RFINANCE15: Investment and Risk Management

Investment analysis in real estate refers to analyzing a particular property in order to evaluate its investment potential.

An investment analysis also answers other important questions. Should the investor purchase the property? How long should the investor hold the property? How should the investor finance the property? What are the tax consequences of owning the investment? How risky is the investment?

Refinancing as an Alternative to Disposition:

As we have just talked about, after an investor has owned a piece of property for several years, the equity may grow as a result of an increase in the value of the property and the amortization of the loan. So the loan balance as it relates to the current value of the property will be lower than when the investor first purchased the property. In this situation, the investor has less financial leverage than when he or she first financed the property. So the investor may choose refinancing as an option. Refinancing would allow the investor to increase financial leverage. Refinancing at a higher loan-to-current-value ratio could give the investor extra funds to invest. In light of this, we can view refinancing as an alternative to selling the property. If the investor's equity has increased because of property value increase and the amortization of the existing loan, the investor should be able to get a new loan based on some percentage of the current property value. The lender would typically base the determination of the current property value through an appraisal. Keep in mind that the investor will probably pay points, appraisal fees and other expenses to get the new loan. However the investor does not have to pay taxes on additionally-borrowed funds, whereas he or she would owe taxes after the sale of the property. Before an investor can decide whether or not it would be a good idea to refinance, he or she must first determine the cost of the additional funds that will come from refinancing. If the interest rate on a new, larger loan is higher than that on the current, existing loan, the cost of the additional funds the investor borrows will be even higher than the rate on the new, larger loan because the investor has to pay the higher interest rate on all the money borrowed, not just the additional funds.

Management Risk:

Most investors need to employ a manager to keep their space leased and maintained so as to safeguard the investment's value. This management risk is based on the capacity of the manager and his or her ability to innovate, respond to competitive situations, and operate the business activity competently. The manager's competence can directly affect the rate of return that the investor earns. Some properties call for a higher level of management expertise than others. For example, a shopping mall will require continuous marketing to lease the space so that the mall will have a good variety of tenants who will draw customers.

Business Risk:

Real estate investors are in the business of renting space. They can experience the business risk of loss due to changes in economic activity that can affect the income the property produces. Changes in economic conditions can have an effect on some properties more than others depending on the property type, its location and any existing leases. Many parts of the country and different locations within cities grow at differing rates due to variations in demand, population adjustments and other factors. The more a property is affected by these changes, the riskier it would be. A property that has a varied tenant mix would probably be less subject to business risk. Also, if a property's leases provide an owner with protection against unexpected changes and expenses, that property would have less business risk.

Risk Management:

Even a casual search of the Internet on the concept of risk management turns up dozens of working definitions. Briefly, let's take a few minutes to gain some general background on the topic and then see how risk management operates in the real estate sector. Risk management developed in the United States as a formal discipline of study out of the insurance sector. In the 1960s, claim amounts began to increase substantially. In turn, this led to an increase in insurance premiums paid by individuals, small business owners and large business organizations. It seemed that as insurance premiums increased the actual policy coverage decreased. Entities were severely limited and powerless to control an entire industry's pricing structure. So, it soon became apparent that reducing and controlling risk would require a management system. The purpose was for organizations to become proactive in controlling liability and lessen their dependence on outside insurance coverage. In addition, when insurance was required, an organization could use a favorable risk history to negotiate lower rates. Risk management principles took some time to develop and be accepted as a valid management tool, but as increasing insurance premiums impacted all business decisions, risk management became a growing discipline. Since these early beginnings, organizations have learned that they are faced with risk threats beyond those usually associated with traditional insurance coverage. In the past, risk management was focused on protecting hard assets from loss due to recurring historical catastrophic events such as fire, floods and theft. Now risk management still deals with traditional areas of coverage, but it also incorporates the elements of those totally unforeseen events and also losses that impact more intangible assets. Risk management has grown beyond its original scope of reducing insurable losses into the formal management all forms of risk.

