House under the Management of Wemabod Estates Limited, Nigeria. BY. LOOKMAN ...... relationship, possibly in the realm of real estate asset management.
Comparative Portfolio Risks of Investment House and Western House under the Management of Wemabod Estates Limited, Nigeria
BY LOOKMAN OSHODI
BEING A SEMINAR PAPER PRESENTED TO THE DEPARTMENT OF ESTATE MANAGEMENT OF THE SCHOOL OF POSTGRADUATE STUDIES, UNIVERSITY OF LAGOS, AKOKA, LAGOS, NIGERIA
IN FULFILLMENT OF THE REQUIREMENTS FOR THE
ESM 808B: SEMINAR IN PORTFOLIO MANAGEMENT
OCTOBER 2009
1
Abstract__________________________________________________________ Because of the abundant available information with which the market can price risk and return metrics, rental and capital values offer a unique and convenient way to study the pricing of the risks associated with portfolios of real property. Using rental and capital data, expected returns were estimated for the two selected office type properties under the ownership of Wemabod Estates Limited. The results reveal the degree to which real property portfolio risk factors, such as the portfolio weight, portfolio obsolescence, functional facilities and management structure affect various measures of portfolio risk. Overall, the seminar attempts the analysis of how variance, standard deviation, expected returns and portfolio risks are influential in explaining performance of real estate asset within the same locality and under the same ownership.
2
Table of Contents__________________________________________________ Content
Page
Abstract
2
Table of Contents
3
CHAPTER 1 INTRODUCTION
4
1.1
Introduction
4
1.2
Aim and Objectives of Study
5
1.3
Brief Overview of Wemabod Estates Limited
5
1.4
Paper Framework
6
CHAPTER 2 LITERATURE REVIEW
7
2.1
Preamble
7
2.2
Risk Measurement
7
2.3
Risk Management
8
2.4
Real Estate Risks
9
2.5
Identification of Real Estate Risks
10
2.6
Real Estate Risks and Returns in International Real Estate Investments
12
CHAPTER 3 DATA ANALYSIS
17
3.1
Preamble
17
3.2
Data and Investment Analysis on Investment House and Western House
17
3.2.1
Expected Returns [E(R)]
21
3.2.2
Portfolio Weight
21
3.3
Portfolios Variance, Standard Deviation and Risks
22
3.3.1
Variance and Standard Deviation
22
3.3.2
Combined Portfolio Risks [E(Rp)]for Investment House and Western House
23
CHAPTER 4 SUMMARY OF FINDINGS, RECOMMENDATIONS AND CONCLUSION
25
4.1
Preamble
25
4.2
Summary of Findings and Results Interpretation
25
4.2.1
Summary of Results
25
4.2.2
Interpretation of Results
25
4.3
Recommendations
26
4.4
Conclusion
27
References
28 3
CHAPTER ONE
1.1
INTRODUCTION
In 1952, Harry Markowitz introduced the concept of modern portfolio theory into the financial investment domain [De Reyck et al., 2005]. This theory permitted the determination of an investment selection that generates the highest return for a given level of risk; in other words, the maximization of investment returns. This concept was later applied to the project management domain and real estate investment, which became the basis of property portfolio management [Project Management Institute [PMI], 2006a, p. 5].
In line with Markowitz's approach, a property portfolio is a collection of properties that maximizes the portfolio value in terms of strategic goals for a given level of risk. Value can be, for instance, the scientific contribution or the creativity development delivered by the property portfolio [Beaujon, Marin, & McDonald, 2001; Weisbin, Rodriguez, Elfes, & Smith, 2004].
