Learning how to determine and manage risk can increase returns on real estate investments.
In the commercial real estate
investment context, risk is anything that creates volatility in a
property or portfolio's expected or actual returns. In addition to
analyzing returns and running cash-flow projections, the most astute
investors effectively understand risk analysis and management.
deal with risk effectively, investors must know how to determine and
manage its causes, as well as how to mitigate problems or shift risk to
third parties, such as other brokers, sellers, tenants, or insurance
companies. Pricing risk also is essential in determining acceptable
risk premiums that are built into an investment's required returns.
What Causes Risk?
Risk analysis begins by assessing factors that influence an
investment's returns. Economic factors as well as industry fundamentals
and trends weigh heavily in real estate analyses - unlike the stock
market where investors seldom do fundamentals research and instead rely
on the assumption that statistics repeat themselves over time. Real
estate investing clearly is different: Careful consideration of
industry trends, market fundamentals, and the investment's financial
statements better reflects the return's true drivers.
real estate investment risk stems from five major categories, which
follow in the order of least controllable to most controllable at the
time an individual makes an investment decision.
Economic Risks. Investors
should analyze demand influences, such as employment, population,
income, and accessibility trends, and supply influences, which
generally come from competition, and factor them into rents, vacancy
rate projections, and appreciation expectations. Using market analyses,
investors should consider a range of realistic rents, vacancy rates,
Liquidity Risks. Liquidity
relates to an investor's ability to convert an asset to cash while
preserving capital. Due to high transaction costs and relatively long
marketing periods, commercial real estate is not a very liquid asset,
yet property liquidity varies over time due to changing market
conditions. For instance, lowering the price may hasten a sale, but it
may result in less capital. Generally, as liquidity risk increases, the
required return rate, or premium, over more liquid investments also
Political, Legal, and Environmental Risks.
Investors need to monitor local, state, and federal land-use controls,
fees, and regulations because they can act as market constraints or, in
some cases, incentives. Examples at the local level include zoning,
building codes, eminent domain, property taxes, and incentives such as
property tax abatement or subsidies that encourage development. Some
federal regulations include the Comprehensive Environmental Response,
Compensation, and Liability Act; Americans With Disabilities Act;
Endangered Species Act; Fair Housing Act; clean air, water, and
wetlands protection acts; and interstate signage acts. Changes in these
regulations or new regulations or incentives enacted at the local,
state, or federal levels may affect property returns.
example, in Chicago a recent citywide requirement for property owners
to add sprinkler systems to existing buildings may reduce property
values by several dollars per square foot due to equipment installation
and tenant displacement costs. This is an example of a political/legal
risk that investors must monitor and factor into their projections of
income, expenses, and possible capital expenditures for compliance.
Business and Management Risks. Owners
and investors have some degree of control over business risks that are
inherent in management decisions influencing a property's rental flows
and operating expenses. These include lease elements that affect how
rents may change over time and how property owners share operating
expenses with tenants, as well as tenant credit, tenant mix, and lease
Good managers may
influence property returns through creative marketing efforts,
especially with retail properties. For example, regional malls can
sponsor events that attract more customers, which in turn may increase
sales and rental income. Good management also may be evident in
contracts that reduce operating and maintenance expenses or allow fair
Financial Risks. Financing
is the only risk category in which owners have a great deal of
influence. Owners control their properties' leverage, or the proportion
of debt financing used to purchase the property. Increasing the
leverage directly affects the volatility of the cash returns to the
equity position anytime something unexpected occurs.
addition to leverage, risk is inherent in loan terms, such as
prepayment penalties and variable rate clauses, which cause investors
to shift or accept future interest rate risk. For example, lenders bear
the interest rate risk in fixed-rate loans, while variable-rate loans
shift the risk to borrowers. Accepting such risk is fine, as long as
the investor clearly understands the return volatility implications.
The Most Controllable Risk: Financial Leverage
Leverage always increases any equity investment's risk because it
allocates the lowest-risk portion of the property's returns to the debt
holder, so the equity holder is left with the higher-risk portion.
Using mortgage debt leverage, an income-generating property can offer
different types of investment products.
instance, a property owner can divvy a moderate-risk real estate asset
presenting moderate growth and yield into two investments: one that
supports a high-risk equity investment with high growth and a low
current yield and another that supports a low-risk debt investment with
zero growth and a high current yield. Doing so increases the pool of
investment partners or groups that can invest directly or indirectly in
the property, thereby maximizing the property's value. Thus, various
partners can maximize their own objectives with one investment that, on
its own without preferential returns, would satisfy none.
general, wisely applied leverage - in which returns exceed the cost of
debt - always increases an equity investment's expected total return.
