Real Estate Risk Management

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Real Estate Risk Management

Risk can be referred to as an opportunity of something, making it a term with double meaning, so its analysis should not be performed on the negative aspect only. Estimated from Markowitz’s portfolio theory we can divide risk into unsystematic and systematic constituents. The systematic risk is not diversifiable, so far as it is provided by the market. As a contradiction to the portfolio theory of Markowitz, the assertions of a transparent and efficacious market do not work in the conditions of the real estate market. The unsystematic real estate risk cannot be insured to the same degree and is as simple as it is done in the financial market because of the restriction, described above, and the lack of liquidity.

As risk is generally defined as a collective term, risk management includes several risk-related processes and reflections. The progress of risk management is shown in Figure 1. Four risk-involving steps are shown: assessment, evaluation, management, and measuring. Assessing the risk includes the recognition of risk factors and conduction of their analysis. During the evaluation step, the risk is measured, and a degree of its significance to the project is identified. The step of management includes the evolution of the risk-handling methods. To control the risk, the measuring step is applied. It shows a possibility of the risk management to use a certain risk strategy (Klaproth, 2004, p. 58). All the risks are dynamic, and they keep changing over time. Risk management itself possesses a dynamic structure and carries the frequentative cycle design. The overall dynamics of risk management are influenced by the evolving interdependencies, taking place among risk factors. Complete evaluation of all the risk categories, followed by the appropriate distribution of risk “weights”, risk control, and readiness for changes(e.g. recalculating weights or introduction of the new categories of risk), along with the proper understanding of cause and effect chains is extremely important.

Economic Development Risk

The influence of the economic development risk is what makes the situation in the economy change on both regional and district levels. Such kind of risk is researched concerning the current trends and prospects of the economic situation. Financial and industrial markets, as well as the real estate market, are strongly influenced by any alterations in economic growth. Socio-economic tendencies may also vary in the long-time perspective. There is a strong correlation between the factors, described above, and the economic development risk. The impact of politics on the growth of the national economy is inessential.

The economic development’s main qualitative indicator is the growth of the Gross Domestic Product (GDP). Demand can be changing tracking in case permitted by the inflation, which is derived from the consumer price index and may be harmonized and adjusted seasonally. Analysis of the unemployment rate and the total sovereign debt level can round off the indicators for economic development risk. Recently, these factors gained importance in some European economies, e.g. Greece, Spain, etc. Since the sovereign debt level threat applies to economies beyond the EU and the US, it can be used for all economies. To summarize, the increase of the national debt leads to higher taxes and other kinds of economic abridgments, followed by falls in the economy, as shown by Greece.

Socio-demographic Risk

The risk of changes in the country’s demographic condition is depicted by socio-demographic risk. This risk includes the reflection of the change of population, along with several real-estate investment-related factors. Investment property yield might be affected by population alterations. The overall development of the economy may be influencing the indicators directly – for example, unemployment rate and purchasing power, and more rarely with a certain delay in time, partially or even indirectly, being influenced over the longer period with higher and longer-lasting influence. It is especially essential in the process of evaluation of demand and its alteration for real estate for all sections. The attempts of the policymakers to change the socio-demographic factors should be considered, as well as such attempts may lead to either improvement of the situation (more likely) or its worsening, with relation to the regulatory risk (see chapter 3.2.4). Therefore, the socio-demographic risk may be described as interrelated with the general economic development and might be useful for investors, coping with real estate.

Analysis of the socio-demographic risk is based on the quantitative indicators, used for its measurement and obtained nationwide, regionally, or city-wide, with national authorities as to the source. It is obtained nationally for this paper. The changes in the population are essential for long-term incomes. The measurement factors for socio-demographic risk are rounded off using the analysis of the Purchasing Power Parity (PPP).

Currency Risk

Real estate investors may find the exchange rate changes important when investing outside their domestic markets. Such changes may influence the investment in either a beneficial or harmful way, if not studied thoroughly. They are usually incorporated in currency risk. The key influential factor for the currency exchange rates is the stable economic performance of the countries, involved in the process. The currencies of the economies in a recession are usually deprived of value compared to the strong stable economies. Good examples are the sufferings of the investors in the recession-involved country from the higher foreign currency’s value, compared to the national rates.

The main task of risk management is the analysis of currency risk to appease possibly any extreme risk, which, in the worst case, maybe initiating a situation, close to default. An investor may take some actions to avoid the risk and fully or partially insure the currency risk. With two solutions possible, one allows purchasing a capital market hedge equal to the overall investment costs, while another requires removing loan contracts for the property investment in the currency, used for the rental cash inflows.