Hedging to Control Risk:

Hedging, which is a frequent practice in securities and commodities markets, may also decrease risk for real estate investors. Purchase options are a form of hedging that is often used in real estate. For example, when thinking about a development project, a developer might decide to purchase an option to buy a particular site. This strategy gives the developer time to plan, to get any government approvals that might be necessary and to obtain financing. The developer could also schedule soil and engineering studies during the option timeframe. The option strategy gives the developer time to remove some of the uncertainty that comes with a development project. Investor-developers also use interim financing commitments as a hedging method. To circumvent a commitment to an unfavorably high interest rate, a developer who believes rates will decrease during the construction may purchase a loan commitment that is binding on the lender, but is an option to the developer. The developer will then choose to exercise the option only if he or she cannot get better terms.

Diversification:

Investors can control risk exposure by considering the connection between the investments they already hold and any potential new investments. When investors hold diversified portfolios, they can expect a more stable and predictable pattern of earnings because issues that have an impact on profitability and market value do not influence all properties in the same way. Portfolio diversification is a much easier proposition for multimillion dollar real estate investment corporations. They can expand their holdings geographically to decrease the effect of any regional shift in economic activity. Also, they can easily obtain a good variety of property types -- apartment complexes, office towers, suburban office parks, and industrial properties. But most small investors have money availability issues that make diversification efforts more complicated. If an investor is forced to sacrifice economy of scale by investing in smaller properties, diversifying may mean giving up some of the expected return. One solution to this dilemma is to pool equity funds with other investors who have the same problem. This popular approach is called syndication. A syndication arrangement typically involves a promoter who arranges the syndicate and manages the enterprise for a fee plus percentage ownership. Passive investors contribute all or most of the equity funds. Most syndicates are organized as limited partnerships or as real estate investment trusts (REITs). We will talk about joint ventures, partnerships and REITs in a later unit.

Shifting Risk to Tenants:

Landlords often shift some risk to tenants though their lease agreements. They use expense stops to get tenants to pay specified operating expenses above some agreed-upon level or they make tenants responsible for all expenses through the use of a triple-net lease. Another strategy that landlords often use with long-term leases is to tie the rental rates to changes in a price-level index, such as the consumer price index, the wholesale price index, or the average rents for that type of property in the local area.

Debt Financing:

Most often investors pay for a property by combining their own money with a loan. Why would an investor choose to do this? The investor may not have enough equity capital to buy the property. On the other hand, the investor may have enough equity capital, but may choose to borrow anyway and use the surplus equity to buy other properties. If the investor spreads his or her equity funds over several properties, he or she could reduce the overall risk of the total investment portfolio. An investor may choose to borrow to take advantage of the tax deductibility of mortgage interest, which increases tax benefits to the equity investor. An investor may use debt to realize the potential benefits related to financial leverage. Financial leverage is defined as the benefits that may result for an investor who borrows money at a rate of interest lower than the expected rate of return on the total funds invested in the property. If the return on the total investment put into a property is greater than the rate of interest on the debt, the return on the equity is increased.

Reducing Risk through Careful Selection:

One way to decrease risk is to invest in less risky projects. If an investor chooses only those opportunities where the outcomes are fairly certain, he or she can lessen the default risk basically to zero and eliminate any uncertainty associated with the outcome of the investment itself. However, when taking this more conservative approach, an investor also eliminates the opportunities for extraordinary profits. In our free market society, high-risk investments create the possibility for significantly high returns, although the opposite is also true - high-risk investments create the possibility of significant loss.

Property Management:

Professional property managers are exceptionally good at improving the accuracy of cash flow projections. They have great access to market data and their knowledge and experience about the economics of property operations are invaluable. A competent manager has a critical role in making outcomes match assumptions. Resident managers are essential for controlling day-to-day operations. They may be able to increase revenue by controlling vacancy and rent losses and reducing tenant turnover. They can hold expenses down by supervising all operations and handling preventive maintenance.

Market Research:

Real estate investors make assumptions about a project's ability to generate income over an extended period. Risk is the discrepancy between the assumptions and what actually happens. One of the best methods of reducing that risk is to make more accurate assumptions.