One of the major concepts of portfolio investments is the relationship between the risk and the return of a financial asset. It is common knowledge that there is a positive relationship between the risk and the expected return of a financial asset. In other words, when the risk of an asset increases, so does its expected return. What this means is that if an investor is taking on more risk, he is expected to be compensated for doing so with a higher return. Similarly, if the investor wants to boost the expected return of the investment, he needs to be prepared to take on more risk. It is possible for an investor to reduce the risk level of a portfolio by including more and more assets in the portfolio. That is, the investor is able to reduce the risk of the portfolio through diversification. Then the correlation of the assets in the portfolio requires to be properly understood as the factor that drives the effectiveness of the diversification of a particular portfolio [Wan, 2004]. 4
It is on the background of relationship between risks and returns in real estate portfolio that this seminar intends to open a discussion about the integration of a risk management approach to property portfolio management by comparing risks between two investment properties under the same ownership. Also, the paper tends to enrich the academic sphere where there is relatively sparse of literature on real estate portfolio risk management, despite the importance of a property portfolio on corporate objectives. Hence, Investment House and Western House, both in Lagos Island under the ownership of Wemabod Estates Limited will be studied for risks comparison and returns analysis. 1.2 AIM AND OBJECTIVES OF STUDY. The aim of the paper is to compare the risks of existing investment properties within the portfolio of Wemabod Estates Limited, Nigeria. The following objectives outlined will be adopted in realizing the aim of the paper. 1.
To understand the theoretical relationship between risk and returns of real estate investments
2.
To study the rental income on the properties over five year period
3.
To calculate the capital value of the properties through the application of discounted cash flow analysis
4.
To determine the rate of returns on each property over the five year period
5.
To make recommendations towards enhancing the rate of return on the properties
1.3 BRIEF OVERVIEW OF WEMABOD ESTATES LIMITED Prior to the independence of Nigeria in 1960, there is dearth of large scale institutional investors in real estate assets. Against this background, the 5
government of Western Nigeria under the auspices of Odu’a Investment Group in 1962 established Wemabod Estates Limited to undertake large-scale real estate development and property management across the Western Region and Lagos city [Wemabod Estates Limited, 2009].
Since establishment in 1962, Wemabod Estates Limited has embarked on various real estate developments spanning residential, commercial and industrial investments within the Western region of Nigeria. Few among these assets are Awolowo House, Ikeja, Great Nigeria House, Lagos, Western House, Lagos, Investment House, Lagos, Banuso House, Lagos, Parklane Properties, Apapa, Wemabod Residential and Industrial Estates, Ikeja. Others are Cocoa House, Ibadan, Oluyole Complex, Ibadan, Great Nigeria Insurance Houses and Akure Shopping Complex in Akure, Ondo State and Great Nigeria Insurance House, Abeokuta, Ogun State [Wemabod Estates Limited, 2009].
However, to provide a competitive risk and returns analysis of Wemabod portfolio, Investment House and Western House both located on Broad Street, Lagos and comprising multi - storey office structure were selected for study.
1.4
PAPER FRAMEWORK
This seminar paper is organized sequentially with first chapter consisting of the introduction, aim and objectives of study and brief overview of Wemabod Estates Limited. The second chapter provides a brief literature review on risk measurement and risk / returns relationship in real estate portfolio. The third chapter analyzed the risk and returns on each property based on the data obtained from Wemabod Estates Limited while the last chapter interprets the results, draw recommendations and concludes the presentation.
6
CHAPTER TWO
LITERATURE REVIEW 2.1 PREAMBLE In this section of the paper, measuring risk tools, management of risks, risks associated with real estate investments and risk / returns analysis of investment across some parts of the world were discussed.
2.2 RISK MEASUREMENT 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 decision makers rarely know every possible outcome, the precise determination of probabilities is difficult. Today, risk, especially in corporate finance, is often measured in terms of the variance [or its square root and 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. The variance, 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 data from which to calculate variability. Real estate investment suffers from this shortcoming. Although, rental income can be estimated, the lack of sales prices makes determining capital values cumbersome. Consequently, 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 7
of risk is that generally the underlying causes of that variability and their specific impacts on variability are often unknown.
2.3 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] were one of the first attempts at development of a model that would encompass the various components of risk exposure and the development of corresponding corporate risk policies. Much of the early discussion centered on the true relationship between risk and returns. One of the major concepts that most investors should be aware of is the relationship between the risk and the return of a financial asset as it is a common knowledge that there is a positive relationship between the risk and the expected return of a financial asset. In other words, when the risk of an asset increases, so does its expected return. What this means is that if an investor is taking on more risk, he is expected to be compensated for doing so with a higher return. Similarly, if the investor wants to boost the expected return of the investment, he needs to be prepared to take on more risk [Archer & Ghasemzadeh, 1999; Caron et al., 2007; PMI, 2006a].