Factors, influencing currency risk, are the growth of involved currencies, their inconstancy, and the development of the involved market’s economy. It may not be inevitably related to economic development risk.

Liquidity Risk

The variety of occurrences that may influence the investor’s power to cover current short-term liabilities and disbursement to the equity holders create the liquidity risk. Despite all equity shareholders hold a right to refund their investments at any time, investment mediums (e.g. public funds) invest into illiquid real property. To secure the liquidity position, public funds have to reduce the market value of their assets during sales. Funds might even be closed down because of this factor, e.g. during the financial crisis (CB Richard Ellis, 2010, p. 2). Reopening takes place in 2 years at maximum, causing the stockholders to redeem unless all the issues were solved during that period. Recent publications prove this happened to a few of them.  Short-date liabilities together with long-dated finishing debt could launch the same trouble, provided there would be no refinancing or interest rates rise.

The liquidity risk of the basic real property investments should be analyzed by risk management. The personal type of investment vehicle might be analyzed this way, as well as the redemption risk for the equity owners. Stocks make an asset category of their own. The liquidity of a stock is defined based on the number of sales for it in the stock market. This allows us to say that investment market volume, which is based on real transactions, makes a perfect market liquidity indicator about the real property market. This does not allow the conclusion that any asset is capable of providing a potential purchaser or seller with time gaps caused by the illiquidity of real estate as an asset class.

Regulatory Risk

A combination of changes in legal, political, and levy structures creates regulatory risks. This risk area is also contributed by bureaucracy, as well as administration and political conditions, followed by the absence of corruption and legal security that developing countries miss. Real property investors perceive regulatory risks from two aspects, as sudden changes may cause negative effects on the estate and investment market, while the positive effect may come with incentivizing of investments by the national authorities. Some countries had to create new laws, supporting energy-saving technologies for existing buildings, and especially new constructions to follow the megatrend of sustainability. The changes in framework conditions influence the other risk factors, mentioned above, making an overall impact on the real estate markets. That is why regulatory risks should be a part of proper risk management to create a complete risk strategy.

Measuring regulatory risk using qualitative analysis of the latest regulatory actions and political consistency is often hard to make or might be even impossible. The upcoming elections may be followed by government change and a new approach to real property management. Other indicators, used for the analysis of regulatory risk, are rural infrastructure and its development.

Ecological Risk

Ecological risk is usually determined as one of the negative influences on residents and the environment in the period of using property, causing possible expenses for the investor. The habitats can be influenced by harmful construction materials, unsatisfactory quality of the indoor air, or a miserable climate. Investors may find it necessary to alter the type of usage or lower the rent rates in case levels of noise are changing or particles of dust are present. Water or soil pollution, caused by heating oil leaks, along with regular property running-related emissions can harm the environment. In some cases, the polluter remains irresponsible for the damage caused, as it is not possible to force the removal of contamination. Existing ecological risks can be partially avoided using proper care and planning. To determine the usage type of the property, it should be analyzed by location and its ecological risk. The reduction of the rent or the need to destruct the building with the current tenant’s further eviction occurs in case of ecological risk detection. Risk management provides the analysis of the factors, having a negative influence on the estate according to the type of encumbrance, and looks for means of proactive control and limitation. The close relation of ecological and regulatory risk lies in its ability to cause a forced introduction of the preventive methods, concentrating on the area of controlled emissions.

Collecting quantitative indicators for the future strategic analysis of the worldwide property investments on the national level is very complicated, as ecological risk is property-specific. That is why all indicators are based on quantitative analysis. For example, the measure of possible pollution and natural disasters, such as earthquakes, tsunamis, volcanoes, and river flooding may be used as one.

Real Estate Market Risk

Real estate market risk includes the risk of changes of the general real estate market or some of its constituents, which are directly or indirectly impacting the investment value. The site, type of usage, and overall building condition are considered during the analysis. Influencing the rental cash flows and property values, real estate market risk is considered one of the most crucial risks. Supply and demand cause the changes. Due to this real estate market risk is closely related to cyclical risk, described in chapter 3.4.2, and other different risk factors, highlighted in this paper.

