The Reporting of Risk in Real Estate Appraisal Property - Assignment Example

Introduction Events of the 2000’s and accounting debacles made of mainly accounting scandals, such as those of Enron Corporation and WorldCom has left investors at a loss as to what next to be done with their investments. This is mostly due to the gross exaggeration of the firm’s position by the financial officers that pushed investors in investing wrongly. Different measures have been put in place to fight this practice. The Securities and Exchange Commission (SEC) Act of 1934 had set limits on trading by Corporate Officers, directors and substantial owners from using insider information to make profits Bodie et al, (2007, pp 240 – 252). Some looked at the problem from the point of lack of clarity on who is supposed to do what and at what time. Eugene Fama and Michael Jensen (1983, 81 - 112) established that firms are seen as some kind of contracts, where one pays the other for the execution of a certain task, that is, the agent (the manager) is employed to work on behalf of the principal (the shareholders), who unfortunately do not observe the actions of the agent. The difficulty of the system lies at what kind of compensation mechanisms to use (“the carrot”) and how to supervise those in charge (“the stick”), as well as in critique of such mechanisms. They believe that this could serve as the better understanding of corporate governance. Areas of consideration in risk analysis In any investment portfolio, the most important aspect to be managed is the risk associated with such investment. This means that, any analysis of risk should be risk that should be directly associated with the asset rather than the portfolio as a whole. This is because, the property market as seen is becoming more heterogeneous and more complex and consequently it is likely that market advisers including valuers will require more powerful risk assessment and control methods. Modern portfolio theory utilises the Capital Asset Pricing Model (CAPM) to define risk for the purposes of measurement and management. It should be noted here that, total risk comprises of systematic risk (market risk) and unsystematic risk (specific components). According to Adair & Hutchison (2003 pp 254 - 268), any valuation taken is considered is said to have a certain aspect of risk, be it at the systematic or unsystematic, but the moat important issue is how that risk is managed and communicated to all third parties. In this report, Carsberg identifies the complexity of this issue by drawing from an earlier debate in the Mallinson Committee in 1994 in which the report emphasized on the need for more acceptable methods of expressing risk, particularly when pricing in thin markets. Recommendation 15 of the Mallison Committee report exhorts that professional bodies (especially as they are the people preparing these valuations) who represent both valuers and end users should agree and use a simple and an acceptable methodology for reporting risk within their valuations, so that it can be readily communicated to third parties who use such valuation reports for their investments. It is stressed that the methodology adopted must enhance the decision-making process in a manner that is not going to confuse the end users who are the investors. In reality the failure to set risk within a proper theoretical framework which distinguishes it from uncertainty is likely to be more confusing to both valuers and clients especially as there is often that confusion between risk and uncertainty. The problem here is that, risk is inherently difficult to systematically reported in a common manner accepted by all. Quantitative methods, which for long had been thought to be the best method are still being doubted by end users especially as many of them have been reluctant to utilise and report any statistical measures of risk. But the problem remains unanswered as to how should risk be measured and reported so that it can be adequately managed. In the report, the writers apparently think there should be a new line of thinking as what should be the best means of measuring risk so as to facilitate its management in pricing of property assets. They look at the D&B model as being the best option. D&B model is a particular model developed by the D&B UK Ltd, a wholly owned subsidiary of D&B Corp. one of the largest rating company in the UK. D&B model rely of the use of a wider range data to produce their ratings as to make useful recommendations and credit ratings for their decision making. See Adair & Hutchison (2003 pp 254 - 268) In this model, D&B has been able to produce a financial strength rating (be it solicited or unsolicited) and a risk indicator for every business that is trading in the UK. The main difference is that a solicited rating is a cooperative process, in that the issuer provides information of both a public and a confidential nature, whereas an unsolicited rating relies almost exclusively on information which the agency is able to compile on its own, typically information in the public domain, Adair & Hutchison (2003, pp 254 - 268). To come out with the overall rating, the D&B model uses the financial ratings, which is based on the financial statements of the business, divided into two bands and D&B risk indicator based on a scoring system of 1 to 4 representing the risk of failure of the business over the next 3 to 12 months. Adair and Hutchison (2003, pp 254 – 268) in trying to apply the D&B model to the property asset as to see how risk can be measured, thinks that the conventional measure of a single asset’s risk is the standard deviation of the distribution of future returns. But since the future return distribution of single asset’s risk is not directly observable, the volatility of future returns must be estimated. And the standard approach to estimate the volatility of these future returns is to measure the volatility of past returns and assume that the future will resemble