Legislative Risk:

Real estate is subject to many laws and regulations, such as tax laws, rent control, zoning and other government restrictions. Changes in regulations can negatively affect an investment's profitability. This can result in legislative risk. The legislation passed by some state and local governments is more restrictive than the legislation passed by others, especially for new development.

Summary/Review:

Risk is the chance of experiencing a loss. Risk is always the outcome of a decision or a series of decisions. Risk management in business usually requires giving prior thought to potential problem areas. Risk management is an ongoing process that changes constantly. However it is a process with distinct milestones that are sequential in application. The main task of risk management is to identify the risks faced by the business. Once risks have been identified, they need a plan of control. Risk control deals with dealing with loss in three ways: Avoid Loss Limit Loss Reduce Loss The first control deals with the issue of avoiding the risk or not entering into the risky situation in the first place. The second control deals with limiting the frequency of losses, that is reducing the number of times a particular event can occur. The third control deals with reducing loss when an event does occur. Investors must consider many variables when purchasing income properties. These factors include: Market factors Occupancy rates Tax influences Level of risk Amount of debt financing and Proper procedures to use for measuring return on investment Investors invest their equity funds for four main reasons. Return Rate Property Appreciation Diversification Tax Benefits

Shifting Risk to Insurance Companies:

The accurate prediction of losses due to fire, flood and other natural hazards is almost impossible for any particular building or property. By obtaining fire and extended coverage insurance, a property owner shifts the risk of property damaged by fire, smoke, wind, hail, lightning and other disasters to the insurance company. Liability insurance protects against any claims that result from injuries that may have taken place on the property. Damage to plate glass can be covered, as well as damage due to a faulty sprinkler system. Other types of insurance that property owners often get includes protection against loss or damage to building contents and coverage on mechanical equipment, such as furnaces, hot water heaters and air conditioning units. If building owners have employees working on site, workers compensation insurance is also a good idea.

Risk management is an ongoing process that changes constantly. However it is a process with distinct milestones that are sequential in application.

The main task of risk management is to identify the risks faced by the business. Once risks have been identified, they need a plan of control. This plan can be divided into two parts: tangible and financial. Dealing with the tangible side involves taking physical action to prevent losses from occurring. For example, a disaster plan should be in place to deal with a natural disaster. Another example is in the installation of fire extinguishers and sprinklers to reduce loss due to fire. Another aspect of developing a risk management plan deals with the frequency and severity of risk. Frequency refers to how often a particular unwanted event might occur. Severity refers to the extent of the damage arising from the event. Risk control deals with dealing with loss in three ways: Avoid Loss Limit Loss Reduce Loss The first control deals with the issue of avoiding the risk or not entering into the risky situation in the first place. For example, a person may decide not to buy that house that has been used as an illegal drug distribution center unless he or she is willing to remediate the property and conform to all government and agency regulations. The second control deals with limiting the frequency of losses. This has to do with reducing the number of times a particular event can occur. For example, a building owner can install tamper-proof HVAC control systems in the public access areas of an apartment complex thereby reducing and limiting annual fuel expenses due to unauthorized adjustments. The third control of a risk management plan deals with reducing loss when an event does occur. Undesirable events may still occur, but the consequences will be controlled. For example, sprinklers could be installed in a factory to reduce the spread of fire. Physical risk control also involves post-loss action taken by real estate owners. The salvaging of damaged materials, disaster recovery and clean up are all examples of post-loss risk control. Post-loss risk control is targeted at reducing the severity of the property loss.

