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UNIVERSITY OF BOTSWANA
FACULTY OF ENGINEERING AND TECHNOLOGY
Department of Architecture and Planning

RES 317 – VALUE AND RISK MANAGEMENT

Dr. Nonso Ewurum
3552109; 74716083; ewurumn@ub.ac.bw

1.0 INTRODUCTION
Risk vs Uncertainty
Types of risk: systematic and non-systematic risk
Importance of risk management in real estate investments
Risk management process
Risk management strategies

1.1 Risk vs Uncertainty

Risk and uncertainty are often used interchangeably, but they have distinct meanings in the
context of real estate investments.
Uncertainty is to the lack of complete knowledge or predictability about future events that
may affect an investment.

Risk, on the other hand, refers to the difference between an expected outcome, and the
actual outcome due to various factors.
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1.2 Types of Risk

There are two primary types of risk in real estate investments: systematic and non-
systematic risk.
1. Systematic Risk
Systematic risk, also known as market risk or macroeconomic, is the risk that cannot be
diversified away. It is associated with macroeconomic factors in the environment or
economy that affect the entire market, such as changes in interest rates, inflation, economic
recession, or a global pandemic. Systematic risk impacts all properties and investments in a
particular market, and this makes it challenging to mitigate.

2. Idiosyncratic Risk
Non-systematic risk, also known as idiosyncratic risk, is specific to an individual property
or investment. It arises from factors such as property damage, tenant vacancies, or local
market conditions. It can be mitigated through diversification, proper property
management, and thorough due diligence.

1.3 Importance of Risk Management in Real Estate Investments

Effective risk management is crucial for successful real estate investments. It helps
investors identify potential risks, assess their likelihood and impact, and implement
strategies to mitigate or manage those risks.
It can be recalled that risk is always not a bad thing, so managing risk also implies that
investors and professionals can leverage opportunities provided by risk to maximize
investment returns.

Risk management enables investors to:

1. Protect their investments from potential losses.
2. Maximize returns by making informed decisions.
3. Identify opportunities to diversify their portfolio.
4. Develop a contingency plan for unexpected events.
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1.4 Risk Management Process

The risk management process involves several stages:
1. Risk Identification
Risk identification is a crucial step in the risk management process, as it helps investors
identify potential risks that could impact their objectives, operations, and assets. So to
identify potential risks that could impact the investment, including both systematic and
non-systematic risks, the following techniques are applicable.
➢ Techniques
Brainstorming: This technique involves gathering a group of people from different
departments and levels within an organization to share their ideas and insights about
potential risks. Brainstorming can help identify risks that may not be immediately
apparent.

SWOT Analysis: SWOT stands for Strengths, Weaknesses, Opportunities, and Threats. This
technique helps organizations identify internal strengths and weaknesses, as well as
external opportunities and threats. SWOT analysis can help identify risks that may arise
from internal or external factors.

Failure Mode and Effects Analysis (FMEA): This technique is used to identify potential
failures or defects in a system, or process, and evaluate their impact on the organization.
FMEA helps organizations prioritize risks based on their likelihood and potential impact.

Scenario Planning: This technique involves creating scenarios to anticipate potential risks
and opportunities. It helps to identify potential risks and develop strategies to mitigate
them.

2. Risk Assessment/Analysis
Examining the likelihood and potential impact of each identified risk. Risk assessment
techniques are methods used to evaluate identified or potential risks. Here are some
commonly used risk assessment techniques:
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Qualitative Risk Assessment: This technique involves assessing risks based on their
likelihood and potential impact without using numerical values.
Example:
Expert Judgment: This technique involves seeking the opinion of experts in a particular
field to assess potential risks. It is often used in situations where there is limited data or
information available.

Quantitative Risk Assessment: This technique involves using numerical values to assess the
likelihood and potential impact of risks. It is often used in later stages of risk management
to provide a more detailed analysis of risks.
Examples:
Let's say we're evaluating the risk of a potential security threat to a commercial real estate
investment. We want to assess the likelihood and potential impact of such an event, so we
can prioritize our risk mitigation efforts. Let us assume a risk threshold of 0.1 for the
investor.
A. Likelihood Assessment
We assess the likelihood of a security threat occurring in the next 12 months. We consider
factors such as customer traffic, different access routes, and the security measures in place.
We assign a numerical value to the likelihood, ranging from 0 (extremely low) to 1
(extremely high).
Say, Likelihood = 0.4 (Moderate)

B. Potential Impact Assessment

We assess the potential impact of a security breach, considering factors such as the number
of customers and personnel affected, the type of goods stolen or compromised, and the
potential financial loss for the company. We assign a numerical value to the potential
impact, ranging from 0 (minimal) to 1 (severe).
Say, PI = 0.7 (Significant)
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C. Risk Score Calculation

We calculate the risk score by multiplying the likelihood and potential impact values.
Risk Score = Likelihood x Potential Impact = 0.4 x 0.7 = 0.28.

We compare the risk score to a predefined risk threshold (0.1) to determine the level of
risk. If the risk score is above the threshold, we consider the risk to be high and prioritize
mitigation efforts. In this example, the risk score is 0.28, which is above the threshold of 0.1.
Therefore, we consider the risk of a security breach at the complex to be high, and
prioritize implementing security measures to mitigate the risk.

