This is the second 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.
Liquidity risk is the risk that an investment cannot be sold, in the expected timeframe, at or near its latest marked price. eal estate is generally not traded on an exchange and therefore has significantly greater liquidity risk than stocks, bonds or commodities. It is critical when constructing a portfolio that includes real estate to take this into account.
The financial crisis of 2008 revealed that many portfolio managers (PMs) overestimated the liquidity of private investments, such as real estate. Post Lehman’s collapse, transaction volumes fell and some funds set up queues to manage investors’ requests to withdraw their funds. Portfolio managers had no choice but to sell more liquid assets to meet the cash flow needs of the portfolio’s beneficiaries. This resulted in the portfolios becoming unbalanced, deviating from their long term asset allocation targets and further elevating the allocation to the illiquid asset classes.
What can be done to mitigate liquidity risk? The first step is to understand it. Most real estate investment funds have very specific rules that govern how much money can be withdrawn from the fund over specific time periods. They also describe procedures, such as gates, that could be implemented if a group of investors request redemptions greater than permitted in a given period. It is critical that the portfolio manager understand these rules and the impact they could have on his portfolio.
For portfolios that aren’t required to generate periodic cash flows, liquidity risk in not a major concern. For example, if the portfolio will be used to fund a lump sum, many years in the future, it may not be necessary to take this risk into account when making an investment. However, most portfolios are used to fund more immediate needs. An endowment would most likely need to make monthly or quarterly payments to support its institution and a retirement portfolio needs to make monthly payments to the retiree. In these situations, liquidity risk can have a significant impact on the overall success of the investment program and result in shortfall risk.
Many portfolio managers will run stress tests on their portfolios to better understand the potential impact of liquidity risk. Most portfolios are well diversified and have sufficient liquid assets to meet a number of years of expected payments, so the risk is not running out of money. It is more that in a liquidity event the portfolio becomes significantly out of balance due to the withdrawal of funds only from the liquid assets.
The point is not to scare investors away from illiquid assets. It is to demonstrate that a liquidity event can have a significant impact on a portfolio and the portfolio manager needs to understand and be comfortable with this risk before investing.
Information and Analytical Risk
Most registered investments such as stock, bonds and mutual funds operate under very specific information disclosure rules mandated by the SEC and other state and federal entities. Private investments and funds, including private real estate funds, are generally not bound by these regulations. Specifically, this means that performance results may be released less frequently and with more of a delay. Information about material changes in the fund’s investments or personnel might not be disclosed as rapidly, if at all.
Over all, the PM should not assume that the information available on any private investment will be similar to that of a registered vehicle.
This information risk can be managed in a number of ways. The first is to have a clear understanding of the frequency, timeliness and quality of the information the fund will deliver. Furthermore, the due diligence process takes on additional importance as does the reputation and experience of the firm and the team managing the real estate fund. In addition, the quality and reputation of the support service providers such as the auditor, appraisers, outside council, custodian, etc. are more critical as they represent the investors’ interest in the fund. Finally, since the underlying investments in a real estate fund are brick and mortar buildings, their fundamentals generally don’t change as rapidly those of a stock or bond. As a result, less frequent disclosure of performance results are not that significant a worry for the investor.
Most portfolios containing real estate fund(s) will also contain other assets such as stocks, bonds and cash. Various techniques exist for determining the optimum mix of these assets based on the investor’s risk and return objectives. Modern Portfolio Theory (MPT) is one method that is broadly used in the industry for this purpose and results in the commonly used concept of the efficient frontier. There are many inexpensive software packages that can perform this analysis in a spreadsheet or on a tablet.
The challenge with any MPT approach is that it relies on future estimates of each asset’s return, risk and correlation with each other. Most forecasts start with historical return series as a guidepost for estimating future return and risk. This is more difficult to do for real estate and leads to the second risk of this section – estimation risk.
Estimation risk results mainly from the observation that real estate returns exhibit serial correlation. That is, each quarter’s return is not an independent event but is correlated with the prior quarter’s return. This can result in an under-estimation of the volatility of a real estate investment and its correlation with other asset classes.
It’s easy to explain why real estate returns would be serially correlated. There are two main factors. The first is due to the relatively high income component of the return, (which is one of the key reasons people invest in real estate). If a real estate portfolio generates an income stream of 8% per year, or 2% per quarter, it would be relatively easy to predict next quarter’s return based on what the fund delivered this quarter. This is one of the attractive qualities of real estate, but it must be compensated for when analyzing real estate relative to other asset classes.
