Risk Analysis of Institutional Investors in The Private Rental Sector Can Be Enhanced with Probabilistic Risk Modelling

Abstract

This paper investigates the use of traditional risk analysis in investment decision-making in the private rental sector in the Netherlands and how probabilistic risk modeling and Monte Carlo simulation can expand and improve this risk analysis. Semi-structured interviews with institutional equity capital providers in the rental sector offered insights into how they consider risk in their investment decisions. In addition, the benefits of probabilistic modeling to better capture risk will be analyzed through an investment case study of traditional residential discounted cash flow analysis complemented with Monte Carlo Simulation. Interviewees highlighted four methods to analyze risk; scenario analysis, sensitivity analysis, risk-mitigation matrix and in some cases the risk premium versus the risk-free rate. Investors either used all four metrics or selected a few. None of the institutional investors employed probabilistic risk modeling in their investment decisions. All mentioned they lacked a metric to clearly capture risk in one number; in the same way they use the internal rate of return to capture their expected returns. Probabilistic risk modeling using Monte Carlo simulation based on traditional cash flow projections can provide that single probability number to capture the probability of achieving the mandated return requirements. This study is limited to risk analysis by institutional investors in the private rental sector in the Netherlands. Probabilistic modeling for larger residential projects, which are characterized by frequent tenant turnover and a volatile rental market, is likely to provide more quantitative insights into risk than the traditional qualitative tools currently used. Practical/Social implications: When risk is captured in one standardized probability number and linked to the expected internal rate of return, a sharp style ratio can be calculated. This enhances risk-return investment decision-making for institutional investors and makes ranking and selecting investments better and easier. Better risk adjusted allocation of pension fund capital provides better outcomes for pensioners. This paper presents a solution to the “single risk metric” residential investors in the private rental sector are missing. This metric aligns with risk as defined in prospect theory where investors assess risk versus a reference point, the mandated target return.