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Shifts that impact the economics of real estate

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Shifts that will impact the real estate industry over the next decade, according to Christopher Lee, author of "Leading a Real Estate Company: Winning Strategies for the Next Decade," include a shift from historical precedents to innovation.

"There are unlimited opportunities available for those firms that innovate and exhibit new ways of creating, adding and protecting value for their customers," Lee said.

There is also a shift from information gatherers to knowledge workers. According to Christopher Lee, the "'80s business style is rapidly being replaced by those who know how to take information, which is readily available to all who want it, and convert it into knowledge that enables a customer to achieve a competitive advantage."

In real estate however, there is always a risk factor involved. So when considering an economic forecast, let us imagine any of the following three scenarios:

* Your client can acquire one of two buildings. They both have the same internal rate of return (IRR). Do they have the same risk? Of course they do not; thus, the two IRRs cannot be the same even though they are the same nominal amount. How do you distinguish between two 18.75 percent IRRs on the basis of comparative risk?

* Two brokers compete for the listing on a building. One broker tells the seller he can sell the property for a 6 percent capitalization rate, the other for a 5.5 percent capitalization rate. Of course, the broker who claims he can get the 5.5 percent cap rate gets the listing and the one who was right does not. The property is on the market for an extra 90 days at the higher price, during which time interest rates rise. The property finally sells at a 6.5 percent cap rate. How could the seller have avoided a mistake that cost him thousands of dollars?

* Your buyer client complains that the seller's price is too high. The seller's agent counters with the claim that rents can be raised. Your client admits that this might be true but wonders how much rent can be raised and what sort of difficulties come with doing so. He asks you to do some research on this and provide an analysis of the probability that rents can be raised by a certain percent over a particular time period.

These are all risk questions. "Why is this one a better deal than the other?" Today's investors want more sophisticated information. They see their neighbors involved in some sort of risk management and ask, "Why can't this be done for me?"

Risk is a science. Insurance companies, banks, doctors, civil engineers and stockbrokers all have highly developed and sophisticated risk models. Some models are more complex than others, but all help manage risk in their respective fields.

Risk is also a cost. One would not think of projecting a property's income and completely ignore its operating expenses. Yet every day real estate returns are projected without any reference to the associated cost. Intuitively everyone knows that high returns are not free, that increased return is accompanied by higher risk. But how do we quantify the extra cost associated with higher risk?

At the base of the science of risk is probability theory. In every transaction, a real estate investor implicitly asks, "What are the chances of that?"

Real estate is multidimensional and dynamic. Its complex nature calls for complex analysis, but analysis that is readily available to the investing public and their advisers.

Data vendors will deliver large amounts of data in bulk, permitting you to organize and analyze the data. Alternatively, there are tailored data packages that are ready for input into spreadsheets or Internet-based applications.

Gather the information that is available for you. Become knowledgeable and innovative. This will lesson the risk factor and avail you to unlimited opportunities in creating value on your investment.

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