The Real Estate Cycle:

The real estate industry is cyclical in nature. It is helpful to understand that fact in light of the investment styles and strategies we will be talking about shortly. First let's discuss some facts about the real estate industry. - The real estate industry is extremely large in terms of both numbers of properties and square footage. - The real estate industry is highly competitive. - Ownership of real estate is highly fragmented. That means that no one owner or developer controls a considerable share of the real estate market in major US cities. Another fact to consider is that when local real estate owners and investors sense that vacancy rates are declining and rents are rising, it usually means that the amount of space available for leasing is also declining. Because of this, development may become more realistic at that point in time. As a result, developers begin to do studies on specific sites and analyze markets to determine if additionally developed space can be easily leased at a profit. If a number of developers have this feeling at the same time, they may all begin to get financing and develop at once in an effort to satisfy the demand. Even though there may be a need for additional space, with everyone working at the same time, the potential for "overdevelopment" is real. There is really no way to determine how much space should be developed, because it is difficult to predict the extent of the future demand. As a result, the real estate industry is often said to have a tendency toward cycles of overdevelopment. Because the industry is so competitive and forecasting the future demand for space is difficult, there are times when there is an excess supply of space which has been unintentionally created. This excess supply increases vacancy rates, reduces rents, and causes instability in property values.

Investments and Risk:

There are many variables that investors must consider when purchasing income properties. These factors include: Market factors Occupancy rates Tax influences Level of risk Amount of debt financing Proper procedures to use for measuring return on investment Since the property is being used as collateral for a loan, lenders are also concerned with these same questions. As we have said earlier, lenders are concerned also about whether or not the property will generate enough cash flow to cover the loan payments. Why People Invest As we have seen, there are a number of different categories of income property types. Why would an investor choose one investment type over another? Let's first talk about an equity investor. Equity refers to funds invested by an owner or a person who is purchasing property. Equity funds could be invested in a fee simple estate, a leased fee estate, a leasehold estate, etc. Equity funds are different from debts, which are funds provided by a lender using the property as collateral for the loan. So why would an investor want to make an equity investment in an income property?

Controlling Risk:

There is no way to avoid risk when dealing with real estate investments. However, risks can often be significantly reduced with relatively simple risk management procedures. Here is a list of those procedures. Reducing risk through careful selection Diversification Market research Property management Shifting risk to tenants Shifting risk to insurance companies Hedging to control risk

Summary/Review:::

There is no way to avoid risk when dealing with real estate investments. However, risks can often be significantly reduced with relatively simple risk management procedures. Here is a list of those procedures. Reducing risk through careful selection Diversification Market research Property management Shifting risk to tenants Shifting risk to insurance companies Hedging to control risk After all possible risk control techniques have been put in place, some amount of unavoidable risk still remains. Before making any commitment of funds to a real estate project, most rational and well-informed real estate investors will do the following: Specify investment objectives with reference to the return on investment, the timing of the return and acceptable risk levels. Identify the major risks that are involved and calculate them as completely as possible. Eliminate some risks, transfer others through insurance or other techniques and limit the remaining risks to acceptable levels. Make decisions to accept or discard specific investments, based on whether the expected returns justify carrying the remaining risks in light of how the project will contribute to the investor's overall objectives. Many things can change during the time period an investor holds a property that affect the actual performance of the property. Another factor that an investor looks at is the potential benefits associated with leverage. Factors such as these could cause the investor to consider selling the property. If an investor has less financial leverage than when he or she first financed a property, the investor may choose refinancing as an option. Instead of selling one property and buying another, an investor could consider renovation as an option.

Strategy as to Size of Property:

These investors tend to specialize in a sub-sector of a particular property type, believing that it would be more cost-effective to lease and manage a particular property within that property type. For example, an investor may choose to invest only in neighborhood or community-size retail shopping centers and not invest in larger regional malls. These investors believe that, if they have a better understanding of these particular property sectors and the tenants in these market sectors, their investments will be more profitable than would be the case if they invested in more complicated property.

Investing in Core Properties:

This investment style is based on a goal of acquiring existing, tested, relatively low-risk properties that are at least 80 percent leased to tenants with good credit. The investor wants to realize a relatively stable cash flow with returns that are competitive with comparable properties. The investor does not anticipate changing the operation of the property or making capital improvements.

Liquidity Risk:

This risk occurs when the real estate market is slow with not many buyers, sellers or transactions. The more difficult an investment is to liquidate, the greater the risk that the investor will have to lower the price considerably if he or she has to get rid of the investment quickly. Real estate has a relatively high degree of liquidity risk. It may take from six months to a year or more to sell real estate income properties, especially during times when the demand for investment real estate is weak. A special-purpose property would have much more liquidity risk than a property that could be converted to an alternative use.

