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Top Risks in Real Estate Investing: Part II

In 2008, the real estate community was understandably reflecting on the important question, “How the hell did we get here?” By over leveraging and a ridiculous lack of common sense, many realized much too late how dangerous return chasing without appropriate risk management really can become when the economy turns, as it always does. Risk identification and management is neither fun nor simple; it is multi-dimensional and can become very confusing. So, I thought it important to continue with the theme from our last blog and dive a bit deeper into the different types of risk and the ways we as investors can build risk management into every aspect of our businesses.

Risk, as we defined last blog, is “the measurement of a loss identified as a possible outcome of the decision” (Gupta & Tiwari, 2016, p.158). So, let’s talk about that measurement for a minute. Many people believe that risk can be measured through standard deviation given it is an appealing and convenient method, but for real estate assets, it is limited because of the non-volatility related risks that are not an issue in things like stocks where standard deviation is much more appropriately used (Kaiser and Clayton, 2008). For example, the NCREIF Property Index (NPI) had a 3.4% volatility over 1978-2007, while bonds were at 7% and stocks lead with a whopping 15.3%. So, if the risk calculation of volatility for real estate was so accurate and shows real estate is the obviously more stable option, shouldn’t all investors be funneling all their money into real estate making the risky stock market a cute figment of the past?

Clearly, that is not reality; many investors know intuitively that real estate has risks associated to it that are much more challenging than a 3.4% volatility statistic would lead one to believe. It is the real estate asset class risk, or the possible outcome of losses specific for real estate investments, that real estate investors must respect and recognize that standard deviation is insufficient in capturing these risks accurately (Kaiser and Clayton, 2008). But why are real estate assets special? The reason is because public markets are able to readjust rather quickly when something shocks the market through adjusting the price of stocks and bonds. Private asset markets, like real estate, adjust much slower through price and liquidity. It seems obvious when said, but liquidity, especially times of illiquidity, represents a significant risk factor for investors in real estate and obviously must be taken into account when trying to contextualize risk management and it plays a larger role in the value and risk calculations for real estate than other asset classes tend to face.

So, real estate is risky. And we all agree on that. What do we do with that though? Gupta and Tiwari (2016) offered up three categorizations to help investors with risk: market, property and lease. Simple, macro to micro, and clearly delineated to allow everything to bucket nicely. However, things are rarely that clean and neat. And actually, to help create a more complete understanding of risk in the real estate context, Kaiser and Clayton (2008) broke real estate portfolio risk into their own categories: beta, alpha, and gamma. They summarize beta as market risk, alpha as the risk on portfolio “bets”, and gamma as the representation of the value in our actions as investors (Kaiser & Clayton, 2008). I like these categories more because they allow a more professional application of risk ideology to our real estate vocabulary and also open us up to more responsibility and reflection about how our own actions and beliefs interact in our investing businesses. Let me explain.

Whereas the market, the property and the lease are all external features, Kaiser and Clayton’s categories specifically focus on a portfolio and portfolio manager (you, the investor) approach. Beta risks are similar to market risks, they have the ability to infiltrate the entire portfolio; it represents “the systematic or non-diversifiable real estate market risk” (Kaiser & Clayton, 2008, p. 293). But, it is with Alpha and Gamma that we, the investors, come into play. Alpha risks result from your investor efforts to match or exceed benchmark return rates through the properties you chose and the financing tactics you employ. Gamma risks are those associated to our attempts at improving the value of individual assets whether it be through lease improvement or property improvement. We cannot control the market, but that is only one of the three arenas in which risk can cause us to lose, so I would recommend to focus on the areas you can control and prepare against the market changes through rational and realistic behavior.

(Kaiser & Clayton, 2008, p.293)

We have the ability to impact our personal risk exposure levels. Kaiser and Clayton (2008) recommend that investors focus on longer time horizons, pay attention to diversification methodologies and support an overall questioning of your investing strategies when times are good to protect yourself appropriately to bring risk to acceptable levels (for what you personally define as appropriate given your risk tolerance level). Apsley & Grand is here to help you identify your risk tolerance, find appropriate investments for you, and to make sure you are constantly protected with strategies that work in any market.

Gupta, A. & Tiwari, P. 2016, "Investment risk scoring model for commercial properties in India", Journal of Property Investment & Finance, vol. 34, no. 2, pp. 156-171.

Kaiser, R.W. & Clayton, J. 2008, "Assessing and managing risk in institutional real estate investing", Journal of Real Estate Portfolio Management, vol. 14, no. 4, pp. 287-306.

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