The understanding of the concept was crucial since one early study, Bowman [1980], found that, contrary to general accepted theory, risk and return were negatively related while Shilling [2003] argued that the relationship between risk and return in real estate is unstable and often counterintuitive. 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. Therefore, current risks assessment models entail an analysis of specific risk exposure and a consideration of their impact on returns. 8
Risk management is rapidly being integrated into the corporate culture. Barton et al [2002] propose an “enterprise – wide” risk management strategy that manages all risks together. They specify a 3-stage model for risk assessment that consists of risk identification, ranking and measurement. Other techniques are the plotting of functions to assess the effect of corporate risk exposure on revenues, earnings and shareholder values, and the development of scenarios to identify key risks and their impacts.
A major shortcoming in the assessment of specific risks is that there is little detailed reporting of specific risk exposure for any organization. Annual reports of United States companies are required to enumerate various risk possibilities. Along other filings with regulators, these reports give some idea of the financial health of the firm and its vulnerabilities. But recent events such as the collapse of Enron, World – Com and others illustrate that current GAAP financial disclosure requirements are far from perfect.
One of the difficulties in the reporting of risks is often that the corporation is unaware of its vulnerabilities. As Thompton [2002] notes, firms report very little on how they assess, monitor and mitigate specific corporate risks and the firm may have little understanding of its risk exposure or be unable to predict what may happen. 2.4 REAL ESTATE RISKS Executives face a number of risks in managing real estate assets portfolio. Most importantly are varied risks associated with property development. The risks incurred in development activities run the gamut from financing risk to physical risks to regulatory risks [Huffman, 2002].
9
Bajai [2001] examines the risks associated with construction and bidding specifically. A number of factors enter into the decision to bid. Most relevant to decision makers in estimating the construction costs of corporate facilities would be such variables as the size of the project, duration and the state of the market.
Real estate development also entails significant interest rate risk associated with construction loans, the effect of interest rates on the demand for rental space, and the effect of interest rates changes at any future sale or refinancing. Cameron, et al [1990] illustrates various methods of offsetting interest rate risk including the use of interest rate caps, collars and swaps. However, given the multitude of activities comprising real estate development, no single risk management strategy can suffice.
Risks that can be incurred outside the development sphere include the financial risks incurred in leasing, purchasing and the potential of reversion of the asset, and various physical risks such as design weakness, site and location risks. Corporate real estate will also be burdened by the risks associated with the regulation of such assets by a host of local, state and national agencies [Huffman, 2002].
One of the more difficult aspects of risk is assigning accurate values to corporate real property. According to Brueggeman, et al [1990], one of the management’s greatest challenges is to capture “hidden value”. The underestimation of corporate property assets artificially depresses share values and can provide the incentive for hostile takeover.
2.5 IDENTIFICATION OF REAL ESTATE RISKS Despite the difficulty of quantifying corporate risks and more particularly, real property asset risks, any attempt in risk assessment must eventually arrive at an 10
overall determination of the real estate risk exposure of the firm. Such a risk index would require an identification of specific real property risks affecting the firm and attempt to measure or rank these risks. An overall risk index could then be developed based on the identification and assessment stages.
Following the developments in general risk assessment, the first step in creating a real estate risk index would be to identify the appropriate factors inherent in the control and use of property. The next step is to attempt to measure or rank these risks. Using a standard index or scoring methodology, an index could then be constructed.
Huffman [2002] identified specific risks to include, at a minimum, development risks, financial risks, physical risks and regulatory risks. To recognize the risks associated with potential hidden values, a risk factor to account for other risks such as under – valued /over – valued real estate assets could be included. These risk measurement could then be compared, or added to other risks and risk measurements to integrate real property risks with the overall corporate risk profile.
Development risk is perhaps the single most important real estate risk exposure to the firm since it encompasses many other related risks and thus significantly increases the risk exposure of the firm. This exposure would require a significant risk premium or ranking.
Financial risks would be a function, to some extent, of the firm’s preference for owning over leasing. Ownership would require the consideration of potential mortgage default risk, property management risk, and reversion risk. Leasing on the other hand, would require the measurement of risk exposure associated with 11
lease terms, particularly their length, risks associated with increased expenses under a net lease and the amount of space leased.
