Chapter 1 | Introduction: Risks and Opportunities

Audiobook Recording

Be sure to check out the visual animations at 23:50 through 29:00.

Overview

This chapter discusses topics which a real estate investor must consider when analyzing an investment. While building a financial pro forma is a necessary step, many of the underlying assumptions built into it will be wrong. Many factors beyond financial modeling, such as personal risk tolerance, competitive landscape, the capital market environment, among others play into the decision-making process.

Summary

Operating costs can easily be incorrectly forecasted. An increase in expenses will reduce net operating income. Unexpected changes in vacancy can have a large effect on the accuracy of a financial model as well. In a weak or over-supplied market, buildings may have occupancy well below expectations for long periods of time. Liquidity is another underlying risk as it takes a long time to sell a property, and sometimes an investor needs cash quickly. However, real estate also offers unexpected opportunities for investors. Just as operating costs can increase, they can also fall, rents can rise, and property values can appreciate. This chapter lays out some of the risks and opportunities an investor must consider when underwriting an asset.

Conducting market research can help to clarify the supply and demand balance within the market and is the backbone for assumptions made in the pro forma. In this chapter, the importance of conducting such research is reviewed, and examples of sources for information, and what to look for when researching a market are provided.

Finally, this chapter reviews how personal decisions play a role in choosing investments. Investment decisions ultimately depend on who the investor is, how risk-averse they are, and what expertise they bring to the table.

Excel Figures

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Key Term

Discounted Cash Flow (DCF) – analysis framework that postulates that the value of a property is equal to its expected future cash flows discounted to present dollars; premised upon two basic concepts: 1) the only source of value for a property is its ability to generate future cash flows, 2) a dollar received today is more valuable than a dollar received tomorrow.

Chapter Headings

  • Risks and Opportunities – That’s What It’s All About
  • The Risks
  • Operating Expenses
  • Vacancy
  • Natural Disaster
  • Leasing
  • Liquidity
  • The Opportunities
  • Operating Expenses
  • Terminal Value
  • Rental Growth
  • Where You Should Focus Your Analysis
  • Market Research
  • Personal Decision
  • Risk Parameterization

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