Risk Register: This technique involves creating a document that lists all identified risks,
their likelihood, potential impact, and current status. The risk register helps to track risks
and monitor their progress over time.

SWOT Analysis

Monte Carlo Simulation: This technique involves using statistical models to simulate
different scenarios and assess the potential risks and outcomes. It is often used in finance
and project management to assess risks such as cost overruns and schedule delays.

Sensitivity Analysis: This technique involves analyzing how changes in certain variables can
impact the overall risk of a project or investment. It helps to identify key risk drivers and
assess the potential impact of changes in those drivers.

3. Risk Prioritization
Risk prioritization is a crucial step in the risk management process, as it helps investors to
focus their efforts and resources on the most critical risks. It involves the prioritization of
risks based on their likelihood and most critical potential impact. Here are some common
risk prioritization techniques:
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Risk Scoring: This technique involves assigning a numerical score to each risk based on its
likelihood and impact. The scores are then used to rank the risks and prioritize them.

Risk Register: This technique involves creating a document that lists all identified risks,
their likelihood, impact, and current status. The risk register helps to track risks and
prioritize them.

Monte Carlo Simulation

Risk Prioritization Workshop: This technique involves bringing together a group of

stakeholders to discuss and prioritize risks. The workshop helps to identify and prioritize
risks based on their potential impact and likelihood.

4. Risk Control
Risk control involves the regular monitoring, and review of risks to devise mitigation or
acquisition strategies to ensure effective investment performance. Risk control comprise a
range of options which include:
Risk Monitoring: This involves regularly reviewing and assessing risks to ensure that they
are being managed effectively and to identify any new risks.

Risk Avoidance: This involves identifying and eliminating risks by avoiding certain actions
or situations that could lead to potential risks.

Risk Transference: This involves transferring the risk to another party, such as through
insurance or outsourcing.

Risk Mitigation: This involves taking steps to reduce the likelihood or impact of a risk, such
as implementing safety measures or contingency plans.

Risk Acceptance: This involves accepting the risk and doing nothing to mitigate it, which
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may be appropriate for low-level risks or risks that are not cost-effective to mitigate.

Risk Acquisition: This involves accepting the risk and using it for the benefit of the
investment.

Risk Diversification: This involves spreading risks across multiple assets or activities to
reduce the potential impact of any one risk.

Risk Hedging: This involves taking a position in a market that is opposite to an existing
position to reduce the risk of losses.

Risk Management Information System: This involves implementing a system for tracking
and managing risks, such as a risk management software or a spreadsheet.

Risk Reporting: This involves providing regular reports to stakeholders on the risks facing
the project or business and the steps being taken to manage them.

Risk Management Framework: This involves establishing a framework for risk

management that includes policies, procedures, and guidelines for identifying, assessing,
and mitigating risks. It also involves establishing a team responsible for risk management,
which can include members from different departments and levels within the organization.

1.5 Risk Management Strategies

See Risk Control under 1.4

Other risk management strategies that investors can use to manage risks in real estate
investments are:
Property Management: Engage in active property management to minimize non-systematic
risks, such as tenant vacancies or property damage.
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Due Diligence: Conduct thorough due diligence on properties and investments to identify
potential risks and assess their likelihood and impact.

Risk-Return Analysis: Evaluate the potential risks and returns of each investment,
considering the risk-return tradeoff when making investment decisions.

2.0 RISK MANAGEMENT THROUGHOUT THE CONSTRUCTION PROJECT LIFE CYCLE

* Risk management at feasibility stage
* Risk management at planning and design stage
* Risk management at construction stage
* Importance of risk assessment and mitigation strategies

2.1 Feasibility Stage

Let's begin with the feasibility stage, where the project's feasibility and viability are
evaluated. At this stage, the focus is on identifying potential risks that could impact the
project's success. Some of the risks that need to be considered include:
Technical risks: What resource and technology variances may affect the project’s
completion in light of the available resources and technology?
Environmental risks: Will the project have any negative impact on the surrounding
environment?
Financial risks: Is the project financially viable, and are there any potential variances
that could impact the project's budget?
Legal risks: Are there any potential legal issues that could impact the project's
progress?

2.2 Planning Stage

Once the project is deemed feasible, we move on to the planning and design stage. At this
stage, the focus shifts to developing a detailed project plan and design. Risk management at
this stage involves identifying potential risks that could impact the project's timeline,
budget, and quality. Some of the risks that need to be considered include:
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Design risks: Are there any potential design flaws that could arise and impact the
project's success?
Procurement risks: Are there any potential issues with the procurement process
that could impact the project's timeline and budget?
Regulatory risks: Are there any potential regulatory issues that could impact the
project's progress?

2.3 Construction Stage

Now, let's move on to the construction stage. At this stage, the focus is on executing the
project plan and managing the construction process. Risk management at this stage
involves identifying potential risks that could impact the project's timeline, budget, and
quality. Some of the risks that need to be considered include:
Construction risks: Are there any potential issues with the construction process that
could impact the project's timeline and budget?
Health and safety risks: Are there any potential health and safety risks that could
impact the project's progress?
Quality risks: Are there any potential quality issues that could impact the project's
success?

