drivers.

Commercial real estate investment risk stems from five major categories, which follow in the order of least controllable to most controllable at the time an individual makes an investment decision.

Economic Risks. Investors should analyze demand influences, such as employment, population, income, and accessibility trends, and supply influences, which generally come from competition, and factor them into rents, vacancy rate projections, and appreciation expectations. Using market analyses, investors should consider a range of realistic rents, vacancy rates, and trends.

Liquidity Risks. Liquidity relates to an investor's ability to convert an asset to cash while preserving capital. Due to high transaction costs and relatively long marketing periods, commercial real estate is not a very liquid asset, yet property liquidity varies over time due to changing market conditions. For instance, lowering the price may hasten a sale, but it may result in less capital. Generally, as liquidity risk increases, the required return rate, or premium, over more liquid investments also increases.

Political, Legal, and Environmental Risks. Investors need to monitor local, state, and federal land-use controls, fees, and regulations because they can act as market constraints or, in some cases, incentives. Examples at the local level include zoning, building codes, eminent domain, property taxes, and incentives such as property tax abatement or subsidies that encourage development. Some federal regulations include the Comprehensive Environmental Response, Compensation, and Liability Act; Americans With Disabilities Act; Endangered Species Act; Fair Housing Act; clean air, water, and wetlands protection acts; and interstate signage acts. Changes in these regulations or new regulations or incentives enacted at the local, state, or federal levels may affect property returns.

For example, in Chicago a recent citywide requirement for property owners to add sprinkler systems to existing buildings may reduce property values by several dollars per square foot due to equipment installation and tenant displacement costs. This is an example of a political/legal risk that investors must monitor and factor into their projections of income, expenses, and possible capital expenditures for compliance.

Business and Management Risks. Owners and investors have some degree of control over business risks that are inherent in management decisions influencing a property's rental flows and operating expenses. These include lease elements that affect how rents may change over time and how property owners share operating expenses with tenants, as well as tenant credit, tenant mix, and lease duration strategies.

Good managers may influence property returns through creative marketing efforts, especially with retail properties. For example, regional malls can sponsor events that attract more customers, which in turn may increase sales and rental income. Good management also may be evident in contracts that reduce operating and maintenance expenses or allow fair pass-through provisions.

Financial Risks. Financing is the only risk category in which owners have a great deal of influence. Owners control their properties' leverage, or the proportion of debt financing used to purchase the property. Increasing the leverage directly affects the volatility of the cash returns to the equity position anytime something unexpected occurs.

In addition to leverage, risk is inherent in loan terms, such as prepayment penalties and variable rate clauses, which cause investors to shift or accept future interest rate risk. For example, lenders bear the interest rate risk in fixed-rate loans, while variable-rate loans shift the risk to borrowers. Accepting such risk is fine, as long as the investor clearly understands the return volatility implications.

The Most Controllable Risk: Financial Leverage
Leverage always increases any equity investment's risk because it allocates the lowest-risk portion of the property's returns to the debt holder, so the equity holder is left with the higher-risk portion. Using mortgage debt leverage, an income-generating property can offer different types of investment products.

For instance, a property owner can divvy a moderate-risk real estate asset presenting moderate growth and yield into two investments: one that supports a high-risk equity investment with high growth and a low current yield and another that supports a low-risk debt investment with zero growth and a high current yield. Doing so increases the pool of investment partners or groups that can invest directly or indirectly in the property, thereby maximizing the property's value. Thus, various partners can maximize their own objectives with one investment that, on its own without preferential returns, would satisfy none.

In general, wisely applied leverage � in which returns exceed the cost of debt � always increases an equity investment's expected total return. Leverage may increase, decrease, or leave unchanged the current income yield for the equity investor, and this equity yield effect usually is smaller than the appreciation effect. These general results qualitatively apply to the internal rate of return in both single-period and multiperiod analyses.

One useful tool to gauge leverage's effects is a leverage ratio, which is the total property value divided by the equity. Thus, a property with a loan-to-value ratio of 60 percent has a leverage ratio of four as seen in the chart, �Typical Effects of Leverage on Investment Returns.� The appreciation return to equity is 5 percent, or 2.5 times the 2 percent received on the property as a whole. The leverage ratio is a quick way to estimate the increase in returns and approximate risk when adding debt.

Risk's Effects on Returns
Understanding return sources and their predictability is critical to analyzing any projection's risk.

Cash flows generated from the collected income (rent) less operating expenses and debt service are most properties' primary return source. These are predictable to the extent that rents are known and expenses are controlled through pass-through provisions.

