1. §Simple Risk Analysis Techniques in Real Estate : Break Even Point Risk Absorption Capacity Sensitivity Analysis and Simulation For major reference : read Lusht, K.1997, Real Estate Valuation, Ch. 24

2. §Break Even Point : l The point at which there is exactly enough net operating case to cover operating expenses and debt, but nothing for equity return. l Hence, if income fall below break even point, investor must inject additional equity or fold the company ! l Break even point can be expressed as break even occupancy level or break even rent level.

3. §This reflects the number of property units which must be occupied in order to produce enough income to cover operating expenses and debt. §Break Even Occupancy (BEO) is : §(Fixed Operating Expenses + Debt Service) divided by (Annual Unit Rent – Variable Expenses per Unit) Break Even Occupancy Level

4. §Asking Price : US$800,000 §50-unit project with average monthly rent US$300 per unit §Operating expenses : Fixed : 30,400, variable 38,000 §Depreciation expenses : 36,000 §Debt : Loan : 600,000 at 12.5%, or 75,000 annual debt service §Tax rate : 35% »1 2 3 4 5 §Estimated §Income180000185000 191000 198000 206000 §Vacancy (5%)90009250 9550 9900 10300 §Effective §Income : 171000 175750 181450 188100 195700 §Expenses : § fixed 30400 § variable 38000 §Net Operating §Income (NOI) : 102600

5. §Hence : §BEO = (30400 + 75000) / (3600 –800) § = 37.64 units, or 37.64/50 = 75.3% l Where 800 is the figure for 95% occupied estimation of the project. Thus, 0.95 x 50 units = 47.5 units.—> $38000/47.5 = 800 §It shows that the project needs a 75.3% occupancy to be viable : §Rent135,504 (37.64 x $300 x 12) §Expenses : l Fixed 30400 l Variable 30112 (37.64 units x 800) §NOI74992 §Debt service75000 l Net : approx. 0

6. §Break Even Rent Level (BER) = §[Fixed Expenses + Debt Service + (units occupied x Variable expense per unit) ] divided by units occupied §Assuming a 90% occupancy : §BER = 30400+75000+(45 x 800) / 45 = 3142.22 per year or 261.85 per month. Hence : §Rent141,399 (45 x $261.85 x 12) §Expenses : l Fixed 30400 l Variable 30000 (45 units x 800) §NOI74992 §Debt service75000 l Net : approx. 0

7. Risk Absorption Capacity (RAC) §Measures the extent an average decline in annual cash flow can be absorbed before the investor’s yield falls to a minimum level. §RAC = expected NPV / YP factor at the same discount rate §Example : §0 1 2 3 45 §-200000 30540 32393 34616 37209 40172 +315,000 § (re-sale value) §With a 20% discount rate, NPV is 28,658, implying an IRR of 24.1%

8. §Hence, RAC is : §28658/2.9906 = 9583 Where 2.9906 is derived from : {1-(1/(1+20%) ^5 )} /20% §This implies that the minimum level after tax cash flow can fall is 9583 lower than expected level each year, with a constant 20% investment return. To prove, we deduct this amount from annual cash flow : §0 1 2 3 45 §-200000 20957 22810 25033 27626 30590 +315,000 § (re-sale value) §This makes the IRR to be 20%

9. §When comparing investment opportunities, it does not always follow that the higher the RAC, the less risky the project is, as it ignores the size of the projects, and hence capital equity involved. §One therefore needs a relative comparison by the risk absorption ratio (RAR) = [RAC/(1-tax rate)] /NOI. §RAR shows the annual allowable decline in income. eg. : with a tax rate of 35%, the RAR is : 9583/(1-35%)=14743/102600 = 14.4%

10. §Suppose Project B has a RAC of $18,500. §It would seem to be a more attractive project. §If the expected NOI of Project B is 190000, this makes the RAR only 18500/190000 = 9.7%. §This means the first project can absorb a greater extent of erosion of income without affecting the expected minimum rate of return, than the second one.