Growth Investing:

This strategy calls for an investor to research and discover which properties are apt to experience significant or above average appreciation in value. This style depends heavily on market research and the ability of an investor to understand changes in the economic environment and its effect on all types of real estate.

Investing in Core Properties with a Value Added Strategy:

This strategy combines the core investment strategy above with a strategy to make changes in the management of the property or to make some specific capital improvements. These changes are targeted towards increasing rents and outperforming competing properties in the same market.

Developments:

This strategy involves obtaining land, designing a building or set of buildings and then determining a leasing program that will result in stable occupancy. This is a riskier strategy, but investors believe that development will create more value and lead to higher investment returns than would be the case when investing in an already existing property.

Opportunistic Investing:

This strategy involves obtaining properties from investors in financial difficulty or obtaining properties that need renovation, upgrading or repositioning. Whether this investment plan will be successful usually depends upon the ability to purchase properties at a discount. In addition, the investor must understand how to upgrade, modify or reposition the property. The success of this kind of an investment may also depend on a good exit strategy, such as finding buyers who have the ability to obtain financing to purchase the properties.

Strategy as to Tenants:

This strategy is based on a preference for properties that are leased to multiple tenants or leased to a single or very few tenants. In the case of multiple tenants, owners may prefer to take the risk of higher tenant turnover because the ability to adjust rents to market levels more frequently is also greater. On the other hand, some investors prefer properties that are leased to a single tenant, because they believe these properties to be less risky due to low tenant turnover and the good credit of the tenant.

Investing in Trophy or Blue Chip Properties:

This strategy is based on an approach to investing that targets only very visible, well-located properties. This is similar to value investing. However, these investors believe that properties with some unique historical, architectural or locational attributes will prove to be excellent investments over the long term. Such investments might include properties such as the Mall of America, the Empire State Building or Rockefeller Center.

Arbitrage Investing:

This strategy is based on the ability of an investor to recognize the differences in prices that buyers are willing to pay for the same real estate investments that are located in different markets. For example, this strategy is used by investors to buy properties directly in private market transactions and then earn a profit by creating a publicly-traded entity and issuing stock to the public.

Turnaround/Special Situation

This strategy is based on the belief that an investment can be successful if the investor changes or modifies the use of an existing property. For example, an investor may obtain under-performing or under-managed properties. After a period of intense leasing, renovation, and property management, the investor will sell the properties one at a time and receive a total amount that will be greater than the initial cost.

Market Timing:

This strategy is based on the belief that some investors have an ability to predict when to buy or sell properties based on an understanding of the stage of each property type in the real estate cycle and future economic conditions. For example, if an investor believes that occupancy and rents will improve and that the formerly lagging apartment market is in a recovery phase, then an apartment would be a target investment for a market timer strategist.

Contrarian Investing:

This strategy is based on the idea that some major economic, technological, or other event will make the investment outlook for a given property type poorer and less favorable among investors. Contrarians believed that investors tend to overreact to negative news and tend to oversell property they believe to be unfavorable. If a number of investors believe the negative news that a particular investment will perform poorly and then sell those properties, a contrarian will wait until these properties become available at very low prices and then purchase them, expecting that the price will eventually recover.

Value Investing:

This strategy is based upon a performance approach whereby the investor does research to find those properties that have been overlooked by other investors. Value investors try to identify properties that have the ability to produce greater than expected income and appreciation. For example, an investor may prefer to invest in an office property that is located in the central business district and is leased on a long-term basis to several large corporate tenants. In such a situation, the rental income is more assured because the tenants have good credit histories.

Property Sector Investing:

This style uses economic and demographic research to come to the belief that, over the long term, one property type will outperform other property types. For example, if current research shows that office buildings are excellent investment potential and that this type will outperform retail apartment and warehouse properties over the long term, an investor would choose to specialize in office property.

