Effect of Seismic Risk on Lifetime Property Value
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Effect of Seismic Risk on Lifetime Property Value a) b) Keith A. Porter, M.EERI, James L. Beck, M.EERI, Rustem V.Shaikhutdinov,c) Siu Kui Au,d) Kaoru Mizukoshi,e) Masamitsu Miyamura,f) Hiroshi Ishida,e) Takafumi Moroi,g) Yasu Tsukada,h) and Manabu Masudai) We examine seismic risk from the commercial real estate investor’s view- point. We present a methodology to estimate the uncertain net asset value (NAV) of an investment opportunity considering market risk and seismic risk. For seismic risk, we employ a performance-based earthquake engineering methodology called assembly-based vulnerability (ABV). For market risk, we use evidence of volatility of return on investment in the United States. We find that uncertainty in NAV can be significant compared with investors’ risk tolerance, making it appropriate to adopt a decision-analysis approach to the investment decision, in which one optimizes certainty equivalent, CE,asop- posed to NAV. Uncertainty in market value appears greatly to exceed uncer- tainty in earthquake repair costs. Consequently, CE is sensitive to the mean value of earthquake repair costs but not to its variance. Thus, to a real estate investor, seismic risk matters only in the mean, at least for the demonstration buildings examined here. [DOI: 10.1193/1.1810536] INTRODUCTION One of the most frequently occurring seismic-risk management decisions arises dur- ing the sale and resale of high-value commercial real estate in seismically active regions. A commercial building in the United States can change hands on the order of every five to ten years; the same is becoming true of foreign-owned real estate in Japan. In Cali- fornia and Japan, every time such a sale is made using a commercial mortgage, a study is performed to inform the lender of the building’s probable maximum loss (PML). Though there is no commonly accepted quantitative definition of earthquake PML (Za- deh 2000, ASTM 1999), most working definitions involve the level of loss associated with a large, rare event such as a shaking with 0.002 mean annual exceedance frequency. Lenders refuse to underwrite a mortgage if the PML exceeds a threshold amount, usually a) G.W. Housner Senior Researcher, California Institute of Technology, Pasadena, CA 91125 b) Professor of Applied Mechanics and Civil Engineering, Caltech, Pasadena, CA 91125 c) Doctoral candidate in Applied Mechanics, Caltech, Pasadena, CA 91125 d) Assistant Professor, Nanyang Technological University, Singapore e) Kajima Technical Research Institute, Kajima Corporation, Tokyo, Japan f) Kobori Research Complex, Kajima Corporation, Tokyo, Japan g) Deputy Senior Manager, Kobori Research Complex, Kajima Corporation, Tokyo, Japan h) Real Estate Development Division, Kajima Corporation, Tokyo, Japan i) Architectural and Engineering Design Division, Kajima Corporation, Tokyo, Japan 1211 Earthquake Spectra, Volume 20, No. 4, pages 1211–1237, November 2004; © 2004, Earthquake Engineering Research Institute 1212 K. A. PORTER ET AL. 20% to 30% of the property replacement cost, unless the buyer agrees to purchase earth- quake insurance, out of concern that at greater levels of loss, the borrower might default on the mortgage. Thus, PML is of primary concern to lenders rather than borrowers, whose information and decision-making needs during bidding and purchase primarily involve aspects of the net asset value (NAV) or return on investment (ROI). For present purposes, we define NAV as NAVϭI͑t͒ϪL͑t͒ (1) where I(t)ϭUncertain discounted net income stream over t, the lifetime of the building L(t)ϭUncertain discounted future earthquake losses over the lifetime of the building What effect does seismic risk have on NAV of a real estate investment? Bear in mind that the investor’s bidding decision involves other sources of risk besides seismic, such as the possibility that future market rents will be lower than expected, or that vacancy rates or operating expenses will be higher, etc. We refer to these noncatastrophe possi- bilities collectively as market risk. How does seismic risk compare with market risk? In other words, from the real estate investor’s viewpoint, does seismic risk matter? If it does, how can investors consider both market and seismic risk in making a purchasing decision, without radically changing their business practices? Under the sponsorship of the CUREE-Kajima Joint Research Program, Phase IV, we set out to address these ques- tions. RESEARCH OBJECTIVES Our research objectives were fivefold: 1. To learn directly from real estate investors how they actually make their pur- chasing decisions. How does the investment decision situation arise? How many and what decisions do they make before a property is purchased? On what ultimate economic values do they base these decisions? What informa- tion do they receive or collect, and how is that information generated and ana- lyzed to estimate the value outcomes? 