2.4 Assessment and Control

It is crucial to have a robust risk assessment and control strategy in place to identify and
manage these risks effectively. A recap of Lecture 1.0 suffices in this respect.

3.0 RISK ANALYSIS

SWOT Analysis
Risk Register

3.1 SWOT Analysis

SWOT Analysis is a useful tool for assessing the risks and opportunities associated with real
estate investments. Here's a worked example of how to conduct a SWOT Analysis for a real
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estate investment:

Strengths (S)
1. Location: The property is located in a desirable area with strong demand for housing,
proximity to amenities, and good transportation links.
2. Rental income: The property has a strong rental history, with a high occupancy rate and
consistent rental income.
3. Property type: The property is a type that is in high demand in the local market, such as a
family home or a luxury apartment.
4. Condition: The property is in good condition, with no major repairs or maintenance
needed.
5. Growth potential: The area is experiencing growth and development, which could lead to
increased property values and rental income.

Weaknesses (W)
1. Market volatility: The real estate market can be volatile, and market fluctuations could
impact the property's value and rental income.
2. Competition: There may be a high level of competition in the local market, which could
impact the property's occupancy rate and rental income.
3. Economic conditions: Economic downturns or recessions could impact the property's
value and rental income.
4. Property taxes: Property taxes may be high, which could impact the property's
profitability.
5. Maintenance costs: The property may require maintenance or repairs, which could be
costly and impact the property's profitability.
6. Client Attitude: Attitude of the client may be inimical to professional management of the
real estate investment, probably culminating in passive management, heightened chances
of depreciation, and defects.
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Opportunities (O)
1. Rental income growth: The property's rental income could be increased by renovating
the property, adding amenities, or increasing the rent.
2. Capital appreciation: The property's value could increase over time, providing a potential
long-term return on investment.
3. Tax benefits: Real estate investments may provide tax benefits, such as deductions for
mortgage interest and property taxes.
4. Diversification: Real estate investments can provide diversification benefits, as they are
not correlated with other asset classes.
5. Leverage: Real estate investments can provide leverage, allowing investors to potentially
increase their returns through the use of debt financing.

Threats (T)
1. Market downturn: A decline in the real estate market could impact the property's value
and rental income.
2. Economic downturn: An economic downturn could impact the property's value and
rental income.
3. Interest rate changes: Changes in interest rates could impact the cost of financing and the
property's profitability.
4. Regulatory changes: Changes in regulations, such as tax laws or zoning regulations, could
impact the property's profitability.
5. Natural disasters: Natural disasters, such as floods or earthquakes, could impact the
property's value and rental income.
6. Insecurity: Issues of violence, crime and other social ills may develop within the locality
of the investment causing reduced value.

3.2 Risk Register

A risk register is a document that lists and tracks all the identified risks associated with a
particular investment, along with their characteristics, potential impact, and proposed
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mitigation strategies. For a real estate investment, a typical risk register might look like the
description in Table 1:

Table 1: Risk Register for Real Estate Investment

Risk ID Risk Risk Risk Risk Impact Risk Control
Description Category Probability (% of Strategies
investment
operations
likely
affected)

1 Change in Market risk 7/10 8/10 Diversify

demographic investment
attributes, portfolio,
standard of invest in
living, income multiple
levels markets
2 Change in Liquidity 6/10 7/10 Maintain
marketability risk cash
and reserves,
affordability of establish line
investment of credit

3 Roof leakage, Property 5/10 9/10 Insure

wall cracks risk property,
and other conduct
defects regular
inspections
4 Troublesome Tenant risk 4/10 6/10 Conduct
tenants, rent thorough
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default and tenant

others screening,
use a lease
agreement
5 Change in the Interest 3/10 5/10 Use fixed-
monetary rate risk rate
policy rate by financing,
the central hedge against
bank, inflation interest rate
and exchange fluctuations
fluctuations
6 Change in Regulatory 2/10 4/10 Monitor
government risk changes in
policy regulations,
engage with
local
government
7 Floods, Natural 1/10 10/10 Insure
earthquakes, disaster property
erosion, risk against
hurricanes, natural
droughts disasters,
invest in
disaster-
resistant
construction

In this example of a hypothetical real estate investment in Gaborone, the risk register
includes seven risks that have been identified for the real estate investment. Each risk is
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described in detail, along with its risk type, probability, impact, and proposed mitigation
strategies.

The first risk, market risk, is a risk that the value of the property may fluctuate due to
changes in market conditions. To mitigate this risk, the investor plans to diversify their
investment portfolio and invest in multiple markets.

The second risk, liquidity risk, is a risk that the investor may not be able to sell the property
quickly enough or at a good price. To mitigate this risk, the investor plans to maintain cash
reserves and establish a line of credit.

The third risk, property damage risk, is a risk that the property may be damaged or
destroyed due to natural disasters or other events. To mitigate this risk, the investor plans
to insure the property and conduct regular inspections.

The fourth risk, tenant risk, is a risk that the tenant may default on their rent or cause
damage to the property. To mitigate this risk, the investor plans to conduct thorough
tenant screening and use a lease agreement.

