Investment Risk

Risk is a major determinant of return. Modern Portfolio Theory sees the investment decision as a trade-off between risk and expected return; see Figure 91. Much research in property risk has been devoted to the application of measures, already devised for equity investment, to the property market and these are related to portfolio risk analysis which is covered in the following chapters. Waldy (1991) suggests that the main argument for considering single asset risk to be equally as important in practice is that most investors in the UK are not able to diversify away the individual property element of risk adequately. Aspects of risk analysis have already been discussed in Chapter 8. Waldy suggests there is a hierarchy of these approaches, starting with the intuitive approach used in traditional valuation for the assessment of the all risks yield (ARY) which is assessed in accordance with the risk profile of the property; the ARY is thus an implicit valuation which is open to criticisms of subjectivity. Explicit approaches used in discounted cash flow appraisals include sensitivity analysis and scenario testing. Sensitivity analysis measures the effect upon capital value by a change in variable inputs to the calculation. Scenario testing postulates situations by assigning appropriate values to the variables to test for different scenarios. Risk-adjusted discount rates provide for a premium to reflect risk; certainty equivalent techniques through probability and the removal of downside risk calculates risk-free cash flows which can be capitalised using the risk-free rate of return. Probability analysis is inherent in these calculations.