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Real estate market risk uses vacancy rates and rental values as qualitative indicators. While analyzing in terms of the city, up-to-date supply, and overall absorption of space are used to assess the net absorption surplus as a criterion of demand and possibly bigger future rental costs (Bach, Ottmann, & Sailer, 2005). The increase of the equity available in the borrowed-capital market causes the decrease in the debt value and the increases that the investor needs for real property investments. The number of loans can be used as an indicator for demand and later capital value trends. The increase of the loan availability directly depends on the growth of capital value, causing the extra demand.  Nowadays real estate market risk may be revealed using analyzing the share of loan capital outstanding to real property and the ratio of real property debt to total debt outstanding. The information about bank liabilities in real property is hardly obtainable so far as some banks do not fully report them, while the public cannot access the capital markets loans. Debt capital proportions, as a proxy for real estate market risk, are omitted in this paper due to the data non-transparency and inaccessibility. The real estate market's efficiency was enhanced by the improved quality, accessibility, and reliability of the data. They removed the inconstancy for the real property investors, although the decreases the capital value could not be prevented, as most of the countries were influenced by the 2008 global financial crisis. The Global Transparency Index, created by Jones Lang in 1999 is used as a base for the nationwide analysis of transparency. Later it was used as an alternative way to measure real estate market risk.

Cyclical Risk

Changes in demand and supply patterns and essential features of real property cause frequentative cyclical fluctuations of value in real estate markets. Real property cannot be provided on demand, as such asset class as stocks. So far as market equilibrium is almost unreachable due to the illiquidity and restricted fungibility of real property with its covert time delays, real estate cycles are formed.  Cyclical (market) risk is extremely important in terms of real property risk management, in case the nature of the investment horizon is not the long-term one (i.e. carrying the ultimate goal to find appropriate entry and exit points in the market cycle).

Quantitative analysis of the estate, following evaluation of its type, and the possible benefits allow to measure cyclical risk, provided new concepts to create a location. If locations are shaped by one industry or demand scheme, they are more unstable and sensitive to real estate cycles than non-diversified locations.  The performance of securitized real property indicators, relying on the overall all-time return, is a more quantitative indicator. Index standard displacement analysis provides an understanding of the inconstancy of future market changes over the given. Cycle risks may be overviewed with consideration of vacancy rates (Pritchett, 1984). They are also backed through the real property market risk (see chapter 3.4.1). So far real estate experiences time lags due to the nature of it, economic development can become an indicator too. Considering the involvement of both direct and indirect securitized real estate, indirect real property has a faster reaction to changes of economic character due to its higher efficiency regarding market fungibility. According to the results of the latest empirical research, the time lag of direct to indirect real property changes is close to a quarter.

Active risk management cannot predict and avoid disadvantageous investments in the real world. So far as some investment vehicles (e.g. pension funds or REITs) are prone not to surpass some specific portions of not invested capital related to the general size, this produces a certain push to invest and offers higher cyclical risks.

Property Risk Premium Adjustments

Investments can become economically unjustified by adjusting risk premiums due to the rise of the cost of financing overall expense rates and cap rates as well, making the capital values for the leaving strategies significantly lower. Risk premium adjustment becomes risk-involving for any risk management consideration. Estate investment risk premium may be calculated by deducting the risk-free return rate from the cap rate.

 Using the up-to-date payment yield of the 10 year UK government bond index, the risk-free rate of return might be lowered. An amendment, comprising the inflation risk, should be done, as long-dated government bonds carry a negative correlation with any interest rate changes. Due to the government’s power to make the emission of money and the stability of prices due to the short maturity, finance bills are considered to be risk-free. During the analysis of the long-dated average returns of the US Treasury bills and US government bond returns in the period of the last 108 years, an average inflation risk premium of 1.2% was estimated (Dimson, Marsh, & Staunton, 2002). Because both British and German economies are equally mature and their bond markets are similar, sharing the same inflation rate, it is assumed that this 1.2% inflation risk premium applies to them. Brazil has higher inflation of its currency, and therefore its inflation risk premium is higher. Such a conclusion is obtained based on the analysis of the difference of its national mean CPI growth and the long-dated 1.2%, as long-term data for Brazil is unavailable.

The analysis of the risk premium’s inconstancy during a certain period is essential for the identification of possible risk premium changes during the next period. The risk for the market participants gets lower with the rise of quantity and availability of information. The Jones Lang LaSalle Global Transparency Index serves as an indicator for the specific risk of changes in the real property risk premium, used by the market to real property investments in addition to the risk-free rate, as well as an indicator for the total real property market.