The fifth risk, interest rate risk, is a risk that changes in interest rates may impact the
investment's profitability. To mitigate this risk, the investor plans to use fixed-rate
financing and hedge against interest rate fluctuations.

The sixth risk, regulatory risk, is a risk that changes in regulations may impact the
investment's profitability. To mitigate this risk, the investor plans to monitor changes in
regulations and engage with local government.

The seventh risk, natural disaster risk, is a risk that the property may be damaged or
destroyed due to natural disasters such as earthquakes, hurricanes, or floods. To mitigate
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this risk, the investor plans to insure the property against natural disasters and invest in
disaster-resistant construction.

So, generally, the risk register enables real estate investors identify and manage risks more
effectively, and make informed decisions about their investments.

3.3 Expected Monetary Value

Expected Monetary Value (EMV) is a risk analysis technique used to estimate the aggregate
outcome of a decision when there are multiple possible outcomes, each with an associated
probability. It provides an amount in Pula that represents the overall expected value of a
given decision or investment, taking into account both positive and negative outcomes.

EMV is calculated by multiplying each possible outcome by its corresponding probability

and then summing the results. So, to calculate EMV, one needs to know:
1. The potential outcomes of the investment, as obtained from experience or market
research
2. The probability of each outcome occurring, as obtained from experience or market
research
3. The financial impact of each outcome, which is the amount in Pula project is expected to
generate

Once this information is available, we can calculate EMV by multiplying the probability of
each outcome by its corresponding financial impact, then summing these values for all
possible outcomes. This gives the overall expected value of the decision or investment.

Example 3.3.1 (Using Financial Impact)

Suppose you're considering investing in a new project with two possible outcomes: either
it will generate P500,000 in revenue with a probability of 70%, or it will result in a loss of
P200,000 with a probability of 30%. To calculate the EMV, you would first determine the
expected value of each outcome:
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Expected value of success = Probability x Financial Impact

= 0.7 * P500,000
= P350,000

Expected value of failure = Probability * Financial Impact

= 0.3 * -P200,000
= -P60,000

Then, add up these values to get the overall expected monetary value:

EMV = Expected value of success + Expected value of failure

= P350,000 - P60,000
= P290,000

Based on this calculation, the expected monetary value of the investment is P290,000,
which suggests that it could be a good decision if the cost of the investment is less than this
amount.

Example 3.3.2 (Using Projected Investment Returns)

Suppose you are considering investing in a rental property, and you want to calculate the
expected monetary value (EMV) of the investment. Here are the steps you can follow:
1. Define the possible outcomes:
Let's say the property can have one of two possible outcomes:
Outcome 1: The property appreciates in value by 10% per year, and you sell it for a profit
after 5 years.
Outcome 2: The property does not appreciate in value, and you sell it for a loss after 5
years.
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2. Assign probabilities to each outcome:

Based on your research and analysis, you estimate that there is a 70% chance that the
property will appreciate in value, and a 30% chance that it will not.
3. Determine the expected value of each outcome:
For Outcome 1, the expected value is the product of the probability of the outcome (70%)
and the profit from selling the property (10% appreciation per year x 5 years = 50%
profit), all divided by 100.
So, the expected value of Outcome 1 is (70% x 50%)/100 = 35%.

For Outcome 2, the expected value is the product of the probability of the outcome (30%)
and the loss from selling the property (0% appreciation per year x 5 years = 0% profit), all
divided by 100. So, the expected value of Outcome 2 is (30% x 0%)/100 = 0%.
4. Calculate the EMV:
The EMV is the sum of the expected values of each outcome.
In this case, the EMV is 35% + 0% = 35%.
5. Interpret the results:
The EMV of 35% means that based on your analysis, you expect the rental property to
generate a profit of 35% over a 5-year period. This can help you decide whether or not to
invest in the property.

Merits and Demerits of EMV Risk Analysis Technique

The main advantage of EMV is that it allows decision-makers to quantify and compare the
potential risks and rewards associated with different alternatives, thereby facilitating
informed decision-making.

However, there are several limitations and potential biases associated with EMV that
should be taken into account:
1. Probability assumptions: EMV relies on accurate probability estimates, which can be
challenging to obtain, especially in complex or uncertain environments. If the probability
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assumptions are incorrect or biased, the EMV calculation may not accurately reflect the
true risk profile of the decision.
2. Limited scope: EMV only considers the expected value of a single outcome, which may
not capture the full range of potential risks and opportunities associated with a decision. In
some cases, it may be necessary to consider multiple outcomes or scenarios to fully assess
the risk profile of a decision.
3. Ignores non-monetary factors: EMV focuses solely on monetary outcomes, which may
not account for non-monetary factors that can have a significant impact on decision-
making, such as environmental, social, or ethical considerations.
4. Ignores uncertainty: EMV assumes that the probabilities of different outcomes are
known with certainty, which may not be the case in real-world decision-making.
Uncertainty can be addressed using sensitivity analysis or other techniques, but it is
essential to recognize that EMV may not fully capture the uncertainty associated with a
decision.
5. Can be manipulated: EMV can be manipulated by adjusting the probability estimates or
the outcome values, which can lead to biased decision-making. It is essential to ensure that
the probability estimates and outcome values are based on objective and unbiased data.