A measurement of physical risks would require a determination of the amount of functional obsolescence in various buildings and improvements, as well as an assessment of site and location strengths. Regulatory risks involve the consideration of environmental and other land regulations and restrictions.
2.6 REAL ESTATE RISKS AND RETURNS IN INTERNATIONAL REAL ESTATE INVESTMENTS Real estate investment is a key component of global capital flows and international business. As markets around the world become more sophisticated, investors are looking to diversify their portfolios on a global scale [Hoesli and MacGregor, 2000; and Lim, Adair and McGreal, 2002a].
The principal reasons in favor of international diversification emphasize the potential to reduce the risk of the portfolio through foreign investments and/ or the achievement of higher yields [Worzala, 1994]. Other factors promoting international investment include the lack of opportunities in the local market, illiquidity and liability matching [Investment Property Forum, 1993]. In relation to the corporate sector, international investments may be for operational or strategic reasons. Short-term traders may be seeking higher returns than are available in their domestic markets, either due to local market conditions or currency factors. Longer-term investors may seek portfolio diversification and higher risk-adjusted returns. Wealthy individuals may be seeking politically or economically more stable environments for their capital [Lim, Adair and McGreal, 2002b]. Furthermore, deregulation and liberalization of global markets, with erosion of currency controls and regulations that limit foreign ownership of 12
assets, have led to the rapid expansion of international real estate investment during the 1990s [Ball, Lizieri and MacGregor, 1998].
An examination of the returns and risks of global real estate investment is provided by Hoesli, MacGregor, Adair and McGreal [2002], who report on a range of international studies. The theoretical framework for analyzing return and risk is well established in the literature, normally focusing on the role of real estate in mixed-asset portfolios and selected via modern portfolio theory [Hoesli and MacGregor, 2000]. More specifically, the return and risk for each asset class and the correlation coefficients between the returns on each pair of assets are analyzed. However, the literature does highlight some operational differences across countries. For example, in the United Kingdom [UK], the term commercial property includes retail stores, offices and industrial real estate, whereas in the United States [US] it also includes residential properties [apartment buildings and hotels] held for investment purposes.
For the U.K., MacGregor and Nanthakumaran [1992] showed that commercial property up to that time exhibited attractive return and risk characteristics, when valuation-based series are used. From a mean-variance criterion perspective, their results demonstrated that real estate dominated bonds in the U.K., a result comparable to that reported earlier by Ibbotson and Siegel [1984].
Studies have also been undertaken for several other countries, such as Australia, Canada, New Zealand and South Africa. Newell and Webb [1996] highlight semi-annual return and risk figures for Australia and Canada for the period 1985 through 1993. In a further study, Newell and Webb [1998] report semi-annual return and risk figures for New Zealand offices over the period 1990 through 1995, and annual figures for South African commercial property for 1980 13
through 1995. The results for these four countries were different from those observed in the U.S. and the U.K.
From a mean variance perspective, bond returns in Australia, New Zealand and South Africa dominated real estate returns. The paucity of data, in particular the availability of a long time series, is a limiting factor in these studies and consequently substantial caution must be exercised in interpreting the results, since the data do not span a full property cycle [1985 through 1993 for Australia and Canada, and 1990 through 1995 for New Zealand]. When the U.S. and U.K. results are considered for the period 1985 through 1993, real estate exhibits lower return and risk attributes than both stocks and bonds. One of the key questions in the literature is whether investors should diversify by region or sector. In addressing this issue, Lee and Byrne [1998] indicate that there are two basic approaches to test whether it is more beneficial to diversify by sector or region using real estate data, namely the inspection of intra- and intercorrelation coefficients, and the construction of efficient frontiers. In their 1998 study, Lee and Byrne undertake an extensive literature review highlighting the historical development of research in this area, pointing to two surveys of institutional investors’ diversification strategies, which found that real estate type and geographical spread are the dominant criteria [Webb, 1984; and Louargand, 1992]. They also cite the work of Eichholtz, Hoesli, MacGregor and Nanthakumaran [1995] who tested the benefits of sector/regional diversification in the U.K. and U.S. using a variety of methods comprising correlation analysis, principal components and mean-variance analysis. The results indicate that in the U.S. in general, retail investment should be diversified across regions while for office diversification, across types would be superior. In the U.K., the retail sector produced a contrasting result while diversification across both property type and region yielded superior performance for industrial and office property. 14
The authors conclude that property type diversification is more beneficial in reducing portfolio risk than regional diversification.
