August, 2014 Print
Derek Williams, Managing Director, Private Markets, bfinance.
Derek Williams, Managing Director, Private Markets at bfinance, highlights the main risks associated with investing in real estate – both via funds and directly – and comments on how to analyse and mitigate these risks
There are risks associated with any investment – loss of capital, counterparty, leverage and benchmark risks, to name but a few. Many of these are also relevant to investing in real estate funds as well as direct real estate (where the investor invests, owns and has control over the real estate asset). However, there are a few risks that are specific to real estate as an asset class and are rarely found in the same way in other investments. Some risks may also appear similar in nature to those found in other asset classes, but on closer inspection they are considerably different when found in real estate. In other words, some risks are amplified in real estate, while others are downplayed or are of less relevance.
Arguably, the most relevant risk associated with private real estate is liquidity risk (more aptly described as illiquidity risk). Real estate is very illiquid with the price subject to wide variation depending on the market, but also the specific requirements of the buyer and seller, their respective negotiation positions, the speed at which a buyer can execute (a fast sale may necessitate a lower price) and the marketing associated with the asset.
A direct real estate asset in a major city in a sector such as offices may take typically three to four months to sell. Many sales can take longer. In terms of risk mitigation and illiquidity, many institutional and private investors will concentrate on well-located prime Grade A assets which, although they may have a lower yield and lower cash flow from the asset, all things being equal would provide more liquidity in the event of a sale.
There are also many investors that handcraft marketing strategies and broad exit strategies, which may include:
- Buying a portfolio and selling individual assets (wholesale to retail).
- An aggregation strategy of buying assets where the portfolio can ultimately be listed via an initial public offering (IPO).
- A “buy, fix, sell” strategy.
Real estate funds range from fairly liquid open-ended vehicles (in theory with entry and exit each quarter) and closed-ended funds with lives of between five and ten years. Each fund has its own liquidity profile and clearly there are inherent risks with committing to a fund for multiple years. The key point is that the less liquid the exposure, the more there needs to be a focus on the fund terms, sponsor (manager) risk, the strategy, and market conditions. Furthermore, some open-ended funds may over-promise in terms of liquidity to the fund investor.
Tenant risk is another key risk in real estate. Should the tenant not be able to pay the rent, the investor may have to actively manage the asset by taking vacant possession and, if necessary, undertake any capital expenditure works and re-let the asset. The quality of the asset does not mask the risk associated with the tenant and their ability to pay the rent.
Risk mitigation techniques in this area revolve around understanding the tenant and potentially quantifying their covenant strength. This can also be quantified at the total portfolio level using credit-rating scores, and it can even be benchmarked against a market average (for example, the UK retail sector). Where the tenant’s business is new and lacks a trading history then investors can seek a rental deposit and other guarantees. Larger brand name tenants may be able to negotiate lower rents versus their smaller peers in business.
Depreciation and obsolescence
An important risk in real estate is the potential depreciation and obsolescence of a property. Real estate is a tangible, real asset that needs expenditure to keep it in good condition, as well as being subject to the vagaries of fashion, location and sectoral influences. For example, assets constructed for particular uses are only economically viable so long as the specific user wants to use the property. Battersea Power Station in London is an example of one such asset designed for a specific use (a coal-fired power station) and which once vacated (in 1983) was vacant for almost three decades. At the time of writing, the site has now found an alternative use, residential, but in reality the property was obsolete for a long period of time.
Other trends can have a more subtle impact on property and leave certain assets vacant for shorter periods of time or require greater “repositioning” and capital to turn them around. Investment banks demanded large open floor plates in New York and London around the late 1980s and 1990s. This trend meant that in certain locations those offices that did not offer large floor plates had to be redesigned or re-let to alternative, perhaps lower paying, non-bank businesses.
Various research studies have put depreciation and obsolescence at between 1-3% per year on capital values. While the rate of depreciation differs from asset to asset, it is worth highlighting that depreciation rate is often overlooked by investors on the basis that it is difficult to compute. Current risk mitigation techniques include building flexible accommodation in terms of layout, including potential subdivision to allow for multiple tenants, building to high standards in terms of energy efficiency and simply allowing for a sinking fund or annual amounts to accrue to cover any potential obsolescence or depreciation.
Development strategies take different forms: “greenfield” development, which takes a site and constructs a property on it; or “brownfield”, where the property is developed on a site with an existing building. In either form, it involves investing capital into constructing or repositioning an asset. This is inherently a risky strategy within real estate investment that can deliver high returns or, conversely, capital losses.
Risk mitigation approaches include pre-letting the property, fixed price construction contracts, where the cost of construction is mitigated, or perhaps funding a development where the investor has committed a large amount of equity.
Inherent within many development projects is a market timing risk in that it may take two years or more for the development to be completed, at which point the market conditions can be very different to those when the development project commenced. Some of the risk mitigation techniques mentioned above can help, but some party in the transaction (equity or debt holder, or tenant, for example) is taking some form of market risk.
Certain sectors or property types carry different performance characteristics and hence risk patterns. For example, rental growth from retail property will be largely driven by retail spending, retailer margins and the wider economy. These sector-orientated risks can be mitigated through forward-looking projections and research in order to model the expected demand for certain sectors (as well as locations). The supply of property would also need to be modelled (strong sector demand might be outweighed by overbuilding) in order to capture a view on the investment going forwards. This can be used to analyse sector risk and other risks too.
Real estate investors that have the ability to invest across sector types should analyse each sector to make sure they are taking on sector risks that they are comfortable with. At a high level, historic performance data can help in terms of analysing the inherent volatility of different sectors. Scenario analysis of how the investment would look under good and bad cycles would be a sound risk analytical tool at the asset level.
This relates to the risk that a building is not built well or may have construction issues over time.
Risk mitigation methods available to the investor take many forms, from undertaking a thorough structural survey on acquisition, to agreeing a lease where the tenant takes on the construction risk, through to hiring a good contractor with a strong track record of finishing projects on time and on budget
It is harder to mitigate construction risk in developing markets where the construction process is more labour intensive or has less of a developed set of best working practices. Poorly constructed buildings abound in some markets like China and India, in many cases due not to the country itself but to the specific construction company or its oversight by the investor.
Supply risk is worthy of a special mention. Some markets have restricted land availability, either through geographical circumstances or through the planning/zoning process. For example, the West End of London is governed by strict planning laws where only a certain amount of extra space or floors can be created in many locations. In contrast, the regime is less strict in the City of London and Docklands. These contrasting supply dynamics mean that, all things being equal, the West End of London needs less demand to keep rents rising versus the City of London where demand needs to be higher to keep up with the higher supply of new space.
In some countries, like China, the strategy is mainly about developing the real estate to satisfy the ongoing demand from people and businesses. Even in this market, a smart investor will focus on assets where there is likely to be less competition (for example, a dominant shopping mall that has a low likelihood of a new one being built nearby).
Taking a considered view on the future supply of real estate that might impact an investment should be a key risk to be factored into modelling.
This article is a chapter extract from ‘New Strategies for Risk management in Private Equity: The Investor’s Guide to Protecting Asset Value’, published by PEI