Leverage may increase, decrease, or leave unchanged the current income
yield for the equity investor, and this equity yield effect usually is
smaller than the appreciation effect. These general results
qualitatively apply to the internal rate of return in both
single-period and multiperiod analyses.
useful tool to gauge leverage's effects is a leverage ratio, which is
the total property value divided by the equity. Thus, a property with a
loan-to-value ratio of 60 percent has a leverage ratio of four as seen
in the chart, "Typical Effects of Leverage on Investment Returns." The
appreciation return to equity is 5 percent, or 2.5 times the 2 percent
received on the property as a whole. The leverage ratio is a quick way
to estimate the increase in returns and approximate risk when adding
Risk's Effects on Returns
Understanding return sources and their predictability is critical to analyzing any projection's risk.
flows generated from the collected income (rent) less operating
expenses and debt service are most properties' primary return source.
These are predictable to the extent that rents are known and expenses
are controlled through pass-through provisions.
second return source for taxable entities is the tax shelter and
postponement generated from non-cash depreciation deductions.
Depreciation taken during the holding period results in recapture at
the time of the sale, but the recapture is at a lower tax rate. The
return is highly predictable as long as tax rates remain stable.
buildup from reducing the mortgage loan principal (if financing is used
and if the debt service includes principal repayment as part of the
typical level amortization payment) is another predictable return
source, especially if the interest rate is fixed. Interest-only loans
do not involve equity buildup from this action.
or depreciation from a property's change in value is the least
predictable return for most investments, and thus, one of the greatest
Each of these returns has
a certain degree of predictability; if the return flow is more
predictable, the return source is less risky. Tax deductions and equity
buildup returns are highly predictable. Cash-flow returns are somewhat
predictable based on known leases and tenant reliability, but they
become less predictable over time. Returns from value changes are the
least predictable, thus much of real estate investment risk comes from
changes in price and long-term cash flows.
Estimating the IRR to Understand Various Return Sources
To quantify a return source's effects, investors can break down an IRR
estimate's components. There are different procedures to do so, but the
easiest is adjusting the variable of interest.
example, an investor expects an after-tax IRR of 15 percent on his
Anastasia Avenue office property. Within the pro forma is an assumption
about resale price based on the change in the NOI and a going-out
capitalization rate. If the investor changes the resale price to equal
the purchase price on a net basis, the IRR declines. If the IRR drops
to exactly 11 percent, it is safe to conclude that 4 percent of the 15
percent return is from appreciation representing 26.7 percent of the
It also is possible to examine
other variables' effects on IRR through a sensitivity or simulation
analysis. (See the sidebar, ?Risk Analysis Software.?) Breaking up one
or more variables' effect on the IRR provides a type of static
sensitivity analysis. Investors may find the rental growth rate or the
resale going-out cap rate are the most critical
assumptions from such an exercise. Though these analyses provide
insight, use them with caution. Specifically, investors should avoid
changing one variable without changing others since many variables are
driven by similar influences.
compensate the Anastasia Avenue investor for more or less risk relative
to other investment opportunities requires a change in the required
rate of return. For example, an investment similar to Anastasia Avenue
provides an expected IRR of 12 percent based on reasonable assumptions.
The property is similar in all respects except that the tenants have
better-than-average credit and longer-than-average leases at market
These two factors result in less
risk than similar office properties; the investor who wants this
property should recognize the lower risk and bid up the price,
accepting a lower rate of return. If the price necessary to buy the
property reduces the expected IRR to 11.5 percent, then the required
rate of return has been effectively lowered by 0.5 percent;
correspondingly, the investment's value increases.
the property had above-average risk tenants, the investor could have
done the opposite and increased the required rate of return. In more
sophisticated analyses, the investor could assign a different discount
rate to each major tenant's lease and weight the required return by the
resulting sum of the required returns weighted by the dollar proportion
of the total return they represent.
an investor knows how assumptions influence the return, debt coverage,
break-even point, and other financial ratios, he either must accept the
risk and assign a premium over less risky investments or investigate if
any of the risks can be shifted. This process begins with thorough due
diligence. (See the sidebar, "Due Diligence Makes the Difference.")
are several ways to investigate causes of risk. Thorough commercial
real estate investment analysts focus on solid research, factors that
have the greatest impact on returns, and the risks that are most
controllable. Sensitivity and simulation analyses also may provide
insight into the most critical assumptions of any pro forma. Finally,
the most savvy investment risk managers are superb and creative
negotiators who attempt to shift risks whenever possible to a different
entity in the investment.