Risk Unit 8 PDF

Unit 8 Risk Property related numerics The property market is increasingly dominated by institutional investors who require periodic performance measures of their investment portfolios. Property performance needs to be measured and monitored so as to ensure an o...

Unit 8 Risk Property related numerics The property market is increasingly dominated by institutional investors who require periodic performance measures of their investment portfolios. Property performance needs to be measured and monitored so as to ensure an organisation′s business and property strategies/goals/objectives are being achieved. Like any investment, we need to be able to measure performance not only in order to ascertain whether, or not, it is meeting expectations, but also to be able to compare it against other property investments and other investment categories, e.g. calculating the performance of a group of properties relative to a benchmark for a particular market, sector or region, or comparing the performance of a property investment against an equity investment. - Cap rate (capitalisation rate) Definition: The cap rate is a rate that helps in evaluating a property investment. It is the rate of return on a property investment based on the income that the property is expected to generate. Cap rate = Net operating income / Current market value of the asset. Description: The cap rate shows the potential rate of return on the investment (this is not to be confused with gross/net yield). Before a purchase, an investor can use the cap rate to assess a property's value, thus helping them to make an investment decision (the higher the cap rate, the better it is for the investor). Net operating income is found by deducting the operating expenses from the gross operating income. The operating expenses can be property taxes, maintenance costs, etc. Operating expenses however do not include depreciation. A reasonable range is between 5% and 10%. Example: If a property is currently valued at R1,000,000 and has an NOI of R100,000, then: Cap rate = R100,000 / R1,000,000 = 10%. - Profitability index Definition: The profitability index is the ratio of payoff to investment of a proposed property investment. Profitability index = (NPV + initial investment) / initial investment Description: The profitability index is a useful tool for ranking property investments because it allows you to quantify the amount of value created per unit of investment. A ratio of 1 is the lowest acceptable measure on the index. As values on the profitability index increase, so does the financial attractiveness of the proposed project. Example: If a company invested R20,000 in a property and expected a NPV of that property investment of R5,000, then: Profitability index = (20,000 + 5,000) / 20,000 = 1.25 That means the company should invest in the property because the profitability index is greater than 1. - IRR (recall from Unit 4 - Decision-Making Approaches/Capital Budgeting) Definition: Internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. Description: Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. At this point, the NPV of a project's cash flows are equal to the NPV of a project's costs. Internal rate of return is used to evaluate the attractiveness of a project or investment. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. The higher the IRR on a project and the greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the investor. (A company may also prefer a larger project with a lower IRR to a much smaller project with a higher IRR because of  the higher cash flows generated by the larger project.) Negative IRR indicates that the sum of post-investment cash flows is less than the initial investment. Risk Risk implies future uncertainty about deviation from expected earnings or an expected outcome. Risk measures the uncertainty that an investor is willing to take to realise a gain from an investment. Risks are of different types and originate from different situations. Risk is the chance that an investment's actual return will be different from expected. Risk includes the possibility of losing some or all of the original investment. Starting a business always involves some risk-taking, as does purchasing property. Risks are of different types and originate from different situations and include: - Credit risk - Market risk - Operational risk - Liquidity risk - Business risk - Reputational risk - Systemic risk - Moral hazard There are ways of minimising or even negating some of or all risk, e.g. diversification, derivatives, and systems that highlight unusual activity. - Measures of central tendency Definition: Mean the average of the data Median the middle value of the ordered data Mode the value that occurs most often in the data Description: Mean, median and mode are usually not equal. When the data is symmetric, they are all equal. For the data set: 1, 1, 2, 3, 13 mean = 4, median = 2, mode = 1 Steps to finding the median for a set of data: - Arrange the data in increasing order - Find the location of median in the ordered data by (n + 1) / 2 - If the sample size is an odd number then the location point will produce a median that is an observed value as in the example above. If sample size is an even number, then the location will require one to take the mean of two numbers to calculate the median. The result may or may not be an observed value as the example below illustrates. For the data set: 69, 76, 76, 78, 80, 82, 86, 88, 91, 95 Mean = (69+76+76+78+80+82+86+88+91+95)/10 = 82.1, With n = 10, the median position is found by (10 + 1) / 2 = 5.5. Thus, the median is the average of the fifth (80) and sixth (82) ordered value and the median = 81, Mode = 76 - Normal distribution Definition: A normal distribution is a function that represents the distribution of many random variables as a symmetrical bell-shaped graph. Description: A normal distribution is an arrangement of a data set in which most values cluster in the middle of the range and the rest taper off symmetrically toward either extreme. It is represented by a bell-shaped symmetrical frequency distribution curve. It is characteristic of many economic, natural, social and other real-world phenomenon (such as IQ scores, height variation within a population, weights of crop yields, variation in quality of manufactured goods) where two or more variables have direct relationship and high predictability (low variation). In normal distribution, extremely large values and extremely small values are rare and occur near the tail ends. Most frequent values are clustered around the mean and fall off smoothly on either side of it. Example: Height is one simple example of something that follows a normal distribution pattern. Most people are of average height and a very small (and still roughly equivalent) number of people are either extremely tall or extremely short. - Standard deviation Definition: Standard deviation is a quantity expressing by how much the members of a group differ from the mean value for the group, or a measure that is used to quantify the amount of variation or dispersion of a set of data values. Description: Standard Deviation is a measure of how spread out numbers are. Its symbol is σ (the Greek letter sigma).The formula is the square root of the Variance. The standard deviation is a statistic that measures the dispersion of a data set relative to its mean and is calculated as the square root of the variance. If the data points are further from the mean, there is higher deviation within the data set. Specifically, it shows you how much your data is spread out around the mean or average. For example, are all your scores close to the average? Or are lots of scores way above (or way below) the average score? Standard deviation can be considered as a measure of risk. The standard deviation is often used by investors to measure the risk of a stock or a stock portfolio or a property portfolio. The basic idea is that the standard deviation is a measure of volatility: the more a stock's returns vary from the stock's average return, the more volatile the stock/property. For behaviours that fit this type of bell curve (like performance in a test), you’ll be able to predict that 34.1 + 34.1 = 68.2% of students will score very close to the average score, or one standard deviation away from the mean. When the bell curve is flattened (your data is spread out), you have a large standard deviation — your data is further away from the mean. When the bell curve is very steep, your data has a small standard deviation — your data is tightly clustered around the mean. - Coefficient of variance Definition: The coefficient of variation (CV) is a measure of relative variability. It is the ratio of the standard deviation to the mean (average) or expected value. Coefficient of variation (CV) = (standard deviation) / (expected value) Description: The coefficient of variation is a useful statistic for comparing the degree of variation from one data series to another, even if the means are drastically different from one another. In the investing world, the coefficient of variation allows you to determine how much volatility, or risk, you are assuming in comparison to the amount of return you can expect from your investment. In simple language, the lower the ratio of standard deviation to mean return, the better your risk-return trade-off. Distributions with a coefficient of variation to be less than 1 are considered to be low- variance, whereas those with a CV higher than 1 are considered to be high variance. Example: With a mean of 62.51 and a standard deviation of 1.92, calculate the coefficient of variance. CV = standard deviation / mean = 1.92 / 62.51 = 0.03071 The standard deviation and the mean of 16 values are 15.6 and 20.5. Find the coefficient of variation. CV = 15.6 / 20.5 = 0.76098