Several common themes have emerged when we have worked with clients on their investment process. One issue has been how to adjust the expected return for the level of property specific risk?

Splitting specific and market risks was one of the great insights of Modern Portfolio Theory. If you have preferred games of chance to investment text books then you have probably grasped the concept already: specific risk is where there are multiple potential outcomes around a common mean. In the case of dice, the mean is 3.5, with individual rolls of any number between 1 and 6.

There are many specific risks that need to be incorporated into property analysis, such as the probability of lease renewal, variable letting periods and covenant strength. As a lease expiry gets closer the value of a property is reduced in proportion to the likely average potential vacancy period and increased costs.

Adjusting the value can be achieved either through adjusting the yield or adjusting the cash flow – the answer using either method should be identical. At RES we prefer to be explicit in our assumptions for reasons that will become clear in future posts.