3.4 Pareto Analysis (The 80/20 Rule)

Pareto Analysis is a decision-making tool that can be used in risk management to prioritize
risks and allocate resources effectively. It's based on the Pareto Principle, also known as
the "80/20 rule," which suggests that a small number of causes often contribute to the
majority of effects.

In the context of risk analysis, Pareto Analysis involves identifying and categorizing risks
according to their impact or likelihood of occurrence. The next step is to rank these risks in
order of importance, usually by assigning a score or weight to each risk category based on
its potential impact or likelihood. Once this ranking has been completed, it becomes
possible to focus attention and resources on the most significant risks first. This approach
helps organizations to manage their risk exposure more efficiently and cost-effectively.
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Pareto Analysis provides several benefits for risk management:

1. Prioritization: By focusing on the most critical risks, organizations can prioritize their
efforts and ensure that they are addressing the areas of greatest concern first.
2. Efficiency: Pareto Analysis allows organizations to allocate resources more efficiently,
ensuring that time and money are spent where they will have the most impact.
3. Transparency: Using Pareto Analysis creates transparency around risk management
decisions, making it easier to communicate with stakeholders about why certain actions
are being taken.
4. Continuous improvement: Regularly conducting Pareto Analyses can help organizations
identify trends and patterns over time, allowing them to make improvements to their risk
management processes continually.

Application 3.4.1
Imagine that you are responsible for managing a commercial property portfolio consisting
of five buildings. You want to conduct a Pareto Analysis to identify the most significant
risks facing your properties so that you can prioritize your risk management efforts. To do
this, you follow these steps:
Step 1: Identify Risks
To begin, you create a comprehensive list of all the potential risks that could affect your
properties. Some examples might include natural hazards (e.g., floods, earthquakes), fire,
theft, vandalism, tenant defaults, maintenance issues, and environmental concerns.

Step 2: Assess Impact and Likelihood

Next, you assess the impact and likelihood of each risk. For instance, you might rate the
impact of a major fire on a scale from 1 to 10 (with 10 being the highest) and estimate the
annual probability of such an event occurring. Similarly, you would repeat this process for
every risk identified.
Likelihood Assessment
We assess the likelihood of a security threat occurring in the next 12 months. We consider
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factors such as customer traffic, different access routes, and the security measures in place.
We assign a numerical value to the likelihood, ranging from 0 (extremely low) to 1
(extremely high).
Say, Likelihood = 0.4 (Moderate)

Potential Impact Assessment

We assess the potential impact of a security breach, considering factors such as the number
of customers and personnel affected, the type of goods stolen or compromised, and the
potential financial loss for the company. We assign a numerical value to the potential
impact, ranging from 0 (minimal) to 1 (severe).
Say, PI = 0.7 (Significant)

Step 3: Calculate Risk Scores

Once you have assigned impact and likelihood ratings for each risk, you calculate a risk
score by multiplying the two values together. This gives you a single value representing the
overall risk associated with each threat.
Risk Score Calculation
We calculate the risk score by multiplying the likelihood and potential impact values.
Risk Score = Likelihood x Potential Impact = 0.4 x 0.7 = 0.28.

Step 4: Sort Risks by Score

After calculating the risk scores, sort them in descending order to identify the highest
priority risks.

Step 5: Create a Pareto Chart

First, sum up the risk scores and assign each of them percentages of the total sum. This
helps to understand the proportion of the total risk affecting the project, that a risk score
represents.
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Then, plot the sorted risks onto a Pareto chart using their percentages. A Pareto chart
consists of bars arranged in decreasing order of height, along with a line showing the
cumulative percentage of total risk represented by each bar. This visual representation
makes it easy to see which risks account for the bulk of the potential loss.

Here's what a sample Pareto chart for our hypothetical real estate portfolio might look like:

Figure 3.4.1

As we can see from the chart in Figure 3.4.1, the most incidental risk is illustrated with a
red bar, accounting for approximately 75% of the total risk score. Therefore, it makes sense
to prioritize risk management efforts in these areas. Specific actions might include
installing fire suppression systems, implementing rigorous tenant screening procedures,
and retrofitting buildings to better withstand natural hazards.
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3.5 Fishbone Diagram

A Fishbone Diagram, also known as an Ishikawa Diagram or Cause-and-Effect Diagram, is a
visual tool used to identify and analyze the potential causes of a problem or effect. It was
developed by Kaoru Ishikawa in the 1960s and has since been widely adopted as a risk
analysis tool in various industries, including manufacturing, healthcare, finance, and
construction project management.

The Fishbone Diagram consists of a main arrow representing the problem or effect being
analyzed, with smaller arrows branching towards it, each representing a possible cause or
factor contributing to the problem/effect. The problem or effect is placed at the “head” of
the fishbone. This is the issue you’re trying to explore or the risk you’re trying to mitigate,
and it is represented as the spine of the fish.

The branches are typically categorized into six major areas: People (staff), Processes,
Equipment, Materials, Environment, and Method. These categories can be adjusted based
on the specific context and industry.