2. To understand how market risk is quantified in practice and to propose proce- dures for quantifying it for use along with seismic risk in the investment de- cision situation. 3. To define a procedure for calculating the probability distribution of NAV, in- cluding calculation of variance and higher moments of discounted future earthquake losses. 4. To formulate a decision-analysis approach to making real estate investment de- cisions, without requiring a costly change to current business practices. 5. To exercise and illustrate these procedures using demonstration buildings in California and Japan. When exercising the procedure, we sought to do so for two or more realistic risk-management alternatives for each building, such as buy and do nothing, purchase earthquake insurance, or perform seismic reha- bilitation. EFFECT OF SEISMIC RISK ON LIFETIME PROPERTY VALUE 1213 PURCHASING DECISION INVESTOR COLLABORATION We arranged collaboration with two U.S. investment firms; let us refer to them as A and B. Company A is a small real estate investment group with four employees, special- izing in class-A commercial properties in the range of $10 to $100 million value in the San Francisco Bay area. Company B is a publicly traded real estate investment trust (REIT). It specializes in developing, investing in, and managing large commercial prop- erties in California, including office, retail, and mixed-use buildings. It owns and man- ages a total inventory in the range of 10 to 50 million square feet. A typical property might be 50,000 square feet to 500,000 square feet in area, class-A, low-rise, mid-rise, or high-rise. We spoke with an investment decision maker in each company, first, to as- sess his subjective risk attitude; second, to summarize the current practice of investment decision making; and third, to assess the reasonableness of the methodology resulting from the research. Results of these interviews are now summarized. INVESTMENT DECISION PROCESS Broker information package. Typically, a real estate broker approaches the investor with a package of information about an investment opportunity. The package contains a description of the property, area measures (occupied and total by type of use), informa- tion about the rent roll including income and lease term for each tenant, expected op- erational and capital expenses, and all other details necessary to perform a financial analysis of the property. The information is often provided in both paper and electronic format. Preliminary assessment. The investor follows a two-stage analysis approach: in the first stage, the investor decides whether and how much to bid on the project. The analysis of the property during this stage is limited to a few labor hours. The property is screened to ensure that it is in the investor’s market segment and of appropriate size and quality. The pro forma financial assumptions presented by the broker are assessed for reason- ableness using in-house expertise. These assumptions include lease marketability, future vacancy, condition, and cost of management. A deterministic financial analysis is then performed to determine the yield on investment, with an analysis period of five to ten years. Limited studies are performed to determine the sensitivity of the yield to key un- certainties such as future vacancy rate and property rent inflation. The parameters of the analysis are summarized in Figure 1, based on Byrne and Cadman (1984). This first stage lasts two to four weeks, after which the first bidding round begins. A top executive at the level of president typically decides whether and how much to bid, based on the results of these preliminary analyses. Company A’s investment decision typically uses yield as the investment criterion; if the property will yield more than ap- proximately 10%, the company will bid. Within four to six weeks of the first bidding round, a winning bidder is selected. The winning bidder is not yet committed to the pur- chase, which is typically contingent on the results of a detailed due-diligence assessment of the property. The due-diligence stage can last 30 to 45 days. 1214 K. A. PORTER ET AL. Figure 1. Calculation of the present value of an existing income property. Due-diligence assessment, including PML. The due-diligence assessment is more extensive than the preliminary assessment. In this latter stage, attorneys confirm the leasing conditions with the current tenants, and engineers review all aspects of the prop- erty, including structural, architectural, mechanical, electrical, and plumbing compo- nents. The purpose of these engineering analyses is to determine the need for mainte- nance and improvement expenses. The cost of these analyses for a recent $75 million investment by Company A was $50,000. Company B recently spent $100,000 on a due- diligence study of a $150 million property, and $30,000 for a study of a $25 million property. For buildings valued in excess of approximately $10M, the due-diligence assessment includes a study to evaluate earthquake risk, typically quantified as probable maximum EFFECT OF SEISMIC RISK ON LIFETIME PROPERTY VALUE 1215 loss (PML).