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.
Carlson Capital's Double Black Diamond Fund returned 85 basis points net in August, bringing its year-to-date net return to 4.51%. According to a copy of the fund's September update, which ValueWalk has been able to review, its equity relative value and event-driven strategies outperformed during the month, contributing 131 basis points to overall P&L. Double Read More
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 can be brought down to the level of risk that would ordinarily imply a 10% return, investment value has been created. Moreover, given that investments are often made by corporate entities with their own risk profiles, lowering risk at the investment level also serves to create value upwards through the chain of entities that hold the investment. This can positively impact their own share value and access to financing, which in turn can lead to other value creation opportunities.
Risk-Based Perspectives and Different Market Conditions
The advantage of using a risk-based perspective to create potential investment value is that it does not depend on whether markets are moving up, down or sideways. It is just as easy to underpay for real estate investment opportunities in markets with different types of adverse investment conditions (meaning to get a high return for an investment even though actual risk is very low) as it is overpay for real estate investment opportunities in markets that appear to have very little risk (meaning to get a low return for an investment where actual risk is very high).
To take a risk-based view of the world it is necessary to avoid fixed preconceptions about what is good and bad from an investment perspective (“China is a good place to invest”, “location is the key factor in real estate investing”, “land always increases in value”, “liquidity is good”, etc.) and instead pare the perceived world down into sets of bias-blind fundamental quantitative relationships between different risks and returns that are paid to people for assuming those risks.
Doing so creates an investment possibility map that looks very different from the visual maps many people have of the world and the role of institutions and people in it: rather than seeing a country as a separable unit with static commercial realities and a single, uniform level of risk it becomes a collection of many markets on different growth trajectories with different risk drivers and levels; rather than seeing single investment channels as fixed, financially frictionless conduits between capital deployment and capital recovery they become cost and benefit relationships that are constantly changing over time; and rather than seeing people as passively dragged along by massive market forces they become actors with the ability to make dramatic investment and market impacts – for better or for worse – within very short periods of time. In a mapless view of the investment world, parts of the investment map of China may include French and Brazilian real estate market realities; parts of the investment map of the United States may include Portuguese and Australian real estate market realities. Rather than needing to traverse great distances to find changes in risk and return relationships, they can often be found on the same street.
Risk and Return Mismatch Causes
The main reason that risk and return mismatches exist in the present is that it is impossible to predict the future with certainty. Financial markets are simply a collection of aggregated projected returns and every projected return is a statement about the likelihood of future events. Because the future cannot be predicted with certainty, every investment return forecast contains a degree of error risk, a constant that is indivisible from financial and economic life. This risk may be low, such as with respect to the repayment of a sovereign bond by a country with a strong credit rating or it may be very high, such as with respect to a highly speculative investment that depends solely on the occurrence of an unlikely event, but mathematically it cannot be eliminated entirely and it remains embedded in the financial system. Because of differences in how the future is viewed, risk is priced differently and risk and return mismatches are created.
Apart from the human inability to know exactly what tomorrow will bring, risk and return mismatches are created because new possibilities are constantly being created and levels of risk are constantly changing. While holding the bond of a real estate company or purchasing a building at a fixed cap rate implies a fixed level of risk over the course of an investment period, in fact risk levels will constantly change, often in ways that are not linear. Similarly, the cost of capital for an equity investment in a real estate project is based on the ability of the management team to implement the project’s business model, and the ability of the team to do so can vary dramatically due to market conditions, competitive threats and their own professional and personal motivations. Beneath the surface of risk pictures that seem relatively stable or to be moving in predictable patterns lies an incredibly complicated mix of risk factors that shrink and grow in size, affect each other in different ways, cancel each other out and amplify each other’s impact.
For almost every type of activity, major risks are not distributed evenly over time. If the key risks of flying in an airplane were plotted on a graph with the level of risk on the y-axis and time on the x-axis, it would likely show a spike in risk when the plane took off, a sharp decline in risk while the plane was flying and another sharp spike in risk when the plane was landing. If the key risks of rock climbing were plotted on a similar graph, it would likely show a low level of risk at the time when the rock climbing activity started (when the climber was on the ground) and a progressive increase in risk as the climber was farther from the ground, experienced greater and greater physical and mental fatigue and was subject to external factors that could hinder climbing performance.
Risks in connection with investments are also generally not distributed evenly over the life of an investment. For a real estate development project, for example, risk is very high at the beginning of the project until the time when the building is constructed and then tends to decline as risks which can prevent the entire project from going forward are replaced with the generally lesser risks of operational income and cost variations.
