Risks and Returns
Like all investments, real estate involves risks – and the expected returns on investment usually vary commensurately with the riskiness of a particular project. We’ve discussed elsewhere some of the due diligence needed to analyze risks associated with different property types. Here, we review some of the more basic risks involved with all kinds of investments.
Risk is the possibility of suffering adverse consequences. In the investment context, there are several primary types of risk:
- Inflation / Systemic
- Variance / Sensitivity
Business risk reflects the possible unsuccessful operation of a project. It is determined by the project type, its management, and the market in which it is located. Each of these factors can affect the expected operating cash flows from a project. A regional shopping center fully rented under long-term leases to top-credit tenants has a lower business risk than a raw land investment anticipating some future construction of a motel.
Generally, business risks are especially concentrated in management and the market. Management must keep the space leased and maintained to preserve the value of the investment, and management must innovate, respond to competitive conditions, and operate the property efficiently. These key factors in project’s success speak to why sponsor due diligence is very important. Market changes constitute another key risk, but one over which an operator sometimes has little control. New competition, changes in local demographics, and slow regional growth would all affect a project’s business risk.
Financial risk primarily reflects uncertainty about the residual equity return when debt financing is used. Debt increases the variability of the investment return to the property owner; increased leverage can mean increased returns, but since debt service must always be paid before the equity holder, it might also mean lessened or even negative returns. Financial risk also includes interest rate risk; larger-than-expected increases in interest rates with a variable-rate or short-term loan will increase a property’s debt service and thus decrease the rate of return to equity investors. Increased interest rates may also lower the price that subsequent buyers are willing to pay. Yield rates that investors require for real estate tend to move with interest rates generally.
It is important to thoroughly assess a project’s anticipated net operating income, because it is this amount that will be required to cover the debt service. The risk of a shortfall is increased when there is more debt on a property.
Inflation / systemic risk arises when universal risks are higher than anticipated. In the case of inflation, it may be at a higher rate than was anticipated in the discounted cash flow analysis or IRR calculations. If this occurs, an investor’s purchasing power of the dollars later returned by the investment will be reduced. Other systemic risks include war and political changes that influence the whole economy. These risks affects all investors equally (at least within one country’s economy) and don’t really vary by project.
Liquidity risk relates to whether, and when, the investment can be “cashed out” in the future. Real estate is generally considered to be an illiquid asset; it is not always readily salable. If the economy is suffering through a downturn, financing sources may dry up to a significant extent, reducing the pool of potential buyers to those who don’t require conventional financing. It is thus sometimes difficult to sell a property quickly without substantially discounting the price below fair market value.
Variance/sensitivity risk relates to all of the foregoing four types of risks, and refers to the degree of variability of each of those risks. The more variance an investor expects in the equity portion of the property’s return, the greater the risk associated with receiving that cash flow.
Risk and Return
Risk and return are positively correlated, because people are risk-averse. Increased risks require that an investor demand increased returns in compensation; people don’t normally accept the same rate of return on a very risky investment that they can already get on a low-risk investment. If an investor can get some minimal return on a risk-free investment (generally considered to be the yield on U.S. Treasury bonds), then he should demand an increased return for any other investment involving greater risks.
This risk premium can be difficult to determine, however, particularly as it can vary both among investors and over time. For example, the risk premium for institutional-quality commercial real estate compared to the U.S. Treasury rate declined dramatically from 2004 to 2007 as the real estate bubble grew, and then rose back to 2003 levels as the bubble deflated. This swing in the pricing of risk caused dramatic changes in the prices of commercial real estate, at first rapidly increasing asset prices and then dramatically decreasing prices.
Investors must always be aware of the various risks involved with an investment, both those related to the economy and real estate markets themselves and those that relate to a specific project. Undergoing appropriate due diligence on a project, including on the project’s sponsor or (for loan investments) on the proposed loan-to-value ratio, is key to understanding whether the expected rates of return for a certain investment are commensurate with the project’s overall level of risk.