To adopt a Fishbone Diagram for risk analysis, the following processes are applicable:
1. Define the Problem Statement: Clearly define the problem or issue that needs to be
addressed. This statement should be concise, measurable, and actionable.
2. Identify Potential Causes: Brainstorm potential causes or factors that may contribute to
the problem. Use the six major categories mentioned above to guide your thinking.
Encourage participation from team members who have different perspectives and
expertise.
3. Analyze Root Causes: Once you have identified all the potential causes, use data and
evidence to determine which ones are most likely to be root causes of the problem. You can
do this through techniques such as Pareto Analysis.
4. Evaluate Risks: For each root cause, evaluate the likelihood and impact of the associated
risks. Determine whether they are acceptable or they are to be mitigated.
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5. Develop Action Plans: Based on the risk evaluation, develop action plans to address the
root causes and reduce the associated risks. Assign responsibilities, timelines, and
resources necessary to implement these actions.
6. Monitor Progress: Regularly monitor progress towards achieving the desired outcomes.
Review the effectiveness of the action plans and adjust them as needed.
Figures 3.5.1 and 3.5.2 illustrate typical Fishbone Diagrams.

Figures 3.5.1: Fishbone Diagram showing the 6 options (More options can be added where
necessary)
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Figures 3.5.2 Fishbone Diagram showing a substitution of the 6 options.

3.6 Scenario Planning

Scenario Planning is a strategic planning methodology that involves creating multiple
plausible future scenarios to help organizations prepare for uncertain events and make
informed decisions about the future. It is a powerful risk analysis tool that allows
organizations to anticipate and plan for different types of risks, both internal and external,
rather than just reacting to them after they occur.

Here's how Scenario Planning works as a risk analysis tool:

1. Identify Key Drivers: Start by identifying the key drivers of change that could affect the
organization's success in the future. These might include economic trends, technological
innovations, regulatory changes, social shifts, political developments, environmental issues,
and other relevant factors.
2. Create Multiple Scenarios: Using the key drivers, create several distinct but equally
plausible scenarios that describe different ways the future could unfold. Each scenario
should explore different assumptions, uncertainties, and possibilities, while remaining
within the realm of possibility.
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3. Analyze Impact and Likelihood: For each scenario, assess the potential impact and
likelihood of key risks that might arise. Consider both positive and negative consequences,
as well as any opportunities or threats that might emerge.
4. Prioritize Risks: Rank the risks according to their severity and probability, taking into
account the organization's goals, values, and priorities. Focus on managing the highest
priority risks first.
5. Develop Strategic Options: Based on the prioritized risks, brainstorm and evaluate
alternative strategies that can help the organization respond effectively to each scenario.
Consider a range of options, from incremental improvements to transformative changes.
6. Test and Refine Strategies: Simulate how each strategy would perform under different
scenarios, testing its strengths and limitations. Adjust and refine the strategies accordingly,
making sure they remain flexible enough to adapt to changing circumstances.
7. Implement and Monitor: Choose the preferred strategies and put them into practice,
regularly reviewing and updating them as new information becomes available.
Continuously monitor the environment for emerging risks and opportunities, and adjust
the scenarios and strategies as needed.

Application 3.6.1
A real estate developer is considering investing in a large mixed-use development project
in the downtown area of Gaborone. The project includes residential units, office space,
retail stores, and public spaces. The developer wants to understand the potential risks and
opportunities associated with this investment over the next ten years.

Step 1: Identifying Key Drivers

* Economic growth and job creation in the region
* Changes in population demographics and preferences
* Interest rates and inflation
* Government policies related to housing, transportation, and urban development
* Technological advancements affecting construction, property management, and tenant
behavior
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Step 2: Creating Multiple Scenarios

Based on the key drivers, four scenarios were created:
1. Strong Economy: High GDP growth, low unemployment, increasing demand for
commercial and residential properties
2. Downturn Economy: Low GDP growth, high unemployment, decreasing demand for
commercial and residential properties
3. Tech Hub: Rapid adoption of technology and automation, shift towards remote work and
e-commerce, increased demand for modern offices and logistics centers
4. Green City: Growing awareness of climate change and sustainability, focus on green
buildings, renewable energy, and smart cities

Step 3: Analyzing Impact and Likelihood

For each scenario, the following risks were evaluated based on their impact and likelihood
as shown in Table 3.6.1:
Table 3.6.1: Different Scenarios that may occur during our Real Estate Investment
Risk Strong Downturn Tech Hub Green City
Economy Economy
Construction Moderate High Moderate Moderate
Cost Overruns
Leasehold Low High Moderate Moderate
Vacancies
Tenant Low High Moderate Low
Bankruptcies
Regulatory Low Moderate Low High
Compliance
Environmental Low Low Moderate High
Liabilities
Operational High Low High High
Efficiency
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Step 4: Prioritizing Risks

Based on the impact and likelihood assessment, the following risks were prioritized:
1. Construction Cost Overruns
2. Leasehold Vacancies
3. Regulatory Compliance
4. Environmental Liabilities
5. Tenant Bankruptcies
6. Operational Efficiency

Step 5: Developing Strategic Options

For each risk, the following strategies were considered as illustrated in Table 3.6.2:

Table 3.6.2: Strategic Options to Manage Risk

RISK STRATEGY
CONSTRUCTION COST Negotiate fixed-price contracts, engage early contractors
OVERRUNS
LEASEHOLD VACANCIES Offer flexible lease terms, target niche markets, provide
incentives for tenants
REGULATORY Stay updated on regulations, consult legal experts, adopt best
COMPLIANCE practices
ENVIRONMENTAL Conduct thorough due diligence, incorporate sustainable
LIABILITIES features, obtain insurance coverage
TENANT BANKRUPTCIES Screen tenants carefully, require financial guarantees,
diversify tenant mix
OPERATIONAL Invest in digital technologies, streamline processes, optimize
EFFICIENCY resource allocation
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Step 6: Testing and Refining Strategies

Each strategy was simulated under each scenario, and adjustments were made as follows:
In the Strong Economy scenario, the emphasis shifted towards maximizing revenue
streams and operational efficiency

In the Downturn Economy scenario, cost containment and cash flow management became
critical

In the Tech Hub scenario, the focus turned to adopting cutting-edge technologies and
attracting tech-oriented tenants

In the Green City scenario, incorporating sustainable design elements and promoting green
initiatives took center stage

Step 7: Implementing and Monitoring

The preferred strategies were implemented, and regular reviews were conducted to ensure
ongoing alignment with the evolving market conditions and risks. The developer continued
to track the key drivers and update the scenarios as needed, allowing for continuous
adaptation and improvement of the investment strategy. Through careful consideration of
various scenarios, the developer was able to develop robust and flexible strategies that
enabled the successful execution of the project, even amidst rapidly changing market
conditions.

3.7 Monte Carlo Simulation

Monte Carlo simulations are advanced statistical modeling techniques employed in risk
analysis to tackle complexity and uncertainty inherent in diverse fields, including real
estate, finance, economics, engineering, and scientific disciplines. Unlike deterministic
models predicated on single-point estimates, Monte Carlo simulations operate by
repeatedly sampling randomly drawn values from user-defined input parameter
distributions, constructing thousands or millions of potential outcome scenarios.
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Subsequent examination of output distribution statistics elucidates probable event

sequences, illuminating latent risk dimensions obscured by conventional point-forecasting
techniques.

Application 3.7.1
Let's say you are considering investing in a rental property, and you want to estimate the
potential return on investment (ROI) and the risk associated with this investment. Monte
Carlo simulation can help you do this by simulating different scenarios and analyzing the
results. It normally utilizes the following procedure:
1. Define the variables:
* Property price: P500,000
* Rental income: P3,000 per month
* Expenses (property taxes, insurance, maintenance, etc.): P1,500 per month
* Occupancy rate: 90% (i.e., the property is occupied 90% of the time)
* Rental growth rate: 2% per year
* Interest rate on mortgage: 4% per year
* Loan-to-value ratio: 80% (i.e., you need to put down a 20% down payment)
2. Determine the Monte Carlo simulation parameters:
* Number of simulations: 1,000
* Number of years to simulate: 10
* Random variables: property price, rental income, expenses, occupancy rate, rental
growth rate, interest rate, and loan-to-value ratio
3. Create a Monte Carlo simulation model:
* Use a spreadsheet software like Excel or Google Sheets to create a model that
simulates the real estate investment over 10 years.
* In the model, include variables for the property price, rental income, expenses,
occupancy rate, rental growth rate, interest rate, and loan-to-value ratio.
* Use random number generators to simulate different values for each variable in
each simulation.
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* Calculate the ROI for each simulation by dividing the total revenue (rental income
minus expenses) by the total investment (property price plus loan interest).
4. Run the Monte Carlo simulation:
* Run the simulation 1,000 times, each time using different random values for the
variables.
* Record the results of each simulation, including the ROI for each scenario.
5. Analyze the results:
* Calculate the average ROI across all simulations.
* Calculate the standard deviation of the ROI across all simulations.
* Create a histogram or distribution chart to visualize the distribution of ROI across
all simulations.
6. Interpret the results:
* The average ROI and standard deviation of the ROI can help you understand the
potential return on investment and the risk associated with the real estate
investment.
* The histogram or distribution chart can help you visualize the range of possible
outcomes and the likelihood of different ROI values.

For example, let's say you run the Monte Carlo simulation and get the following results:
* Average ROI: 8%
* Standard deviation of ROI: 2%
Based on these results, you can see that the real estate investment has a potential return on
investment of around 8%, with a standard deviation of 2%.

Advantages of Monte Carlo Simulations as a Risk Analysis Tool

1. Robustness: Integrating entire distributional arrays instills greater reliability vis-à-vis
traditional models anchored exclusively on precise estimates susceptible to error
propagation.
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2. Realism: Capturing erratic behaviors characteristic of real-world systems affords more

authentic representations, rendering predictions eminently suited for practical
applications.
3. Visualization: Graphical depictions foster intuitive comprehension, particularly in
discerniblizing convoluted interactions between interdependent variables.
4. Insights: Quantification of extreme events or rare tail occurrences, frequently overlooked
by simplistic methods, promotes prudent decision-making armed with worst-case
knowledge.
5. Transparency: Documenting assumptions, correlations, sensitivities, and convergence
criteria establishes audit trails, reinforcing credibility and fostering confidence among
stakeholders.