the past. But the question that critics of this model still ask is, what about a new asset that is just newly acquired especially as the model is based on predicting old assets that must have traded on the market for years and the new assets do not have any past information. Risk compensation in the investment In we have to go by the CAPM model, we know that the Capital Market Line (CML), which is the capital allocation line provided by the market index portfolio to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio should be the best portfolio if we are to adequately compensate for any risk taken by an investor.1 Figure 1. From figure 1 above, it can be stated that, for an investor to get that maximum premium (compensation for the risk), the investor should hold assets that lie on the point of tangency (black dot on graph) between the combination of a risky asset and a risk free asset (green line) and the curve (brown line). It is at this point that we can clearly say that the investor is getting a maximum premium for the risk taken, with a higher expected rate of return and lower volatility (standard deviation). But in the case of this research by Adair and Hutchison, (2003 pp 254 - 268) the authors are trying to come out up with a new method on how finance professionals and bodies should measure risk and report such risk to third parties, in this case users as investors so as to help them come up with that meaningful decision that will help them make a profit or premium for the risk they take. In the same line of thinking was the Carsberg report that recommended that the methodology adopted for reporting uncertainty and risk within the valuation must be readily communicated to third parties, so as to enhance the decision-making process and not confuse end users. Risk in their paper is compensated by using the Property Risk Scoring (PRS) method, in which the analysis and scoring of the total risk of a property asset should be reported to the client under four key headings; market transparency risk, investment quality risk, covenant strength risk, and depreciation and obsolescence risk. These headings were chosen based on the findings of the Carsberg Report (2002) and of the Investment Property Forum/Investment Property Databank (2000) which both indicated that these headings were the areas of greatest concern if the PRS method was to be considered that important. At same time, not only were these areas of great concern, but if the design and implementation of PRS was to be considered, then calibration, consistency, and validity should be the three crucial points to take a closer look at when trying to compensate for risk through a communication process to the end users as to help them make informed decisions. 1. Calibration: Here, PRS is built on the D&B model by adopting a five point system, 1 to 5, which represents the risk assessment decision at a particular time when the investment decision is made. The five point systems are; minimal risk, lower than average risk, average risk, greater than average risk, and higher risk. If an investor is able to be informed of the risk level, then the investor will know about all the risk inherent in the asset he is about to invest in. And in this way, the investor is able to use the “all risk yield” to capitalise on the net income in perpetuity in the conventional approach to valuation. At same time, all risk involved in the asset are made known to the investor. As Adair and Hutchison puts it, “as with the D&B model, underpinning the 1 to 5 headline score for each heading, will be a “risk scorecard”. The compilation of the risk scorecard requires extensive consultation with the valuation community in order that the components of the scorecard and their calibration are agreed. The latter could be based on a statistical model, which would attribute weightings to the different characteristics of the property asset.” See Adair & Hutchison (2003 pp 254 - 268) 2. Consistency: The PRS report must be designed in a way that is widely accepted by the small and large practices so as to gain acceptance from the client and valuation community. Therefore, it is vital that PRS should produce consistent results, whether the sector or location is for property at the level of retail or office, urban or rural, primary or tertiary, the results be consistent as to merit the trust of the client and for their understanding. Adair & Hutchison (2003 pp 254 - 268) 3. Validity: Since the PRS is compared to a risk scorecard, it should therefore properly record what it purported to record. This means it should be able to reveal the current market risk. To gain this status, it must be constantly reviewed and emphasis be placed on current risk characteristics. Adair & Hutchison (2003 pp 254 - 268) Relationship between equities, real estate and bonds In all, what brings all these areas together, equities, real estate and bonds is that all of the investors involved in these sectors carry out any investments through professional bodies (portfolio managers). The investors are using these portfolio managers to find mispriced stocks in a bit to make a profit from their investments. The rationale behind active portfolio management strategies is to beat particular benchmarks used to assessing the performance of an investment. The benchmarks among the dozens used by financial analysts include the S&P 500, the Dow Jones Industrial Average, the Russell 2000 Index and the Lehman Brothers Aggregate Bond Index. Portfolio managers have their own complex security selection and trading systems used in analysing market trends, the economy and the company-specific factor and methods such as fundamental analysis, technical analysis, quantitative analysis and macroeconomic (factors such as inflation, economic growth, etc) to implement their investment ideas for their customers. Portfolio managers usually use the following strategies: Stock selection: To be up to date with every company’s situation, an active