Inflation Risk:

Unexpected inflation can diminish an investor's rate of return if the income from the investment does not increase enough to make up for the effect of the inflation. Some investments are positively affected by inflation while others are negatively affected; some investments are affected more than others in either direction. Even with inflation risk, however, real estate has traditionally done well during periods of inflation. This might be caused by the fact that many investors use leases that allow the net operating income to adjust with unexpected changes in inflation. In addition, the replacement cost of real estate tends to increase with inflation. However, when vacancy rates are high, demand for space is low and new construction is not realistic, the income from real estate investments does not increase with unexpected inflation.

Tpes of Risk:

What investment characteristics are unique to real estate that would make it riskier than investing in government securities? What risk characteristics make real estate investing different from such things as stocks, corporate bonds and municipal bonds? To answer those questions, let's look at some of the different types of risk, which include the following: Business risk Financial risk Liquidity risk Inflation risk Management risk Interest rate risk Legislative risk Environmental risk

Investment Strategies:

When deciding about investing in certain properties, it is always important that investors carefully make forecasts of future cash flow, taking into account expected market supply and demand and capital market conditions. However there are a number of strategies and investment styles that real estate investors follow. The styles may vary; however, they all have the objective of realizing superior investment performance. These strategies include the following: Investing in Core Properties Investing in Core Properties with a Value-Added Strategy Property Sector Investing Contrarian Investing Market Timing Growth Investing Value Investing Strategy as to Size of Property Strategy as to Tenants Arbitrage Investing Turnaround/Special Situation Opportunistic Investing Investing in Trophy or Blue Chip Properties Developments

Summary/Review::

When deciding about investing in certain properties, it is always important that investors carefully make forecasts of future cash flow. Real estate investors follow a number of strategies and investment styles: Investing in Core Properties Investing in Core Properties with a Value-Added Strategy Property Sector Investing Contrarian Investing Market Timing Growth Investing Value Investing Strategy as to Size of Property Strategy as to Tenants Arbitrage Investing Turnaround/Special Situation Opportunistic Investing Investing in Trophy or Blue Chip Properties Developments Financial leverage is defined as the benefits that may result for an investor who borrows money at a rate of interest lower than the expected rate of return on the total funds invested in the property. Different types of risk carry investment risk characteristics that investors must consider when deciding among alternative investments. Risk types are: Business risk Financial risk Liquidity risk Inflation risk Management risk Interest rate risk Legislative risk Environmental risk

Check Your Understanding-Answers:

- How did risk management develop into a formal discipline? From the insurance industry - What are the three ways of controlling loss? Avoid Loss Limit Loss Reduce Loss - What are the four main reasons that investors invest their equity capital? Return rate Property appreciation Diversification Tax benefits - What is often said about development in the real estate industry? Because the real estate industry is cyclical, the real estate industry is often said to have a tendency toward cycles of overdevelopment.

Check Your Understanding-Answers::

- If investor Jim is skilled at predicting when to buy or sell property based on property types and economic conditions, what investment strategy would he be most likely to use? Market timing - What is arbitrage investing? The investment strategy based on the ability of an investor to recognize the differences in prices that buyers are willing to pay for the same real estate investments that are located in different markets. - Define financial leverage. The benefits that may result for an investor who borrows money at a rate of interest lower than the expected rate of return on the total funds he or she invested in the property. -What kind of risk results from a slow real estate market with few buyers and sellers? Liquidity risk

Check Your Answers:::

- List three risk management procedures. (See screen 23 for other correct answers.) Diversification Property management Shifting risk to insurance companies - Use of a triple-net lease is an example of which risk management procedure? Shifting risk to tenants - List two types of hedging mechanisms. Purchase options Interim financing commitments - What are two alternatives to selling a property that an investor can use if the property is not performing as well as anticipated? Refinancing Renovating

More Alternatives to Disposition:

- The Benefit of Diversification If an investor does decide to refinance a property, he or she will get additional funds. Those funds represent equity capital that the investor can reinvest in a second property. So refinancing makes it possible for the investor to increase the amount of property he or she owns. Plus, the investor may be able to diversify his or her investments even more by owning more than two properties, especially if he or she could purchase different property types in different locations. - Renovation as an Alternative to Disposition Instead of selling one property and buying another, an investor could consider renovation as an option. For example, depending on how the economy is doing in the properties market area and location, the investor may think about improving the property by making it larger or by making major capital improvements to upgrade the property and reduce the operating costs. On the other hand, the investor may consider converting the property to a completely different use, such as converting a small multifamily residence into a small professional office building.