Another factor that causes risk and return mismatches is that upside and downside risks for many investments, particularly real estate investments that require high up-front capital expenditures, are not symmetrical. This means two things. First, it means that downside risks can often materialize faster than upside risks (i.e., a building can fall down faster than rents can rise or land values can appreciate). Second, it means that possible return/risk evolution scenarios are often skewed against the investor, at least in the short and medium term (meaning that the possibility for increased risk is greater than the possibility for increased return). This causes true risk levels in connection with an investment to vary considerably over time.
Risk return mismatches and the ability to take advantage of them also occur because of constant information inaccuracies and asymmetries. Markets price investment opportunities largely on information and relevant information about investments is very often lacking or wrong. Even for a publicly listed company that is required to continually inform the market of its financial situation and factors that materially affect its business, any statement of where it stands from a corporate or financial perspective is at best likely to be a very ephemeral snapshot that is instantly altered by constantly changing internal and external conditions rather than a fixed risk reference point that can be relied on by investors for lengthy periods of time. For investments in private real estate companies or real estate assets, particularly in markets that are not well developed, reliable information can be very hard to come by.
Another reason that risk and return mismatches are created is because many investment strategies are based on taking broad offensive or defensive asset class positions that cover many specific investment situations rather than making investment-by-investment choices. A fund, for example, may decide to reallocate a certain percentage of its investment portfolio from one type of asset, such as bonds, to another, such as stocks. While in general terms and on a total portfolio basis this may position the fund to better withstand some types of market shocks or for better overall risk-adjusted returns, these shifts in investment positions will invariably involve selling some securities at a discount and buying others at a premium.
This can also occur due to inefficiencies in investment portfolio diversification. While in theory investors seek to diversify their investment portfolios to maximize risk-adjusted returns, in practice many investors do not have well-diversified investment portfolios and often choose investment opportunities from a relatively small set of possibilities which are pre-filtered based on rigid investment guideline rules, analytical biases or limited investment sourcing channels. The effect of this is that a disproportionate amount of investment capital is often funneled into a small set of investment opportunities (i.e., only those within a certain country or a certain sector) and this can inflate their values relative to their actual levels of risk.
Risk and return mismatches are also created due to the fact that, although many investments are valued as though investment positions will be converted into cash at optimal periods of time, this is often not the case. Private equity funds, for example, have fixed fund lives and when the fund period ends they must ordinarily exit their investment positions. Individuals may come to points in their lives when they need to convert their investment positions into cash for different types of personal use. In these circumstances, the need to convert investment positions quickly often takes precedence over waiting to do so at the best terms possible (or those implied in original risk/return assumptions) and this often causes assets to be sold at risk-adjusted discounts. Further, many investors sell on bad news and in these situations investment exit prices are often artificially low due to negative market sentiment, particularly where the bad news affects large segments of the market.
Psychological Factors and Risk/Return Mismatches
One reason that risk and return mismatches are created is because of human bias in how the world is viewed. Because the complexities of the world, economies and financial markets vastly exceed the human ability of comprehension, we view the world through the lens of theories that reduce this complexity into manageable conceptual chunks. How carefully these theories are thought out and how sensible they are varies widely, but the key point is that simplifying reality to make it easier to deal with does not mean that the part of reality which is not so easy to simplify conveniently goes away. On many occasions, what are characterized as unpredictable black swans are perfectly visible white swans that we as individuals or societies collectively have, consciously or unconsciously, placed outside of our field of vision to accommodate other priorities. As Blaise Pascal has said, “we run carelessly over the precipice after putting something in front of us to prevent us from seeing it.”
The process of turning white swans into black ones is greatly aided by several elements of modern society, including the facts that new information is created faster than our ability to process it, the great physical distance that can separate the causes and recipients of financial and economic harm, biases in how information is distributed and the fact that given, as noted above, the tendency of most people to view the world in positive terms, dedicating one’s time to crying wolf about low probability events is often not the shortest path to winning friends and professional advancement. The gap between our working reality and actual reality creates misperceptions that strongly distort the risks implied in investment returns and actual risks.
Another psychological factor that creates risk and return mismatches is the power of collective thinking on individual perspectives. One consequence of the formation of most views of reality based on a very small snapshot of it is that we are often willing to change our perspective if enough people hold a different view, even if that different view may be completely false or even manifestly inconsistent with obvious facts or common sense.
