Excerpted from Dynamic Real Estate Investment Risk Management: Practical Value Creation Strategies for Volatile Markets by Darin Bifani

When most people think about investing, the prospect of gain is often given a lot more attention than the possibility of loss, principally because human existence is mainly driven by the endless siren call of optimism. In the boardrooms of the world’s largest firms, the offices of startup companies and the streets that serve as the stage for millions of commercial transactions every day, it is this belief that things will be better that causes the wheels of the financial system and our economies to continually turn.

Dynamic Real Estate Investment Risk Management

Dynamic Real Estate Investment Risk Management: Practical Value Creation Strategies for Volatile Markets

Optimism affects every component of economic and financial life, from the launch of new ventures, to the valuation of financial assets to the belief that payment obligations, regardless of whether they are those of countries, corporations or people shopping at street stalls, will be honored. Perhaps nowhere is this more visible than in the lifeblood of the financial system, the extension of credit: the trade of something of value in the present for the promise that something of equal or greater value will be provided in return at some point in the future.

Yet optimism, despite its many victories, is repeatedly confronted with economic reality and the expectation of financial return is often met with financial loss. In the difficult march forward of markets through uncertainty, volatility and crisis, it has been, without doubt, a great loss to the financial sector that for the most part risk management perspectives and practices have been hidden in the dark corners of the corporate and financial world and played a secondary role to the business functions of client origination, new product development and sales.

Looking at the world from the risk side of the risk/return coin, rather than simply constituting an institutionalized form of taking tadpoles for dragons or nay-saying designed to shortsightedly derail money-making activities, in fact contains a great degree of offensive as well as defensive power that can be used to identify investment opportunities, structure investment portfolios and execute investments in every conceivable type of market situation. Like the Taoist concepts of yin and yang, risk and return are unified, mutually dependent components of a single financial whole.

Risk and Return’s Imperfect Relationship

The key to using risk management principles to identify and create investment value is the simple realization that, rather than being separate, investment risk and investment return are two inseparable sides of the same coin. As a matter of both well-established financial theory and tried and true common sense, the greater the risk an investor takes, the more he should be compensated for taking that risk. If a rational investor were offered a 10% return for investing in a low risk investment and the same return for a high risk investment, he would, all other things being equal, always invest in the lower risk choice.

The problem with the risk and return relationship (or the opportunity if you look at it from a risk arbitrage perspective) in practice is that there is no agreed way to price risk and no agreed set of risks that should be included in the calculation of an offered or a required investment return. In other words, any time an investment return is offered to an investor, it implies that the investor is being asked to assume an aggregate level of risk but there is ordinarily no specification of what risks are implied in the return offered, how those risks are weighted and how those individual risks are assigned a quantitative value.

Risk in reality is almost always priced through a process of relative inference rather than through rigorous and transparent bottom-up construction. If capital is sought for a real estate development project, the cost for the capital will be primarily based on the cost of capital for similar real estate development projects – which may have different risk characteristics – rather than through an attempt to convert every conceivable development risk of the project into a unique capital cost; if a mortgage is sought, the cost of capital is often primarily based on market mortgage interest rates rather than an attempt to convert every possible mortgage default scenario into the interest rate and loan terms; and if capital is sought for an equity investment in a real estate company, the cost of capital will generally primarily be based on a multiple of the company’s EBITDA or general equity and debt cost estimation techniques rather than through a detailed analysis of every possible risk to a company’s future cash flows.

From the investor’s perspective, particularly in connection with real estate development, project capital is often not priced based on a detailed analysis of risk but rather on the investor’s required rate of return, regardless of whether or not the level of risk implied in that return and the actual level of risk in connection with an investment opportunity are the same.

The practical implication of imperfections in how risk is priced means that the relationship between risk and return often breaks down and the return provided does not reflect the risk assumed. At any given time, there are investments that offer the same return with very different levels of risk and there are investments with very different returns that have the same level of risk: two markets with the same cap rate may have very different probabilities of downward or upward correction; two loan portfolios with the same average interest rate may have very different borrower aggregate risk profiles; and two real estate companies with the same cost of capital may have business models with very different chances of success.

The mismatches between investment returns that are offered and the risks involved in those investments allow investment value to be identified and created. If a reasonable return for a real estate investment based on its risk is 10% and a project promoter is willing to give an investor a return of 12%, the investor has arguably realized a risk-adjusted gain of 2%. Similarly, if a project promoter is only willing to provide an investor with a 6% return on the ground that the investment is “low risk”, but the possibility of a market correction means that the real risk in connection with the investment merits a return of 18%, the investor has realized a risk-adjusted loss of 12%. The failure of investors and markets to see actual risk levels in purportedly low risk investment environments has repeatedly had severe financial consequences; on the other hand, the failure of investors to see relatively high degrees of investment certainty in markets that are volatile or characterized as “high risk” has often resulted in the loss of many excellent investment opportunities.

The application of risk management techniques to real estate investments does not only involve the passive identification of risk and return mismatches; it can also create a great deal of value over the course of an investment. If the level of risk implied in an investment return is 14% but through risk management techniques the actual level of risk

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