A second return source for taxable entities is the tax shelter and postponement generated from non-cash depreciation deductions. Depreciation taken during the holding period results in recapture at the time of the sale, but the recapture is at a lower tax rate. The return is highly predictable as long as tax rates remain stable.

Equity buildup from reducing the mortgage loan principal (if financing is used and if the debt service includes principal repayment as part of the typical level amortization payment) is another predictable return source, especially if the interest rate is fixed. Interest-only loans do not involve equity buildup from this action.

Appreciation or depreciation from a property's change in value is the least predictable return for most investments, and thus, one of the greatest risk sources.

Each of these returns has a certain degree of predictability; if the return flow is more predictable, the return source is less risky. Tax deductions and equity buildup returns are highly predictable. Cash-flow returns are somewhat predictable based on known leases and tenant reliability, but they become less predictable over time. Returns from value changes are the least predictable, thus much of real estate investment risk comes from changes in price and long-term cash flows.

Estimating the IRR to Understand Various Return Sources
To quantify a return source's effects, investors can break down an IRR estimate's components. There are different procedures to do so, but the easiest is adjusting the variable of interest.

For example, an investor expects an after-tax IRR of 15 percent on his Anastasia Avenue office property. Within the pro forma is an assumption about resale price based on the change in the NOI and a going-out capitalization rate. If the investor changes the resale price to equal the purchase price on a net basis, the IRR declines. If the IRR drops to exactly 11 percent, it is safe to conclude that 4 percent of the 15 percent return is from appreciation representing 26.7 percent of the return.

It also is possible to examine other variables' effects on IRR through a sensitivity or simulation analysis. (See the sidebar, �Risk Analysis Software.�) Breaking up one or more variables' effect on the IRR provides a type of static sensitivity analysis. Investors may find the rental growth rate or the resale going-out cap rate are the most critical assumptions from such an exercise. Though these analyses provide insight, use them with caution. Specifically, investors should avoid changing one variable without changing others since many variables are driven by similar influences.

To compensate the Anastasia Avenue investor for more or less risk relative to other investment opportunities requires a change in the required rate of return. For example, an investment similar to Anastasia Avenue provides an expected IRR of 12 percent based on reasonable assumptions. The property is similar in all respects except that the tenants have better-than-average credit and longer-than-average leases at market rents.

These two factors result in less risk than similar office properties; the investor who wants this property should recognize the lower risk and bid up the price, accepting a lower rate of return. If the price necessary to buy the property reduces the expected IRR to 11.5 percent, then the required rate of return has been effectively lowered by 0.5 percent; correspondingly, the investment's value increases.

If the property had above-average risk tenants, the investor could have done the opposite and increased the required rate of return. In more sophisticated analyses, the investor could assign a different discount rate to each major tenant's lease and weight the required return by the resulting sum of the required returns weighted by the dollar proportion of the total return they represent.

Once an investor knows how assumptions influence the return, debt coverage, break-even point, and other financial ratios, he either must accept the risk and assign a premium over less risky investments or investigate if any of the risks can be shifted. This process begins with thorough due diligence. (See the sidebar, �Due Diligence Makes the Difference.�)

Norman Miller is director of the University of Cincinnati's Real Estate Center and a DePaul University 2003-04 visiting professor. He also serves as the CCIM Institute's educational consultant and is author of Real Estate Principles for the New Economy. Contact him at (312) 362-8785 or nmiller@sbcglobal.net.

Due Diligence Makes the Difference
Due diligence is a critical step in the risk management process. Overlooking, miscalculating, or misunderstanding critical items can add significantly to the purchase price and reduce future investment returns. Potential buyers should analyze the following areas during due diligence to minimize risk and maximize a commercial real estate investment's profitability.

Pass-Through Expenses
Pass-through expenses are subject to the inherent risks of owner/tenant expense interpretations and assumed future expense growth. Many purchasers simply review the lease provisions and assume that tenants will abide by the new owner's interpretation of pass-through expenses. However, this isn't always the case.

In some instances, new owners attempt to bill existing tenants for new pass-through expenses, but the tenants refuse to pay the charges, which can result in negotiation, arbitration, or even litigation. While landlords often prevail, many times they do not. The litigation, time, and other costs of a poor tenant relationship are significant.

To avoid interpretation problems, investors should hire experienced lease analysis professionals to scrutinize lease documents. Thoroughly reviewing the seller's billing practices and tenant correspondence and payment histories to determine soft areas of past billing practices are equally important steps.

