This is the first in a two-part series on how to assess risk in real estate investments. Part one provides an overview of risk, along with the historical context. Part two delves deeper into the six main areas of risk management. 

Real estate investment professionals are likely to have seen a wide variance of results across their historical investments, with negative surprises coming from regional markets – be that supply, demand or more neighborhood factors — or from capital markets, leverage, the unknown, or from operational surprises. Yet these investors have stuck with real estate as worthwhile given the other investment alternatives, each surprise being a lesson from which to manage in the next investment. This chapter will break down different risks to better prepare readers for pitfalls that could be avoided.

Historical Context for Risk in Real Estate

In examining the history of real estate investing, the last 40 years have seen not only issues with individual properties, but often have experienced risks coming from the sector itself.  Both supply and demand have had nationwide effects. In fact, evidence shows that commercial mortgage defaults have been more the result of national supply and demand trends then they have resulted from issues with individual properties.  For this reason, understanding risks from the market, or as they are often referred to “market fundamentals,” should be a primary exercise.

There are historical examples with wide applicability. Infamously, the commercial real estate downturn in the early 1990s saw the industry suffer more than other industries in the same recession. This result was built in the construction boom of the 1980s. 

Even before the recession and despite years of strong demand, the amount of construction drove vacancy rates to highs even before the economy slowed. This set up markets like the Dallas office market for extreme declines once the economy slowed. Even on a national level, it is telling that vacancy rates did not reach the highs of the early nineties even in this last severe recession.

The severity of the nineties office downturn is not to say that the economy cannot be a primary risk. Taking another historical example, the San Jose office market in the late nineties could barely keep up with demand coming from dot-com companies. The need for more buildings springs from more employment. It should not surprise, then, that when dot-com companies went bust, Silicon Valley internet companies quickly emptied out of buildings. In addition to leaving high vacancy behind, the prevalence of sublease space offered by bankrupt companies put further downward pressure on rents with so much competition in the market.

Though the national economy and national supply trends can have profound effects, differences across markets that can be positive or negative are also important.  Many analysts start with an understanding of metropolitan areas, that is cities and their suburbs combined. This is proper because most economic activity takes place within rather than across these areas. 

Though not true for each individual tenant, there is enough of a pattern of choosing locations across the city and suburbs combined that rents tend to be driven largely by demand, supply and vacancy trends in metropolitan areas. As such, a metropolitan economy with a stronger industrial mix or an area where there is a building boom in the broader area can wind up doing better and worse respectively than national statistics on a particular property type would suggest. This is at the core of diversification strategies, but it is also the reason for considering employment forecasts or counts of square footage under construction at the metropolitan level.

Within metropolitan areas there are often differences from neighborhood to neighborhood.  While it is difficult for a real estate asset to fully escape the effects of the metropolitan area within which it resides, submarkets (for example, a downtown) may lead or trail the market based on submarket supply and demand trends. This comes from even more specialized industry concentrations and supply responses to those. Again, understanding the submarket surrounding a building and forming opinions on the future of that submarket should be part of a company’s due diligence.

While building returns are correlated and buildings within a submarket are even more highly correlated, event risk has certainly struck individual buildings. 

Some events that can strike the physical building will be discussed later in the chapter, but an understanding of additional building risk can come from thinking of the income stream of the building as a collection of leases. This can allow risk mitigation as well as risk-reward trade-offs. As a strategic choice, management of the property can add or subtract value.  To take some extreme examples, a building that has a 20 year lease to a AAA rated tenant will perform very differently than a building that looks the same but signs leases that frequently roll to a number of tenants. 

The first building is likely to see a very stable income stream while the second can take full advantage of rising rents but will also be fully exposed to falling rents. Compound this simple example with the related risk from tenants. In managing a property, a landlord cannot be guaranteed that any particular company will survive for the length of its lease. 

Again, the leasing process can examine this issue as part of mitigating or at least understanding risk.

Overview of Risks

The goal of measuring and managing risk in any portfolio is twofold:

  1. Develop an accurate expectation of the range of possible outcomes (returns) for the portfolio
  2. Estimate the probability of the portfolio value moving  below the expected range and causing a shortfall 

Shortfall risk is the risk that a portfolio won’t have sufficient funds, by a certain time, necessary to meet its intended purpose. A shortfall can be caused by a wide range of factors, some that can be foreseen and others that cannot. In this excerpt from my book, dskjlsdfjlksfda, we will cover a range of risks that can impact a real estate investment or a portfolio containing real estate, including:

  • Liquidity
  • Leverage
  • Macroeconomic
  • Capital markets and interest rates
  • Information and analytical
  • Operational and other non-market risk

As long as the return of the portfolio exceeds that of the liability the investment program is considered successful. Although there is a range of possible outcomes for the value of the portfolio, these were estimated beforehand and viewed as acceptable risks.

A bad outcome occurs when the portfolio’s return is less than the liabilities’ and there is a shortfall. This can be caused by mis-estimating the risks listed above or from an unforeseen event. In either case, it is the goal of risk management to minimize the probability of generating a shortfall.

Read previous installments from David Lynn:

  1. 5 ‘Whys’ for Commercial Real Estate Investing
  2. Best Places for Commercial Real Estate Investments: Office Sector

The above article was drawn from The Advisor’s Guide to Commercial Real Estate Investment, and originally published by The National Underwriter Company, a Summit Professional Networks business as well as a sister division of ThinkAdvisor. As a professional courtesy to ThinkAdvisor readers, National Underwriter is offering this resource at a 10% discount (automatically applied at checkout). Go there now.