© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 1 CHAPTER THIRTEEN RISK ANALYSIS

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 2 Types of Risk Business- uncertainty of renting space Financial- effect of leverage on return Liquidity- ability to sell quickly without loss Inflation- effect of unexpected inflation on return Interest Rate- effect of change in interest rates on return

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 3 Types of Risk Continued Management- effect of management on returns Legislative- effect of national, state, and local laws and regulations on returns Environmental- effect of environmental hazards on return Other? (physical, weather, plagues, terrorism)

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 4 Risk Preferences Risk- averse behavior Risk- neutral behavior Risk- loving behavior

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 5 Measuring Project- Specific Risk State of the Economy ProbabilityReturn Deep Recession % 5.5% 7.0% 8.5% Mild Recession0.20 Average Economy 0.50 Mild Boom0.20 Strong Boom % Expected Return7.0%

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 6 Risk Management Three primary tools may be employed by investors to minimize their expose to risk: –Avoid risky projects –Use insurance and hedging –diversification

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 7 Portfolio Risk Diversifiable Risk: (unsystematic risk) can be eliminated by holding assets that are less than perfectly correlated. Nondiversifiable Risk: (systematic, or market risk) is the risk remaining in a fully- diversified portfolio.

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 8 Optimal Portfolio Decisions Investors base their investment decisions on its contribution to the portfolio’s risk and return. Efficient investments increase the portfolio’s expected return without adding risk. Efficient investments decrease the portfolio’s risk for a given expected return.

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 9 Accounting for Risk The investor’s required rate of return is (E(R j )) E(R j )= R f + RP j –Where R f is the risk free rate and RP j is a premium for bearing risk.

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 10 Accounting for Risk Asset pricing model to estimate risk Sensitivity analysis

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 11 Quantifying Risk Sensitivity analysis- what if… –Market rents lower –Vacancy rates higher, etc, –How sensitive is return to change in an assumption Scenarios –Pessimistic, most likely, optimistic –E.g., rents lower and vacancy higher for pessimistic scenario –Calculate return or other measure for each scenario