portfolio manager holds few companies in their portfolio for better management purposes. By analysing all publicly available information about the portfolio, the portfolio manager is able to come up with a stock that is undervalued, since this offers the greatest opportunity for growth above the market averages. Market timing: Managers at all times try to sell their stocks at peak periods, that is, when prices are up and buy them when prices are down. But it is extremely difficult to find managers who in the long run will get that right. But on the whole, they believe in their skills and experiences to be able to succeed. Bond swapping: Portfolio managers are well aware of the fact that long term bonds are very sensitive to interest rates and capital gains are linked to interest rate changes, portfolio managers attempts to guess periods when interest rates are expected to rise so as to sell long term bond and buy short term bonds and to pursue the opposite action when rate fall for capital gain. Ladder approach: Portfolio managers often buy different securities with different times of maturity just as to keep some fix income at all times. In all, portfolio managers believe that capital markets are inefficient making it possible that anomalies and irregularities in the capital markets can be exploited by those with skill and insight especially as they believe that prices on the market react slowly to any major changes that may occur on the capital market. With all of this said, the main advantage for active portfolio managers is that, there is that possibility of managers to outperform the index due to their superior skills. This can be achieved because they have the skills to make informed investment decisions based on their experiences, insights, knowledge and ability to identify opportunities that can translate into superior performances. In cases where due to the experiences and skills, if the active portfolio managers believe that the market might face a turn downward, they take on defensive measures such as hedging or increasing their cash positions to reduce the impact on their portfolios. But according the Efficient Market Hypothesis (EMH) formulated by Fama (1970, pp. 383-417), an efficient market is one that at any given time, prices fully reflect all available information on a particular stock and/or market.2 This therefore means that no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else. Simple microeconomic principles indicate that if capital markets are sufficiently competitive, then investors should not expect to make superior profits from their investments Dimson and Massoud, (1998, pp 91-193). In their line of thinking and following the EMH, Jensen (1968, pp. 389-416) in trying to assert the position that even corporate managers cannot make a profit by trading from insider information conducted a study on 115 mutual funds over the period 1955 – 1964. Using a risk-adjusted basis, he found that any advantage by the portfolio managers by trading on such insider information might be eroded by fees and expenses. This means that even if investment management fees and loads were added back to performance measures, and returns are measured gross of management expenses (ie, assuming research and other expenses were obtained free), this will result to them making zero profits. Jensen then concluded that “on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses”. It is important to recall here that, portfolio managers are both divided into passive and active portfolio managers. Active portfolio managers are those managers who attempt to achieve returns more than the commensurate risk or outperform the market by either forecasting broad market trends or simply identifying mispriced securities on the market, while passive portfolio managers are those managers who make no attempts at outsmarting the market by neither trying to find out under valued or over valued stocks, but instead aim at establishing a well-diversified portfolio. These managers believe in the buy and hold strategy. They simply believe in the Weak form of EMH that states that stock prices already reflect all information available that can be derived by examining market trading data such as the history of past stock prices, volumes of stock traded on the markets, or the short term interest rates. Thus to them, there is just no need to frequently buy and sell stocks which generates large brokerage fees without increasing expected performance. Conclusion In conclusion, it is hard to take a stand point as whether providing all relevant market information about risk through analysis or whether the active or passive portfolio manager’s position should be best. This is because of the increasing uncertainty that surrounds our security markets. But in my opinion, the best option in managing any portfolio should be diversification. Through diversification, an investor is able to control the risks involved as it may not happen that all assets fall in value at the same time. References Alastair Adair, Norman Hutchison (2003): “The reporting of risk in real estate appraisal property risk scoring.” Journal of Property Investment and Finance, (23) No 3 2005, pg 254 - 268 Elroy Dimson and Massoud Mussavian (1998): “A brief history of market efficiency”, European Financial Management, (4), Number 1, pp 91-193 Eugene Fama and Michael Jensen (1983) The Separation of Ownership and Control, Journal of Law and Economics, (58): 81-112 Fama, Eugene (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work", Journal of Finance, (25) pp. 383-417. Jensen, Michael (1968). "The Performance of Mutual Funds in the Period 1945-1964", Journal of Finance, (23) pp. 389-416. Zvi Bodie, Alex Kane, Alan J. Marcus (2007), Investments. 5th edition, McGraw-Hill List of web sites consulted http://www.investopedia.com/articles/02/101502.asp, retrieved on 08-12-2008 at 09:20 am http://www.investopedia.com/terms/c/cml.asp, retrieved on 08-12-2008 at 11,05pm Read More