Most investors utilize cash-flow projection models or software to predict future expenses and returns. However, many investors either improperly develop the models or, due to time constraints, shorten the process by hard coding pass-through expenses, which often results in costly inaccuracies.

To reduce cash-flow risks further, owners should protect against inflationary impacts. Many leases' pass-through provisions are broad and pave the way for tenant disputes, specifically regarding what insurance expenses can be passed through to tenants. Lenders often require terrorist-related coverage as a rider or separate policy, but many tenants question if they should incur these additional costs. Lenders now frequently require landlords to maintain terrorist-related policies, and many tenants claim these are an owner's expense. In addition, many older leases state that tenants only pay the pro-rata share of insurance premiums; thus they refuse to pay other insurance-related costs such as risk management consultants or expeditors that property owners often hire to assist in making claims.

To avoid such potential problems, review leases carefully to determine what insurance-related costs are reimbursable. Specifically define insurance costs when negotiating new leases. Also, never use the seller's insurance costs when projecting future cash flows, as your risk management profile and your portfolio's size, among other factors, affect your insurance costs. Always obtain a quote from your own insurance provider.

Deferred Costs
Tenant improvement allowances and other unknown costs may be hidden in leases, particularly long-term office leases. For instance, 10-year or 15-year office leases occasionally include $5 per square foot to $7 psf allowances for painting and carpeting midway through the lease term. Landlords generally don't record or track such liabilities, so only a thorough review of leases uncovers such hidden obligations.

Likewise, broker commissions payable over an extended period are common. Carefully review broker agreements and related payment histories to discover these future obligations and even confirm these payments with the broker. For example, in a large portfolio transaction in the Southwest, the buyer received a present-value purchase price adjustment of more than $17 million related to future leasing commission and tenant improvement obligations.

Property Taxes
When acquiring properties, new owners should thoroughly investigate the local jurisdiction's tax assessment policies. This information frequently is available on municipalities' Web sites. In addition, speak directly (anonymously if necessary) with town assessors to learn about the assessment process directly from those who determine and administer it. In certain localities, investors may be able to buy a property's ownership interests rather than the fee interests, thus avoiding transfer taxes and mitigating reassessment's likelihood.

Understand the local jurisdiction's billing practices to ensure proper closing prorations. For instance, some cities such as Chicago bill real estate taxes one year after the actual tax year, and assessors don't determine final assessments and/or millage rates until the fall of the following year (i.e. this year's property taxes won't be assessed until fall 2005). For instance, in a portfolio acquisition a buyer received a closing proration adjustment of almost $1 million in its favor; however, the buyer faces the probability of giving back the $1 million or more when it sells the properties.

Investors also must consider tenant reimbursement impacts. Since real estate taxes may be fully or partially reimbursed by tenants, a buyer needs to understand how this may affect the property's cash flow. For instance, if a tenant has been reimbursing a landlord for taxes one year in arrears, how is the situation settled when the lease terminates? Since they may stand to lose revenues, investors should carefully draft tenant reimbursement lease terms.

In addition, some tenants, particularly national retailers, include lease provisions that prevent landlords from passing on real estate tax increases resulting solely from a reassessment due to ownership changes. Thoroughly review tenant leases to determine if this affects the potential investment. In some instances, shopping center buyers may be able to negotiate a reduced purchase price due to this factor.

Utilities
Buyers often overlook how utilities affect an investment's cost and returns. First, review utility invoices to determine if all utility meters are identified. Sometimes utility companies bill properties for meters that no longer are in use, which offers an operating expense savings opportunity. Second, determine if the utility company's invoices are based on actual readings or long-term estimates. Also read all utility meters prior to or at closing.

Consider hiring a utility expert to review how tenants are billed for utilities where direct meters are not utilized. Many owners, particularly of large malls and industrial and office parks, purchase wholesale utilities or use cogeneration plants and mark up the cost to tenants. In these cases, ensure that the leases permit this practice (or at least don't prohibit it).

Since energy deregulation took effect, some landlords also have purchased gas and electric services under forward contracts or taken part in national buying programs, but new owners may not be able to buy these utilities at the same price. Consider these factors when assessing a property's projected operating costs and related tenant reimbursements. Investors may discover a purchase price negotiating point in this situation as well.

Other Matters
Other risk management and related due-diligence matters include assuring that sufficient working capital exists within your equity and/or debt structure and reviewing tenant (and guarantor) credit matters, among others.