MODULE 1 UNIT 3

Video 1 Transcript

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Module 1 Unit 3 Video 1 Transcript

DAVID GELTNER: Hi everyone. Think back to what you already know about the One
Lincoln Centre development. The developer and investors involved in this project aimed to
make a profit, which they achieved when they sold the building for more than twice the
development cost. However, they took on a significant amount of risk by developing the
building with no prospective tenants in place. The situation easily could have turned out
differently, with the developers suffering major financial losses. There is even investment
risk in stabilized assets that are fully leased up, and in development projects that are fully
pre-leased. Values in the real estate market change over time in ways that are
unpredictable. Real estate markets can be volatile, and this alone is sufficient to make
returns risky.

It is safe to say that all real estate investors expect to receive a good, or at least a fair,
return on their investments. However, since any kind of investment contains an element of
risk, it is possible that investors might not receive the returns they expect. Ideally an
investor would want to quantify or estimate the amount of risk attached to an investment
before committing to the investment. You will learn how to do this in this unit. However,
before you learn how to measure risk, it is important that you first know how to distinguish
between “risk” and “uncertainty”.

Imagine you are offered the opportunity to play a game of chance. A coin will be flipped
once. If it lands on heads you will win a sum of money. If it lands on tails you will lose and
have to pay that same amount of money. How would you decide whether you want to play
the game or not? Even though you run the risk of the coin not landing on the side you
picked, you know that there is a 50% chance that the result will be in your favor, and you
also know what will happen either way the coin lands. When you take a risk, you don’t
know what the outcome will be, but you know the probabilities that govern the outcomes,
and you have enough information to compute the expected profit or expected return.
Uncertainty, on the other hand, is when you don’t know the probabilities of the future
outcomes, or perhaps even what the outcomes might be, which means you cannot
compute the expected return or quantify the risk.

Here is a simple illustration of the difference between risk and uncertainty. Picture a room
filled with potentially dangerous obstacles. You are exposed to uncertainty if you have to
walk through the room in the dark, with no light. You won’t know what the obstacles are or
where they are, what the chances are of you bumping into one of them, or what will happen
if you did. But now suppose you can switch on a light before walking through the room.
You’re still exposed to risk, but no longer uncertainty. Even though you still might face a
challenge getting around some of the obstacles, at least you can make an informed
decision whether or not it’s worth it to try to cross that room.

Test how well you have grasped the subtle difference between “risk” and “uncertainty” by
answering the following question:

QUESTION: Which one of the following is an example of uncertainty?

a. A game of dice.

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Incorrect. A game of dice is an example of risk, as the potential outcome and

probability of each outcome are known.

b. Investing in a newly invented product.

Correct, well done. An investment in a new product is an example of uncertainty,

as neither the outcomes nor the probability of each outcome being achieved are
known.

c. Investing in the stock market.

Incorrect. Investing in the stock market is an example of a mixture between risk

and uncertainty. Although a lot of data is available that can be used to quantify
stock market risk, this data is based on the past and is not necessarily an accurate
reflection of what will happen in future.

DAVID GELTNER: Investors and capital markets can handle risk. Investments with more
risk are priced lower and provide higher expected returns. Uncertainty, however, causes
bigger problems. Too much of uncertainty kills the market, because nobody can be sure
what price they should buy or sell for. That’s why investors shy away from uncertainty. As
investors, we need to try to turn uncertainty into risk. To do that, we need to improve the
information available to us.

We need to gather empirical data about the past performance of assets like those we are
thinking of investing in. We need accurate information about variables such as rents paid,
building occupancy rates, and trading prices for properties. We need to study price
dynamics over time. Having detailed information before you invest is essential. It’s like
turning on the lights in that room. It lets you see and avoid potential dangers.

Traditionally there has been little such empirical data widely available about investment in
real estate. But today this is changing rapidly. More and more high quality reliable data and
analytical products are available for investors. This can, and should, change the culture of
the real estate investment business. Instead of just basing decisions on a gut feeling, or
just telling stories with rule-of-thumb numbers, we can base investment decisions more
soundly on rigorous analysis.

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Look at the following example of empirical data that can assist you in thinking quantitatively
about the nature of real estate investment risk and return.

This example includes data from over two hundred commercial real estate property
markets in the US. It shows the historical price movements of typical investment property
assets, quarterly, from 2001, in each market. You can see that some markets substantially
underperformed the national average, even ending up lower then they started across the
fairly long span of history shown here. While other markets, New York City for example,
increased tremendously after recovering from the financial crisis and recession in the 2008
to 2010 period. This kind of information reveals the typical growth and associated risks in
commercial real estate investments. We see both the longitudinal dynamics of the price
movements across time, as well as the cross-sectional dispersion in price changes across
space. Empirical data like this, which is becoming more and more available, can help
analysts make more accurate forecasts, and investors to make more informed decisions,
with a more quantitative measurement of risk. This helps to, in effect, replace some
uncertainty with risk – like turning on a light in a dark room.

One of the characteristics of a mature real estate investment market is that significant
amounts of good quality empirical data are available for investors to base their decisions
on. In later modules we will discuss empirical real estate data in more depth. You will also
see how the developer of the One Lincoln Centre project used data about the rental market
to gain the confidence to kick off the project without any leases yet signed for the
building.

In this video you learned that an investor should distinguish between risk and uncertainty.
Risk can be described as “known unknowns”, while uncertainty is regarded as “unknown
unknowns”. Investors generally won’t, and shouldn’t, pay as much for an asset about which
there is less information. These are exciting times in real estate investment, because more
and better data is becoming available, rapidly, in many countries. We are replacing
uncertainty with risk!

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Tel: +1 224 249 3522 | Email: [email protected] | Website: getsmarter.com

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We will explore quantifying and measuring investment risk in more detail in the notes
included in this unit.

Did you understand all the concepts covered in this video? If you’d like to go over any of
the sections again, just click on the relevant button.

© 2018 MIT SA+P

All Rights Reserved

Tel: +1 224 249 3522 | Email: [email protected] | Website: getsmarter.com

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