Also highlighted are the difficulties of adequately measuring geographical diversification as most regional data is not only disaggregated but is also the product of an administrative rather than an economic function. The analysis was based on a mean absolute deviation portfolio approach to compare the performance of a traditional regional classification with one based on economic criteria. Lee and Byrne [1998] show that diversification across their Super Rest Region [rest of U.K. outside of London and the South East, based on an earlier study by Eichholtz, Hoesli, MacGregor and Nanthakumaran [1995]] would have outperformed almost all other diversification strategies. This implies a case for the further analysis of investment returns for regional centers outside of London, while in terms of decision-making, Lee and Byrne [1998] conclude that the principal issue to be resolved is the development of widely acceptable functional groupings superior in terms of risk/return performance to standard regional classifications. In terms of a regional perspective at European level, Adair, Berry and McGreal [1997] analyzed comparative investment performance across a number of cities. They hypothesized that the combined effect of European economic convergence and global financial integration may promote specialization rather than a geographical spread of assets across the European Union. However, regional decision-making allows areas to exploit comparative advantages and develop linkages within and across regions. In this regard, as Bru¨hl and Lizieri [1994] argue, an awareness of the driving forces of regional performance is essential. Similarly, the work of Hartzell, Eichholtz and Selender [1993] have examined diversification strategies within Europe on a regional basis with strong linkages
15
identified between regional factors, particularly employment, and the performance of the real estate market.
The findings of a more recent study by Byrne and Lee [2000] across 392 locations throughout the U.K. suggests that a diversification strategy across property sectors offers lower risk levels than by region.
16
CHAPTER THREE
DATA ANALYSIS 3.1 PREAMBLE This chapter collates data collected from the management of Wemabod Estates Limited and analyzed investment variables relating to the two portfolios, that is Investment House and Western House. The investment analysis includes gross rental income, net rental income and capital value over a five year period covering 2005 to 2009. Analysis was also carried out on the portfolio variance, standard deviation and comparative risks. All analysis and assumptions were based on information received from Wemabod Estates Limited.
3.2 DATA AND INVESTMENT ANALYSIS ON INVESTMENT HOUSE AND WESTERN HOUSE Table 3.1 below presents the recent information on Investment House and Western House as obtained from Wemabod Estates Limited. Table 3.1; Investment House and Western House Technical Data Variables
Properties
Investment House
Western House
Description Location
21 / 25, Broad Street, Lagos
8 / 10, Broad Street, Lagos.
Adjoining Streets
Marina, Odunlami Street,
Campbell Street, Hospital Road and
Kakawa Street and Nnamdi
Catholic Mission Street,
Azikwe Street Adjoining Developments
Bookshop House, Niger House,
General Hospital, Island Maternity,
Lagos Cathedral Church and
St. Nicholas Hospital, Tafawa
National Library
Balewa Square and Ministry of Defence Building [Derelict]
Neighborhood Infrastructure
Newly improved road network
Newly improved road network and
and overhead cabling system for
overhead cabling system for public
17
public electricity supply Year of Construction
electricity supply
Not Available
1962
No. of Floors
9
19
400m2
890m2
No. of Parking Spaces
60
100
No. of Elevators
4
5
No. of Generators
1
2
Total Lettable Area per Floor Services
Source of Water Supply
Borehole [Private]
Borehole [Private]
Rate / m2
N7, 500 – N15, 000
N10, 000 – N20, 000
Gross Rent per annum
N 43, 000, 000
N120, 000, 000
Management Fee
10% of Gross Rent
10% of Gross Rent
Maintenance and Repairs
5% of Gross Rent
15% of Gross Rent
Insurance
Not Available
Not Available
Sinking Fund
Not Available
Not Available
Capital Value [Current]
N900, 000, 000
N3, 200, 000, 000
Income
Outgoings [Annual]
Source: Wemabod Estates Limited, 2009
1USD = N150
Table 3.2 presents the estimated rental income per floor on Investment House. Table 3.2; Estimated Gross Rental Income on Investment House. Floor
Lettable Space [m2]
Rate [N/m2]
Rent [N] per annum
1
400
15, 000
6, 000, 000
2
400
15, 000
6, 000, 000
3
400
15, 000
6, 000, 000
4
400
12, 500
5, 000, 000
5
400
12, 500
5, 000, 000
6
400
10, 000
4, 000, 000
7
400
10, 000
4, 000, 000
8
400
10, 000
4, 000, 000
9
400
7, 500
3, 000, 000
Total
3, 600
43, 000, 000 1USD = N150
18
Based on the data received from Wemabod Estates Limited, Table 3.3 below shows the estimated gross rental, net rental, capital value and present value factor of the Investment House from 2005 to 2009.
