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.
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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.