The second cause of the serial correlation is due to the way real estate is priced – the appraisal process. Unlike a publicly traded security, such as a stock, whose price reacts daily to all available new information, real estate prices move much more slowly. Appraisals are generally done at most quarterly and in many cases annually. To get monthly return data, necessary for comparison with publicly traded assets, most analysts simply interpolate between data points. This results in a much smoother data series than a corresponding publicly traded stock or bond with a similar return.
All investments have embedded in their price the market’s view of the future path of the global or local economy. Equity analysts have an underlying view on economic growth when they evaluate a consumer product or technology company. A fixed income PM is taking a view that the economy will keep growing and interest rates will remain stable when she buys a corporate bond. The same is true in real estate. Projecting out the future occupancy rate, rent per square foot, maintenance costs, discount rate and other variables requires a view on economic growth and inflation.There is no need to have a perfect forecast to successfully invest in real estate; however, gross errors, particularly overly optimistic forecasts, can result in significant shortfall risk.
Understanding interest rate risk, specifically understanding the impact of changing interest rates on the portfolio, is critical. The value of a property is effectively the expected stream of future income discounted at a discount rate or cap rate. This discount rate is determined by many factors, but a key component is the comparable rate of interest available in the bond market. Bond rates can be very volatile and move within a wide range. Although property values don’t respond instantly to these changes, over the medium they can be very impactful.
There are a number of factors that cause bond interest rates to move – changes in monetary policy by the Federal Reserve, increases or decreases in the demand for bonds, changes in inflation and inflation expectations, currency fluctuations, financial crisis, etc. All else being equal, property values move inversely with the cap rate. When cap rates go up, property values decline.
Many investors view the spread of the cap rate minus the 10 year Treasury bond yield as an indicator of demand for property. The cap rate itself can move even if the 10 year Treasury rate is stable. This spread can be thought of as a risk premium for real estate. When real estate is viewed as very attractive and the outlook is positive this spread will contract and property values will rise. Conversely, during periods of market distress the spread will rise and property values will fall.
Cap rate volatility is unavoidable when investing in real estate. It is important that the PM have a good estimate of the range of possible cap rates and know the impact this will have on the return of the portfolio. Given the volatility experienced over the past few years, using history as a guide for the future range of cap rates is an acceptable technique.
Unanticipated inflation is a risk that investors in any nominal instrument face. (A nominal instrument is an investment whose return is not adjusted for inflation.) Inflation erodes the purchasing power of a portfolio since the assets can purchase fewer goods and service than before prices rose. Real estate is a good hedge against inflation because rental rates usually increase proportionally with inflation as leases come up for renewal. Increasing rental rates increase the yield on the property and ultimately restore the property’s inflation adjusted value. Therefore, real estate can serve as a good inflation hedge in a multi-asset portfolio.
Since the value of a property is critically dependent on the net income it generates, accurately forecasting net income is imperative. There are a multitude of factors that go into this forecast, one of the most important being the economic growth of the regions that the tenets are exposed to.
Occupancy rates and lease rates are both heavily influenced by economic growth. If economic growth surprises to the down side for an extended period of time, companies will likely downsize or go out of business, resulting in higher vacancy rates. Businesses would cut back on travel, leading to fewer hotel room bookings, impacting hospitality properties. Furthermore, consumer income would grow more slowly or contract, adversely affecting the retail and hospitality sector. Less freight would move leading to a decline in the demand for warehouse space. Finally, expectations of future lease rate increases would need to be adjusted during a protracted economic slowdown. The impact of unanticipated declines in growth can ripple through the entire real estate market.
One way to mitigate some of this economic risk is to diversify regionally. This can include not only investing in different cities within the U.S. but internationally as well. It is also important to understand and be comfortable with the economic projections of the real estate fund manager. Compare their forecast to publically available consensus surveys. The Survey of Professional Forecasters, published by the Federal Reserve Bank of Philadelphia, is a great source for this information.
Geographic diversification is also an effective way to mitigate earthquake risk, terrorism risk, industry concentration risk and other risks specific to one specific city or region.
One additional macroeconomic to consider is deflation, a general and broad based decline in the overall price level. Although deflation has been very rare since the advent of fiat money based monetary systems, it could occur in severe recessions.
For the truly long term investor (with deep pockets), the short term fluctuations in values could be looked past if their belief remained that the value of the property would eventually increase beyond where it was purchased. But even long term investors can get themselves in trouble giving in too much to the temptation of leverage.