The current capital value of N900, 000, 000 was discounted to respective years at the rate of 4.1% per annum applying the Present Value [PV] formula of 1/ [1 + i]n where i = 4.1/100 = 0.041 and n = number of years. For the rental value from 2005 to 2009 using N43, 000, 000 [current rental] as the basis, the following assumptions were made in arriving at the annual gross rental; [i]
That rent revision is implemented every 3 year.
[ii]
That the revision is based on 25% of prevailing rent every 3 year.
The rate of return of 4.1% is obtained through the formula stated below; Net Income X 100 Capital Value
=
N36, 550, 000 X 100 N900, 000, 000
=
4.1%
Net Income = Gross Rent – Total Outgoings [43, 000, 000 – 6, 450, 000 = 36, 550, 000] Table 3.3; Investment Analysis on Investment House from 2005 to 2009 Variable
2005
2006
2007
2008
2009
27, 520, 000
34, 400, 000
34, 400, 000
34, 400, 000
43, 000, 000
4, 128, 000
5, 160, 000
5, 160, 000
5, 160, 000
6, 450, 000
23, 392, 000
29, 240, 000
29, 240, 000
29, 240, 000
36, 550, 000
766, 350, 000
797, 760, 000
830, 520, 000
864, 540, 000
900, 000, 000
0.8864
0.9228
Year
Gross Rental Total Outgoings @ 15%
Net Rental Capital Value Present Value Factor
0. 8515
0.9606
For Western House, Table 3.4 shows the investment analysis from 2005 to 2009. Although, the figures and results differed from Investment House computation, but similar model and assumptions were adopted.
19
The rate of return as at 2009 is 2.8% as obtained below; N90, 000, 000 N3, 200, 000, 000 where i
=
X 100
=
2.8%
2.8/100
=
0.028
Table 3.4; Investment Analysis on Western House from 2005 to 2009 2005
2006
Gross Rent
76, 800, 000
96, 000, 000
96, 000, 000
96, 000, 000
120, 000, 000
Total Outgoings @ 25%
19, 200, 000
24, 000, 000
24, 000, 000
24, 000, 000
30, 000, 000
Net Rental
57, 600, 000
72, 000, 000
72, 000, 000
72, 000, 000
90, 000, 000
Variable
2007
2008
2009
Year
Capital Value
2, 865, 280, 000
2, 945, 600, 000
3, 028, 160, 000
3, 112, 960, 000
0. 8954
0.9205
0.9463
0.9728
Present Value Factor
3, 200, 000, 000
Table 3.3 and Table 3.4 have shown progressive rental increment from 2005 to 2009 and capital value appreciation over the same period. Table 3.5 presents the returns on investment on both portfolios from 2005 to 2009. The return for each year is derived from the aforementioned formula; Net Income x 100 Capital Value For example, return on Investment House for year 2005 = N23, 392, 000 X 100 = 3.1% N766, 350, 000
=
3.1/100
=
0.031
=
0.020
Also, return for Western House for the same year = N57, 600, 000 X 100 = 2% N2, 865, 280, 000
=
2/100
Table 3.5; Annual Returns on Investment House and Western House from 2005 to 2009 2005
2006
2007
2008
2009
Investment House
0.031
0.037
0.035
0.034
0.041
Western House
0.020
0.024
0.024
0.023
0.028
Portfolio
Year
20
3.2.1 EXPECTED RETURNS [E(r)]. Having obtained the annual returns for each portfolio, the next step is to determine the Expected Return [E(r)] of each as calculated below; a.
