Risk-return tradeoff of property market

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BY KOSTA KIOLEOGLOU

Although almost everybody has somehow been involved in a real estate investment, majority of people make irrational decisions based on rumors and expectations without considering even the basic principles of investing such as risks. This is the reason why investors often lose a lot of money when making investments in real estate. Real estate, equities, forex and any other type of investment do have one thing in common, risk.

Property markets are not risk free. In general, there is no risk free investment. This is why a fundamental principle of investing is the risk/return tradeoff, which simply states that the greater the risk, the greater the expected return. Conversely, the lower the risk of an investment, the lower the expected returns. Investments in real estate are no exception.

For everyone involved in the real estate business, it is important to understand the existence of risks. In several new, emerging and premature markets, amateur investors refuse to understand the risks and believe that investing in land and real estate is extremely low risk or even risk free. This is one of the main reasons for people to make wrong decisions that will lead to loss of money in overestimated markets. In a few words the majority of casual investors ignore the fundamental principle of investing which is the risk/return tradeoff.

Generally speaking, a higher risk investment gains a higher return.  Fund managers advertise their successes in achieving above-average returns, but do not include the measures of risk taken to achieve these. To properly analyze risk, both historical (ex post), expected (ex ante) returns and risk are important. Ex post returns can help analyze risk and estimate depreciation and can be used to compare the market. They are also used for forecasting models and portfolio construction.  Risk and return can be measured for an individual investment, a portfolio or the market as whole.

Investors tend to prefer lesser risk. The higher the expected risk, the higher the expected returns and this is to compensate investors for the additional risk. There is a trade-off between return and risk. If investors had to choose between two investments with the same expected return then they would select the asset with the lower variance (expected risk). This decision rule is known as the mean-variance criterion. However, if we are to compare investment assets with different risk and return characteristics then we need to standardize the returns for the different levels of risk. This can be done by using a single measure of risk and return, which measures the units of expected return for each unit of risk. Risk adjusted returns are usually calculated by dividing the expected returns by the risk.

In practice, risk and return can be combined in a DCF cash flow model with scenario analysis reflecting pessimistic, base and optimistic scenarios. Inputs might examine the impact, for example, of possible outcomes in the economy, capital markets etc, with probabilities ascribed to each scenario. Cash flows can be estimated for each of these scenarios. The return would be estimated through capital, income and/or total returns.

Unfortunately, these are tools used by professional investors only. A majority of individuals simply follow the rumors and general market trends without considering risks and all possible market scenarios.To understand how this applies to real estate, it’s necessary to define Investment Risk. A widely accepted definition of Investment Risk is “the probability or likelihood of occurrence of losses relative to the expected return on any particular investment.” Think of Investment Risk as the likelihood or chance that a specific investment will not provide the returns you expect.Here’s the problem, quantifying risk in real estate is really hard. For this reason, there’s a strong tendency for real estate investors to focus the vast
majority of their attention on the expected returns they may receive, rather than the
chances that these returns will be less than expected. This is a mistake that can lead to
big losses.

When investing in real estate, professional investors and market consultants use metrics like cap rates, “cash-on-cash” returns, and internal rates of returns (IRR) to compare and contrast different properties they are considering. It’s rare to have an investor who will seriously consider the possible risk exposure that one property carries compared to another property or even other investment options.The truth is that even if one wants to determine with accuracy the risk exposure it is not easy to make such a determination because there is no framework for assessing risk of a particular investment property.The available tools investors have to assess Investment Risk related to Real Estate compared with the tools associated with a stock or bonds are minimum. These asset classes have widely accepted standardized metrics for measuring Investment Risk. For stocks, the most common measurement of Investment Risk is a stock’s Beta. In a single number, the Beta of a stock neatly measures that security’s expected volatility (Risk) compared to all other stocks. A beta of less than 1 indicates that the stock is hypothetically less volatile than the stock market. A beta of greater than 1 means that a stock is theoretically more volatile than the market. If a stock has a Beta of 1.35 it, in theory, means that it is 35% more volatile than the entire stock market.

