SEL versus SUL: managing seismic risk in commercial real estate investments

Abstract In stark contrast with liquid asset returns, commercial real estate idiosyncratic return means and variances do not scale with the holding period, even after accounting for all cash flow-relevant events. This puzzling phenomenon survives controlling for vintage effects, systematic risk heterogeneity, and a host of other explanations. To explain the findings, I derive an equilibrium search-based asset-pricing model that, when calibrated, provides an excellent fit to transactions data. A structural model of transaction risk seems crucial to understanding real estate price dynamics. These insights extend to other highly illiquid asset classes, such as private equity and residential real estate.

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Effect of Seismic Risk on Lifetime Property Value

Earthquake Spectra ◽

10.1193/1.1810536 ◽

2004 ◽

Vol 20 (4) ◽

pp. 1211-1237 ◽

Cited By ~ 23

Author(s):

Keith A. Porter ◽

James L. Beck ◽

Rustem V. Shaikhutdinov ◽

Siu Kui Au ◽

Kaoru Mizukoshi ◽

...

Keyword(s):

Real Estate ◽

Earthquake Engineering ◽

Seismic Risk ◽

Investment Decision ◽

The United States ◽

Market Risk ◽

Risk Tolerance ◽

Commercial Real Estate ◽

Repair Costs ◽

The Mean

We examine seismic risk from the commercial real estate investor's viewpoint. We present a methodology to estimate the uncertain net asset value ( NAV) of an investment opportunity considering market risk and seismic risk. For seismic risk, we employ a performance-based earthquake engineering methodology called assembly-based vulnerability (ABV). For market risk, we use evidence of volatility of return on investment in the United States. We find that uncertainty in NAV can be significant compared with investors’ risk tolerance, making it appropriate to adopt a decision-analysis approach to the investment decision, in which one optimizes certainty equivalent, CE, as opposed to NAV. Uncertainty in market value appears greatly to exceed uncertainty in earthquake repair costs. Consequently, CE is sensitive to the mean value of earthquake repair costs but not to its variance. Thus, to a real estate investor, seismic risk matters only in the mean, at least for the demonstration buildings examined here.

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Wildcat Capital Investors: Real Estate Private Equity

Kellogg School of Management Cases ◽

10.1108/case.kellogg.2016.000413 ◽

2017 ◽

pp. 1-12

Author(s):

Craig Furfine

Keyword(s):

Real Estate ◽

Cash Flow ◽

Private Equity ◽

Financial Models ◽

Cash Flows ◽

Commercial Real Estate ◽

Office Building ◽

Equity Structure ◽

Financial Model ◽

Real Estate Investments

Wildcat Capital Investors is a small real estate private equity company. Its MBA intern, Jessica Zaski, is asked to develop a financial model for the purchase of Financial Commons, a 90,000 square foot office building in suburban Chicago. By simple metrics, the property seems to be a good value, but with credit conditions tight, Jessica must consider whether outside investors would be comfortable with the risks of investing in the midst of a severe commercial real estate downturn. Wildcat is designed to give students exposure to both the quantitative and qualitative aspects of investing in commercial real estate through a private equity structure. Beyond the numbers, the case allows for a discussion of the process of finding suitable real estate investments. The importance of the simultaneous negotiations that Wildcat must have with the seller, the lender, and the outside investor can be emphasized.By working through the financial models, students will take a given set of assumptions and analyze the cash flows expected to be received by the equity partners of Financial Commons. With a given deal structure, the students can then model the cash flow to both outside equity investors and Wildcat, learning the mechanics of private equity. The model will allow students to investigate how the variations in the underlying assumptions affect returns to the property and to the investors.

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