Limitations of Monte Carlo Simulations as a Risk Analysis Tool

1. Complexity: Computationally intensive algorithms necessitate specialized skills,
sophisticated software, and abundant processing capabilities, constraining accessibility for
novice users.
2. Data Requirements: Precise specification of input distributions mandates extensive
historical datasets, inflicting laborious data collection tasks fraught with pitfalls.
3. Model Misspecification: Improper characterizations introducing bias or distortion may
lead to flawed outputs, eroding utility and accuracy.
4. Interpretation Challenges: Distinguishing genuine signal from background noise assumes
paramount significance, particularly when dealing with copious scenarios harboring
minimal differences.
5. Time Consumption: Extended runtime duration prolongs feedback loops, impeding
prompt responses germane to dynamic situations.

Notwithstanding these drawbacks, Monte Carlo simulations serve as potent instruments

broadening horizons beyond narrow confines imposed by elementary linear regression,
correlation matrices, or variance decomposition tactics. Enlightened integration of Monte
Carlo simulations into risk analysis frameworks fortifies adaptability, augments precision,
 32

and embellishes sophistication, equipping decision-makers with dependable apparatuses

to grapple with increasingly volatile landscapes.

Guide to Learning Monte Carlo Simulation

https://youtu.be/BQv2Uyea8i4?si=0pJV4rGueCxhsFqm

3.8 Sensitivity Test

Sensitivity tests are essential tools for real estate investors seeking to quantify and manage
risks in their projects. They allow analysts to gauge the impacts of fluctuations in certain
variables on a proposed investment's viability and profitability. Simply put, it examines
how the real estate investment responds after being exposed to various changes in the
market. Consequently, it helps investors to identify weak points in their models, stress-test
their assumptions, and ultimately inform strategic decision-making.

In a real estate investment context, sensitivity tests often involve modifying one or more
inputs in a discounted cash flow model or another financial forecasting tool. Typical
variables subjected to sensitivity tests include:
1. Capitalization Rate (Cap Rate)
2. Discount Rate
3. Net Operating Income (NOI)
4. Initial Cash Outlay
5. Exit Cap Rate
6. Holding Period
7. Financing Terms
8. Maintenance Expenses

Application 3.8.1
Assume a real estate developer intends to purchase a P1 million apartment building
generating P100,000 per year in NOI, with financing consisting of a P600,000 mortgage
amortized over 25 years at a 6% interest rate. After completing a detailed financial
 33

analysis, the developer determines the property's net present value (NPV) is P150,000
assuming a 10% discount rate and a hold period of 5 years. To assess the impact of
variations in capitalization rates, discount rates, and maintenance expenses, the developer
performs a sensitivity test as shown in Table 3.8.1.

Table 3.8.1: Sensitivity Test

Variable Base Case Value Lower Value Higher Value
Interest Rate 6% 5% 7%
Discount Rate 10% 9% 11%
Maintenance P1,000 P900 P1,100
Expense
(P/unit/year)

Using the base case values, the developer calculates NPV, Internal Rate of Return (IRR), and
Debt Service Coverage Ratio (DSCR) (solvency). Note that to calculate the DSCR, one needs
to ascertain the amortization value first before substituting it in the DSCR formula:
DSCR = Total debt/NOI

Then, repeat the calculations for the lower and higher cases. The results will reveal
significant variations in NPV, IRR, and DSCR as some variables increase or decrease.
Furthermore, sensitivity tests enable comparisons between competing investment
alternatives, supporting informed decisions about allocating limited resources and
maximizing returns. Thus, integrating sensitivity testing into risk analysis frameworks
contributes to enhancing overall portfolio management strategies for real estate investors.

4.0 RISK PRIORITIZATION

4.1 Pareto Analysis (The 80/20 Rule)
In the context of risk prioritization, Pareto Analysis plays a crucial role in helping
organizations determine which risks require immediate attention and which ones can be
addressed at a later stage. Risk prioritization is essential because it enables organizations
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to allocate limited resources towards managing the most significant risks first. Here are
some ways in which Pareto Analysis supports risk prioritization:

1. Identifying high-impact risks: Pareto Analysis helps organizations identify the risks that
could have the most substantial negative impact if they materialize. These risks may
include those related to financial losses, reputational damage, regulatory compliance,
safety, or operational disruptions.
2. Ranking risks: After identifying the high-impact risks, Pareto Analysis ranks them based
on their severity, likelihood, and other relevant factors. Organizations can then use these
rankings to develop a prioritized list of risks requiring urgent attention.
3. Allocating resources: With a prioritized list of risks, organizations can allocate resources
accordingly. They can direct funds, personnel, and technology towards mitigating the most
severe risks while minimizing investments in low-priority risks.
4. Monitoring progress: Pareto Analysis also facilitates monitoring progress towards
reducing high-priority risks. Organizations can track their performance against established
metrics and adjust their strategies as needed to achieve desired outcomes.
5. Communicating priorities: Finally, Pareto Analysis provides a clear framework for
communicating risk priorities to stakeholders. Organizations can present data
visualizations, such as Pareto charts, to demonstrate the relative significance of different
risks and how they plan to address them.