Expected Return on Investment House [E(rI)] = 0.031 + 0.037 + 0.035 + 0.034 + 0.041 5
b.
= 0.178 = 0.0356 ≈ 0.036 5
Expected Return on Western House [E(rW)] = 0.020 + 0.024 + 0.024 + 0.023 + 0.028 5
= 0.119 = 0.0238 ≈ 0.024 5
3.2.2 PORTFOLIO WEIGHT Portfolio weight simply refers to the total investment value per annum of each property expressed as a fraction of combined assets value. This is shown in Table 3.6 below for both portfolios; Table 3.6; Portfolio Weight for Investment House and Western House from 2005 to 2009 2005
2006
2007
2008
2009
Portfolio Yr Weight Value
X
Weight Value
X
Weight Value
X
Weight Value
X
Weight Value
X
766, 350, 000
0.21
797, 760, 000
0.21
830, 520, 000
0.22
864, 540, 000
0.22
900, 000, 000
0.22
2, 865, 280, 000
0.79
2, 945, 600, 000
0.79
3, 028, 160, 000
0.78
3, 112, 960, 000
0.78
3, 200, 000, 000
0.78
3,631, 630, 000
1
3, 743, 360, 000
1
3, 858, 680, 000
1
3, 977, 500, 000
1
4, 100, 000, 000
1
Investment House Western House Combined Value
x; Fraction Value
21
3.3 PORTFOLIOS VARIANCE, STANDARD DEVIATION AND RISKS 3.3.1; VARIANCE AND STANDARD DEVIATION
The two measurement [variance and standard deviation] always co – move. The derivation of variance leads to calculation of standard deviation. The formulas are below;
∑ [r - E(r)]2
Variance [ σ] =
N–1 Standard Deviation [ σ2] = √Variance
=
√ ∑ [r - E(r)]2 N–1
where r = returns, E(r) = Expected Returns and N = No. in the sample a.
Variance and Standard Deviation for Investment House
Table 3.7 depicts the computation for variance and standard deviation for Investment House. Table 3.7; Variance and Standard Deviation for Investment House Year
Compute
r - E(r)
r - E(r)
[r - E(r)]2
2005
0.031 – 0.036
-0.005
0.000025
2006
0.037 – 0.036
0.001
0.000001
2007
0.035 – 0.036
-0.001
0.000001
2008
0.034 – 0.036
-0.002
0.000004
2009
0.041 – 0.036
0.005
0.000025 0.000056
Variance [ σ]
= 0.000056 5–1
Standard Deviation [ σ2] =
=
0.000056 4
=
0.000014
√0.000014
=
0.00374
0.00374 X 100
= 0.37% 22
b.
Variance and Standard Deviation for Western House
Table 3.8 depicts the computation for variance and standard deviation for Western House. Table 3.8; Variance and Standard Deviation for Western House Year
Compute
r - E(r)
[r - E(r)]2
r - E(r)
2005
0.020 – 0.024
-0.004
0.000016
2006
0.024 – 0.024
0
0
2007
0.024 – 0.024
0
0
2008
0.023 – 0.024
-0.001
0.000001
2009
0.028 – 0.024
0.004
0.000016 0.000033
Variance [σ]
= 0.000033 5–1
Standard Deviation [σ2] =
=
0.000033 4
=
√0.00000825
0.00000825
=
0.0029 X 100
0.0029 = 0.29%
3.3.2; COMBINED PORTFOLIO RISKS [E(rp)]FOR INVESTMENT HOUSE AND WESTERN HOUSE
The formula for combined assets portfolio risk is given as; [E(rp)] = xI X [E(rI)] + xW X [E(rW)] where xI
= Portfolio Weight [Fraction] of Investment House
[E(rI)] = Expected Return on Investment House xW
= Portfolio Weight [Fraction] of Western House
[E(rW)] = Expected Return on Western House
= 0.22 = 0.036 = 0.78 = 0.024
23
Substituting these figures in the above formula, the equation becomes; [E(rp)] = =
0.22 X 0.036 0.00792
+ +
Combined Portfolio Risk
0.78 X 0.024 0.01872
=
0.02664
Expressing each portfolio as percentage of combined risk, the following results are obtained; a.