Once a market tendency begins to develop, it is human nature to assume that the tendency reflects something “that we don’t know” and in the face of uncertainty about what decision should be taken this can very easily cause us to follow a trend rather than oppose it. As we follow the trend the trend is strengthened, increasing the possibility that other people will follow the trend as well. From a risk perspective, however, momentum-driven trends contain a significant likelihood that they are not based on fundamental market realities or accurate investment facts, which creates or amplifies risk and return mismatches. Once a trend slows, a new one often starts in the opposite direction, forming cycles of risk mismatches.
Another psychological dynamic that affects risk perceptions is the human tendency to form a view of the world which best accommodates our preference for participating in it. If I enjoy traveling to Italy and speaking in Italian, the odds are good that I will discount certain risks in connection with doing business in Italy simply because I like doing business there. In other words, I adjust my view of risk and the best course of action to take around the course of action that I prefer to take rather than an objective view of the course of action that I should take. Someone, on the other hand, who strongly prefers to invest in Latin America, may exaggerate the risks of doing business in Italy or minimize those in connection with Latin America to make it easier to conclude that Latin America is the better investment destination choice. Many statements of risk are the simple inverse of one’s own preferences.
Broader Consequences of Risk and Return Mismatches
In addition to identifying real estate investment opportunities on a transactional basis, risk and return mismatches create risks and opportunities at sector, country, regional and global levels. Given the fact that risk is often mispriced in investment transactions and millions of investment and financial transactions occur on a daily basis, these mispricings become aggregated at investor, institutional and market levels and this process of aggregation can lead to very large build-ups of risk and return mismatches. This has very large implications for market and financial sector stability.
While these mismatches exist in all market circumstances they can be particularly pronounced under certain conditions, such as in times of high volatility, high uncertainty and excessive market optimism or pessimism. When these mismatches occur during situations of structural economic or financial system weakness, such as when growth rates are low, the financial system is highly leveraged or there is a lack of confidence in the financial system, they can cause significant financial harm.
While black swan analysis is typically focused on a potential event with extreme consequences, it is often the great web of variables in a larger context which converts an event of manageable proportions into one with uncontrollable far-reaching negative impact. It is many times the backdrop of the event, rather than the event itself, that creates the real consequences; the event is the mere bridge between highly dangerous conditions that had previously been held apart by often the narrowest thread of chance.
It can be predicted that if a dog crosses the road I will likely swerve to miss it, but what are the chances of predicting that at the exact moment I swerve, a truck carrying explosives will swerve to miss me, explode and set a gas station on fire which will in turn explode and cause everyone inside to perish? Swerving to save the dog’s life would have very little impact on thousands of occasions but on the one occasion where a set of conditions is in place (a truck is coming the other way, the truck is carrying explosives, the truck is near a gas station), the consequences can be devastating. These larger and often very complicated sets of factors which surround triggering events are the real black swans because they are much harder, if not impossible, to predict.
Markets have natural defenses, of course, to managing risk and return mismatches. While the world is skewed toward optimism, pessimism is never far behind and the belief that rain clouds are never far from sunny skies helps act as a counterbalance to overly rosy visions of a risk-free future world. The great friend of pessimism is the fact that promises and predictions in the abstract can never be shielded from reality for long and when businesses launch results often fall short of what was expected. This causes people to speculate against rising prices, raise capital costs and scale back investment activities. At times this brake ceases to function, but when it does the consequences of forgetting about risk are sooner or later felt in the hard realities of failed investments, foreclosures and large market corrections.
A key component of the modern financial world, which would seem to greatly reduce risk, can actually amplify it significantly: diversification. Given the interconnectedness of financial markets and the amount of financial products that exist, it has become easier and easier to spread financial risk across among more and more financial market participants. In the past, a lender made a loan to a borrower and if the borrower did not pay the loan back, the lender solely bore the financial consequences. Today, the lender can sell that same loan to other lenders who can create pools of loans and issue securities in those loans to high numbers of investors. Through this process, the risk of non-payment of a single loan to a borrower in a town in a small country can be borne by investors all over the world.
While this spreads out risk it does not eliminate it. Just as in our daily lives we tend to ignore the uncountable “micro-risks” that can harm us, the financial system tends to ignore small financial risks and instead focuses on what are believed to be major threats and the very large practical task of moving money throughout the financial system. These risk build-ups, once they reach a certain level, can have a large impact on asset prices, financial system liquidity levels and economic growth.
Article by Darin Bifani
Darin Bifani is a founder of Cape Horn Investment Advisory, a member firm of ONEtoONE. He is the author of numerous books and articles on finance and risk management. His most recent book is “Dynamic Real Estate Investment Risk Management: Practical Value Creation Strategies for Volatile Markets.”