Risk Analysis

Abstract

In this chapter, the various forms of risk in real estate investment will be described. These forms of risk will be outlined in light of the recent financial crisis. The chapter discussion will elucidate various statistical analyses that the individual investor can perform in quantifying the level of risk in a particular property. As a component of risk analysis, the concept of leverage will be discussed. The internal rate of return (IRR) will be revisited in the context of risk determination. The chapter will conclude with discussion of risk measurement from the perspective of the lender.

Nothing profits more than self-esteem founded on just and right.

Aldous Huxley

Mini-Case: Sensitivity Analysis

When evaluating an existing investment property, a sound due diligence on the part of the investor and the lender includes sensitivity analysis. The sensitivity analysis is essentially a what-if scenario that seeks to find how the risk inherent in an investment property. The risk is defined by increases in vacancy rates and interest rates primarily.

Assume you have a property exhibiting the following financial characteristics:

Tenant	Sq. Ft.	Annual rent
Winn Dixie	22,000	$ 462,000
Dollar general	6,000	$ 123,000
Franco’s Pizzeria	2,500	$ 60,000
Uncle Jimmy’s Toy and Hobby	4,000	$ 92,000
Total gross revenue	34,500	$ 737,000
Market vacancy factor	10%	$ (73,700)
Effective gross income		$ 663,300
Property taxes		$ 75,000
Insurance		$ 27,000
Repairs and maintenance		$ 55,000
Utilities		$ 18,000
Management fee	5%	$ 33,165
Other expenses		$ 5,000
Replacement reserve	1%	$ 6,633
Total operating expenses		$ 219,798
Net operating income		$ 443,502
Annual debt service		$ 305,000
Debt coverage ratio		1.45

Questions for Discussion

• 1. What is the break-even occupancy percentage for the subject property?

• 2. Assume that annual debt service is calculated over a 20 year amortization for a loan amount of $3 million, with an interest rate of 7.97%. What would the interest rate have to rise to (under the current situation) in order for the net operating income to equal the annual debt service?

• 3. How many of the current tenants does the 10% vacancy factor cover in the current underwriting? How would the DCR look if both of the two local tenants vacated the property?

• 4. Research the financial health of Winn Dixie and Dollar General on the internet. How strong are they from a financial standpoint? Any concerns about the bulk of your NOI coming from these two tenants?