Similarly, Bonds carry “Ratings” set by companies like Standard & Poor’s, Moody’s Investors Service and Fitch Ratings Inc. These Ratings help investors’ measure the bond issuer’s financial strength and the likelihood that they will be able to pay the principal and interest as promised. The higher a bond’s Rating, the lower its theoretical Investment Risk.

Unfortunately for real estate investors, there is not a widely accepted method for assessing the Investment Risk associated with a particular property. If you think about it, this makes sense because each individual property has a unique set of variables that affect its Investment Risk. These include location, the financial strength of the tenants that are paying rent, the loan-to-value of the mortgage, the length of each lease, and of course several macroeconomic factors that can affect the market.

Saying all that, it is important to acknowledge that Investment Risk is present in all investments, including real estate. It is important to identify the different variables that may cause volatility in the returns (cash flow and appreciation) one expects to receive on investment properties being considered.

Some basic principals of investing in Real Estate and measuring investment risk in Real Estate include the following ten important rules:

^ Higher expected returns generally carry
higher risk.

^ Debt increases risk. The higher the loan-to value of the mortgage, the more risk. The closer the maturity date on the mortgage, the greater the risk. Variable rate debt often carries more risk than fixed rate debt.

^ Diversifying into multiple properties. In real estate, it’s easy to forget about spreading your risk across multiple properties. This way, when the cash flow from one property unexpectedly decreases, you (hopefully) continue to receive the cash flow from the others.

^ Diversifying by geography. Sometimes it’s easy to ignore the Investment Risks associated with a particular city or region. Say that you diversified into multiple properties, but they are all in the same neighborhood or city. When the city sees an economic downturn, it affects all of your properties.

^ Supply and demand. It’s easy to get caught in the trap of looking at demand for a property (i.e. vacancy and rents), assuming no change in supply. In a growing market it is a fact that competing properties will be built.  This eventually will slowdown rental growth and will change completely any vacancy assumptions. New buildings always are the first preference and in the long term that is a reason to possibly affect the value of your property and your expected returns.

^ Volatility in rents. When considering volatility in rents, it is important to think about the probability that existing tenants will renew their leases or not. Then you need to estimate how much time it will take to find replacement tenants and at what price. Unexpected vacancy is a primary Investment Risk. What level of rent the new tenants will be willing to pay in a good economy and what level of rent will the new tenants be willing to pay in a bad economy. Costs relevant to a new contract have to be also considered.

^ Volatility in expenses. When considering volatility in expenses, consider the likelihood that property expenses will be greater than expected. This is where putting pencil to paper, or even better using a spreadsheet can really help. Attempt to quantify what happens to the projected cash flow of a property if expenses (taxes, property management, utilities, on-site employees, regulations etc.) increase by more than your projection. As an investor you need to be proactive in order to minimize your risks.

^ Real estate is Local. Location, location. You need to understand that trends changeover time, a location that is attracting a lot of interest today might be better or worse in the near future and that will affect the value and the expected returns.

^ Interest rates and cap rates are related. There is a lot of delegation regarding the interest rate caps and how they are affecting the real estate market performance. As a general rule, when the cost of borrowing increases, the price that an investor is willing to pay for your property decreases. So although sometimes it seems that interest rate caps might be negatively affecting the market, in other cases they are actually supporting the market’s price sustainability.

^ Capital expenditure matter and ageing. Any building will eventually require maintenance. Nothing can cause volatility in your expected returns like having to unexpectedly replace a roof, fix a foundation, rewire, or replumb a building. Unlike paper assets, depreciation is an important consideration for investors in property as it results in a loss of rental income (and subsequently capital income) generated from an ageing property investment which may occur due to a number of physical, economic and functional reasons..

Kosta Kioleoglou

Civil Engineer Msc/DBM

REV Valuer by Tegova

Director Avakon ltd