Risk is the chance of experiencing a loss:

- The loss can be either monetary or non-monetary. A loss can be real even if it is only considered a loss by one individual. Knowing how risk creeps up is one of the major elements in managing risk. Risk is always the outcome of a decision or a series of decisions. Since life is comprised of constant, varied and numerous decisions, life is riddled with risk potential. Individuals can often limit the risk by the manner in which they choose to make decisions. Although many decision makers appear to make lightning decisions, most are merely quick to implement strategies that they have carefully thought out in advance of having a situation arise. There are five recognized steps to making a decision. Identify the decision that needs to be made. Identify or evolve all the alternative decisions that could be made. Search for information about all of the possible alternative decisions. Predict the possible consequences of each of the alternative decisions. Make the decision. Individuals may vary in the extent to which they will thoroughly perform each of the five steps, but most people will benefit from performing them when making a decision. Even just knowing that the steps exist might be an advantage to those who are accustomed to using "gut feelings," rather than careful thought, to make decisions. This is not to say that people should ignore their gut feelings. They can be accurate indicators of correct behavior in many situations. However, business risk management is rarely one of the areas in which the gut has sufficient data to make decisions. Risk management in business usually requires giving prior thought to potential problem areas.

Risk Analysis: Once an investor has done a detailed analysis of an income- producing property, he or she must decide whether or not the investment will provide a sufficient or competitive return. The answer to that question will depend on several things:

- The nature of other real estate investments - What other investments may be available to the investor - The particular returns that those other options would yield - Differences in risk between the investments being considered compared to the other available alternative investments

Now let's look at the financial aspect of risk control.

- This primarily deals with having money available in the event something goes wrong. The traditional approach has been to purchase insurance and then allow the underwriter to make restitution. This approach has been losing popularity due to limited policy coverage, delays in payment and limited resources of the insurance institution. A business owner who has to wait for an insurance check may end up out of business altogether. Here's an illustration of the need to have money available when the unexpected happens. A particular property owner has a number of rental units. His customary practice is to use the rental income from the last month of the fiscal year to make a sizeable estimated tax payment to the federal government. This practice has always served him well. However, the unexpected happens. In the last week of the quarter: A flood wipes out four of his six rental units. Families are displaced and damage is catastrophic. The property owner uses his estimated tax payment monies to save his other two properties from total loss. His tax bill still comes due and he has to scramble to make the payment. A good risk management plan will have a contingent source for cash, such as an unsecured line of credit established in advance with a lending institution. A risk management plan can take many forms and be as simple or as complex as the property owner needs. However, it should be formalized in a written document and reviewed on a regular basis. And the plan must be updated as situations change. For example, when an owner sells an existing asset or buys a new property, the risk management plan should change accordingly. Additionally, a plan is of no use to the property owner if it never gets implemented. So a property owner should always be mindful of developing a plan that is a useful, working document.

Other Aspects of Risk:

- Unavoidable Risk After all possible risk control techniques have been put in place, some amount of unavoidable risk still remains. Attitudes towards this remaining risk will be different depending upon the personalities of the investors, their ability to handle financial reverses, and their specific and personal investment objectives. - Rational Risk-Taking Before making any commitment of funds to real estate projects, most rational and well-informed real estate investors will do the following: Specify investment objectives with reference to the return on investment, the timing of the return and acceptable risk levels. Identify the major risks that are involved and calculate them as completely as possible. Eliminate some risks, transfer others through insurance or other techniques and limit the remaining risks to acceptable levels. Make decisions to accept or discard specific investments, based on whether the expected returns justify carrying the remaining risks in light of how the project will contribute to the investor's overall objectives.