Leverage is the technique of borrowing money to purchase more assets than the capital available. It will increase return on capital when markets go up and result in accelerated losses when prices fall. Leverage is not inherently bad and many investors desire the more volatile return stream a leveraged investment provides.
So if an investor put $1,000,000 into a fund, the fund borrows an additional $1,000,000 and invests $2,000,000 in property, the fund is levered 2x or 2:1.
Real estate investors are most likely very familiar with this concept since a mortgage is a form of leverage. A property that is mortgaged with a loan to value ratio of 50% is levered 2:1.
While leverage is not inherently bad and commonly used in real estate investing, it does make the portfolio more risky. It increases the volatility of the portfolio by a factor of the leverage ratio. So if a portfolio is levered 2:1, the value of the portfolio will change twice as fast as the value of the underlying property it contains. The portfolio manager must understand this and be comfortable with the additional volatility of the investment.
Leverage can also multiply the impact of any errors made by the fund manager when purchasing a property. Consider a fund manager who analyzes a property by projecting out a future income stream and discounts that stream by a discount rate. The manager determines the property is worth $10,000,000, obtains a mortgage for $5,000,000 and invests $5,000,000 of his client’s funds. This investment is levered 2:1.
What happens if the fund manager made an error in his calculations and it turns out that the property is worth 10% less than he paid, or $9,000,000. Since the investment is levered 2:1, the loss on the investment is twice the loss on the building, or 20%. Therefore, manager skill becomes much more critical when leverage is used.
Finally, there is the potential for total loss in a levered portfolio. Consider again a portfolio of properties all levered 2:1. If the properties decline by 50%, the entire investment is wiped out. Although sharp declines in value such as this are rare, it again illustrates have leverage increase the portfolio’s dependency on the manager’s skill.
Operational and other non-market risk
Every company, whether a large, publicly traded entity or a small business, faces operational and other non-market risks. Non-market risk can be defined as those risks pertaining solely to a property or fund and not resulting from developments in the overall market. Operational risk is a subset of non-market risk. The Basel Committee on Banking Supervision defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.”
There are generally two layers of risk management for investors in a public company. The first layer of defense is the risk management department of that company. It is their job to provide company management with the tools necessary to decide which risks are acceptable and which are not. The second layer is the analyst who covers the company. The analyst should provide the PM with an opinion on the quality and sufficiency of the risk management process of that company.
Since a stand-alone property doesn’t have its own risk department, real estate investors have just one layer of risk protection – the real estate fund manager. Therefore, it is important that the PM investing in a real estate fund have a general overview of the infrastructure necessary to support a broad range of properties and the specific risks that properties may be exposed to.
One broad category of specific risk is casualty risk. This includes:
- Natural disaster – Earthquake, flood, hurricane, tornado – etc.
- Terrorist act
- Environmental contamination
One of the main methods for mitigating casualty risk is through insurance. Most of these casualties can be insured for; however, insurance may not be available for all events at all times. For example, shortly after 9/11, terrorism insurance was in short supply in a number of metropolitan areas.
Another way to diversify a number of these risks, including natural disaster and terrorism risk, is through geographic diversification. A fund should hold properties spread across various metropolitan areas. International diversification also helps. Unless the fund’s objective is to invest in a specific metropolitan area, geographic diversification is a critical risk management tool.
A real estate fund must also provide critical services to operate the property on a day-to-day basis.
While modern commercial real estate analysis has placed more emphasis on the financial aspects of a real estate investment, an investment gone wrong can quickly remind an investor that what they have purchased is a real asset. Buildings need constant maintenance, and as with the investment in your house, buildings that are not maintained can find themselves with costly capital expenses to say, repair a major heating and air conditioning system. As with the broader question of pro forma financials, a proper estimation of capital expenditures is crucial to arriving at an acquisition price as well as understanding how ongoing capital improvement can make cash on cash yields differ from quoted cap rates. This is because the accounting of what a cap rate is excludes capital improvements.
One of the best ways of mitigating operational risk is to invest in funds that have a proven track record of performing these functions well. In addition, look for funds where the managers have invested a significant portion of their own money. They have “skin in the game,” and have added incentive to ensure that these functions operate well.
Investing in real estate can provide many benefits to a portfolio. However, it also exposes the portfolio to risks that are not usually encountered in publically traded securities. This doesn’t mean that real estate is a riskier asset class than, say, US equity. It just means the PM must be informed about these different risks and be confident that the real estate fund manager is skilled in managing them.
Read previous installments from David Lynn:
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.