Magazine article Real Estate Issues

The Quantification of Corporate Real Estate Risk

Magazine article Real Estate Issues

The Quantification of Corporate Real Estate Risk

Article excerpt

THE ANALYSIS OF THE DECISION-MAKING FRAMEWORK for the efficient usage of corporate real estate assets is a growing aspect of the analysis of real estate assets in general. For example, the major academic literature has devoted significant space to corporate real estate issues. (1) One of the more recent developments in corporate decision making is the consideration of real property risk (Huffman, 2002). The rather recent, and to some extent belated, attention to real estate risk analysis is not surprising since the consideration of corporate risk analysis in general is one of the more recent developments in corporate finance and corporate strategic management. This paper offers some insight to consultants and analysts by attempting to quantify the risk inherent in property usage and summarize these measurements into a score or index that can be used to represent the real estate risk exposure of an individual firm. To that end, this paper first considers the analysis and measurement of corporate risk. We then extend the discussion down to the property level. We develop the concept of a risk score and offer a basic example of how such an index could be constructed. We begin with a discussion of the risk concept.

RISK DEFINITION

Risk in general can be defined and measured in several ways. An early definition of risk was that risk is associated with the probability of an event (Baird and Thomas, 1985). Given that corporate decision makers rarely know every possible outcome, the precise determination of probabilities (and thus overall probability distributions) is difficult. Today, risk, especially in corporate finance, is most often measured in terms of the variance (or its square root, the standard deviation) of expected returns. Unlike the determination of probabilities, which is to some degree subjective, the variance of returns can be estimated so long as sufficient data on past returns are available. (2) The variance in returns, in effect, sets the boundaries of uncertainty or the "riskiness" of a particular venture.

One difficulty in the use of variance of returns lies in the need for sufficient return data from which to calculate variability. Investment real estate suffers from this shortcoming. Each piece of real estate is, to some extent, unique. Although rental income can be estimated, the lack of sales prices makes determining capital values cumbersome. Corporate real estate assets would also suffer from the lack of information on returns.

A more fundamental problem for the corporation exists in the need to be able to translate specific risk exposures, such as from the use of debt or the impact of poor human resource decisions, into a suitable estimate of the impact on returns. That is, a major weakness of the use of returns and return variability as a measure of risk is that generally the underlying causes of that variability and their specific impacts on variability are often unknown.

CORPORATE RISK MANAGEMENT

The relevant aspects of corporate risk management really began in the 1980s with the development of models of corporate risk taking. Baird and Thomas (1985) was one of the first attempts at development of a model that would encompass the various components of corporate risk exposure and the development of corresponding corporate risk policies. Much of the early discussion centered on the true relationship between corporate risk and corporate returns. The discussion was crucial since one early study, Bowman (1980), found that, contrary to general accepted theory, risk and return were negatively related. Subsequent studies amplified and extended the relationship between risk and return such that it became clear that while there might be some circumstances where firms might accept higher risk for lower returns, the expected positive relationship generally held true. (3) Current corporate risk assessment models entail an analysis of specific risk exposure and a consideration of their impact on returns as discussed next. …

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