The 4 main reasons why people invest:

1) Return Rate - An equity investor believes that enough tenants will want to rent space in the property so as to produce a nice income after collecting rents and paying the operating expenses. This income is part of the investor's return before taking into account the taxes and financing costs. 2) Property Appreciation - An investor usually plans to sell the property after holding it for some period of time. Most investors expect that the price will go up during the holding period and they will be able to sell at a profit. 3) Diversification - Investors also invest in real estate to diversify. Most investors hold a variety of different types of investments such as stocks, bonds, money market funds, and real estate. Diversifying reduces the overall risk of investing. 4) Tax Benefits - Another reason for investing in real estate is that there may be some tax benefits. Because real estate was treated favorably with regard to taxes, some investors paid little or no taxes on their returns from real estate for many years. Although the Tax Reform Act of 1986 eliminated many of the favorable tax benefits, it is still essential for investors to understand changes in the tax laws so that they can interpret the effect on rents and real estate values. Investors make their decisions about purchase prices, financing, and when to sell property, depending on how tax laws change.

Disposition of Income Properties:

An investor purchases a real estate investment based on the benefits he or she expects to receive over an anticipated holding period. That is, at the time the investor purchases the property, he or she computes the property's anticipated investment performance. After the property is purchased, however, many things can change that affect the actual performance of the property. These same factors may affect the investor's decision as to whether the property continues to meet his or her investment objectives. For example, market rents may not be increasing as fast as expected, thereby reducing the investor's cash flow. Tax laws may also have changed. As we have previously mentioned, tax laws are frequently revised, which can affect potential new investors in a property in a different way than it affects existing investors. Therefore, investors should periodically evaluate whether it's time to dispose of or sell the property. Other things might influence an investor to sell after some number of years, even if the projections for property were on target. One important factor is the potential benefits associated with leverage. Let's assume that the mortgage on the property has positive amortization. Under these conditions, the outstanding mortgage balance declines each year while the investor's equity position grows. This buildup of equity may appear attractive in the sense that the investor will get more cash from the property when he or she sells it. However, it also means that more of the investor's funds are tied up in the property every year. Additionally, if the value of the property increases over time, the investor's equity buildup also increases. Equity buildup corresponds to funds that the investor could put in another investment if he or she decided to sell the current property. This is referred to as the opportunity cost of not selling the property. We can view the profits that the investor could have received from selling the property as the amount of equity investment the investor is making to keep the property for a longer timeframe. In this situation, a larger amount of the equity capital stays invested in the property with respect to the cash flow the investor is receiving from continuing to keep the property operating. This is true unless the investor refinances the property. Additionally, while the total mortgage payment stays the same, the interest part of the payment reduces each year, resulting in lower tax deductions. So the investor is also losing the benefits of financial leverage every year.

Interest Rate Risk:

Changes in interest rates will affect the price of all investments. Depending on the relative maturity; however, some investment prices will respond more than others, which increases the loss or gain potential. This is known as interest-rate risk. Real estate tends to be highly leveraged. Because of this, changes in interest rates can affect the rate of return equity investors earn. Even if an investor has a fixed-rate mortgage or no mortgage, an interest rate increase could lower the price that future buyers would be willing to pay.

Environmental Risk:

Changes in the environment or the sudden knowledge that an existing situation could pose health hazards can have an effect on the value of real estate. For example, for many years asbestos was used to insulate buildings. However, the public now perceives the presence of asbestos as a possible health hazard. A property could also be found to be contaminated by toxic waste that was either spilled or buried on the site or on a nearby site. In addition, environmental risk can be much more costly than any of the other risks we've talked about. An investor can be required to clean up the site, thus incurring costs that are far greater than the value of the property.

Financial Risk:

Debt financing tends to increase business risk. As the amount of debt on a real estate investment increases, the financial risk increases. The level of financial risk also depends on the cost of the debt and how it's structured. For example if a loan is structured so that the lender has some participation in the property's potential appreciation in exchange for lower monthly payments, it may have a reduced amount of financial risk.