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 Most real estate investment funds have very specific rules that govern how much money can be withdrawn from the fund over specific time periods.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.