Investment House
b.
Western House
=
=
0.00792 0.02664
x 100
=
30%
0.01872 0.02664
x 100
=
70%
24
CHAPTER FOUR
SUMMARY OF FINDINGS, RECOMMENDATIONS AND CONCLUSION 4.1 PREAMBLE Chapter
four
summarizes
and
interprets
the
study
results.
Equally,
recommendations were made towards improving the apparent deficient areas of the portfolios and finally, conclusion on the seminar paper was drawn.
4.2 SUMMARY OF FINDINGS AND RESULTS INTERPRETATION 4.2.1; SUMMARY OF RESULTS
For clarity purpose, the summary of findings is presented in a table format below; Table 4.1; Summary of Results Variables
Portfolio
Investment House
Western House
Rate of Returns [Actual] - [%]
4.1
2.8
Expected Returns [2005 – 2009] - [%]
3.6
2.4
Portfolio Weight
0.22
0.78
0.000014
0.00000825
0.37
0.29
0.00792
0.01872
30
70
Variance Standard Deviation [%] Portfolio Risk Percentage Risk to Combine Assets [%]
4.2.2; INTERPRETATION OF RESULTS
The results are interpreted under the various variables as follows; [i]
Rate of Returns; On the Investment House, the net income received on the current total investment of the portfolio yield an annual returns of 4.1% compared to Western House that yields 2.8%. Under the present economic situation, investment in the Investment House is higher and viable when compared to that of Western House. 25
[ii]
Expected Returns; The expected returns on the Investment House is 3.6% which will attracts and encourage further investment on the portfolio compared to Western House of 2.4%.
[iii]
Portfolio Weight; The weight of Investment House at 0.22 is comparatively lower to Western House of 0.78. Despite the low portfolio weight of the Investment House, it commands higher returns. Technically, it is clear that there is low capacity utilization on the Western House.
[iv]
Portfolio Risks; The risk on Investment House is considerably lower at 0.00792 [0.79%] compared to Western House of 0.01872 [1.87%]. Investors are, generally, risk averse, and Western House with high risk and low returns may not be an investor friendly portfolio when compared to the Investment House. Even, in the combined assets risk, Investment house ranked 30% while Western House ranked 70%.
One of the major findings from this analysis is in sharp contradiction with the generally held concept of positive relationship between the risk and the expected return of an asset. That is the higher the risk, the higher the expected returns. The finding is in agreement with the Bowman [1980] submission that, risk and return were negatively related. The Investment House commands a lower risk at 0.79% with higher expected return of 3.6%. Western House, on the other hand, has a higher risk of 1.87% with corresponding lower expected return of 2.4%.
4.3 RECOMMENDATIONS From the foregoing portfolio risk analysis and interpretation, it is obvious that Investment House attracts low risk and high returns to overall capital outlay. The high returns and low risks on any investment property are attributable to the class 26
of tenants, condition of building, location of property, management structure and condition / available facilities. Since the two properties are in the same precinct, location may not necessarily be a factor to determine their risks and returns. Therefore, other factors such as class of tenants, condition of building, availability and condition of facilities, and management structure may be crucial in assessing the high-risk profile and low returns rate of Western House.
Hence, it is recommended that total refurbishment of Western House be carried out after 47 years of construction. The refurbishment should bring the building to contemporary status in terms of function, facilities, use and aesthetic. In addition, there should be restructuring of current tenants composition and strengthening of the management team.
Lastly, insurance should be procured for both properties to spread the inherent risks.
4.4 CONCLUSION The paper had offered some insight to real estate risk analysis by quantifying risk inherent in investment assets under the same management portfolio. Various risk measurement models such as variance, standard deviation and mean returns have been used to determine the risks of same use [office] property assets with emphasis on rate of obsolescence, available facilities and management strategies. Nevertheless, one key attribute of this comparative work is the obvious disagreement with the established conception that the relationship between risk and expected returns is positive. The results of this study shows negative relationship, possibly in the realm of real estate asset management.
27
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