Role of risk management in commercial real estate (CRE) wealth creation

Published on August 24, 2022 by Abhijith Muraleedharan

Introduction:

Risk is defined as a probability of losses or negative rates of return in the investment industry. Every investment involves some degree of risk and an investor primarily focuses on limiting the risk with the help of efficient risk management. Similar to other financial products, risk is a critical factor in real estate investment. Moreover, risks in real estate can be trickier than risks in other assets, due to numerous factors, such as inefficiency of the market and capital intensity of investments. Real estate asset classes are classified into two types:

Real estate is an important asset class that contributes to wealth creation, which is the process of investing in different asset classes to help meet the long-term financial goal of the investor. Moreover, investment in real estate helps diversify an investor’s portfolio, and diversification is an essential element in successful wealth creation.

Advantages of investing in real estate over other investment vehicles:

  • Hedge against inflation: Inflation results in the decline of the purchasing power of a currency and an increase in the prices of goods and services. Real estate prices increase simultaneously with the rise in inflation, and sometimes increase more quickly than inflation.
  • Tax advantages: Real estate investors get tax advantages in the form of tax breaks and deductions. This helps exclude valid costs of owning, running and controlling a property.
  • Capital appreciation: Investors usually make real estate investments for long-term needs, and a major benefit of investing in real estate for the long term is the appreciation of its value over time.
  • Cash flow: One of the key advantages of investing in real estate property is the steady cash flow that investors receive from rental income. Moreover, cash flow in real estate investment becomes net income after the payment of debt services and business expenses.
  • Low correlation with other investment assets: Correlation in the finance and investment industries is a statistic that measures the degree to which two investments move in relation to each other. Real estate is a non-correlated asset class, and performance is not typically linked to that of the stock or bond markets.

Advantages of investing in CRE over other real estate types:

  • Higher return: CRE properties give higher returns to investors vs residential real estate properties, as rental income is more stable and offers an excellent source of value appreciation, attracting more investors.
  • Secure investment: CRE has a stable real value (intrinsic value). Buying the appropriate type of commercial property in the right location will keep investors safe from loss of cash inflow even during an economic downturn.
  • Long-term leases: The duration of a lease in CRE properties is longer than that in residential properties. As a result, investors in CRE properties do not need to look for new tenants frequently.
  • Increase wealth by leveraging: As investment in CRE is safe, the loan to value (LTV) can increase to 95%, but in the case of residential properties, the LTV stands at 65–80%. Therefore, for CRE, investors can use additional leverage to generate more returns.

Types of risk in CRE investing:

Similar to investments in any other asset class, investing in CRE comes with various risk factors that have a correlation to returns. However, there are a few properties with low risk, such as triple net lease (NNN) properties, where a tenant pays most of the costs incurred for the property. Listed below are risks associated with CRE investment:

  • Inflation risk: On an average, the inflation in the US since 2000 has been at around 2%, and every property owner considers this 2% as a base for his/her rent growth rate for the future. However, if the inflation rate for a year increases above the owner’s expectation, he/she will face an unexpected shortfall in his/her cash flow.
  • Liquidity risk: Liquidity refers to the ability of an assetor security to be converted into cash without affecting its current market price. CREs are substantially expensive, making it less liquid.
  • Credit risk: Credit risk or default risk is the possibility of loss from a borrower’s failure to repay the mortgage or meet contractual obligations. With leased or rented property, there is always a risk that tenants will not be able to make lease or rental payments on time.
  • Lending rate risk: Lending rate risk or Interest rate risk is the possibility of loss due to a change in interest rate. In case of an increase in rate, borrowers holding a floating rate loan are negatively impacted. In addition, an increase in interest rate will likely result in a higher internal rate of return, which will eventually reduce the net present value of the investment.
  • Regulatory risk: Regulatory risk refers to the risk from a change in laws and regulations.

Risk mitigation in CRE:

Risk mitigation is essentially reducing the risk exposure and adverse effects of risk to increase the return on investment. Listed below are mitigants of risk in CRE:

  • Diversification: Investors who diversify prefer not to put all the eggs in one basket. They try to balance the portfolio by investing across multiple property types or locations. The main benefit of diversifying an investment portfolio is to reduce the market risks associated with one type of investment property or real estate market.
  • Demand and supply analysis: Investors must analyse the demand and supply of their property. One of the main drawbacks of a CRE is that it is less liquid, due to higher acquisition costs. Therefore, before employing capital into the property, investors should analyse the demand and supply of the class of property at the location to generate maximum returns for capital invested.
  • Due diligence: Due diligence is a systematic way to analyse and mitigate risk from an investment decision, providing transparency and clarity for a deal. Investors must conduct a thorough research on the property that they are going to invest to prevent any monetary loss arising from the investment.
  • Know the real estate cycle: Real estate investors must pay close attention to the macroeconomic and microeconomic scales of the real estate cycle. The real estate cycle is a four-phase series that reports on the status of real estate markets (expansion, contraction, recession, and recovery). Understanding real estate cycles helps investors take better investment decisions.

How data analytics helps in reducing risk in CRE:

Data analytics is a method of analysing data to make conclusions about decisions. All the decisions in real estate primarily revolves around numbers, and CRE investors currently use various data science to take a decision to minimise their risk and maximise their return.

Types of CRE analytics:

  • Predictive analytics: An advanced type of analysis that uses statistical modeling combined with machine learning, data generation methods and historical data to predict future outcomes. Predictive analytics in CRE helps investors accurately predict the profitability and risk of various investment alternatives to enable investors to select the best opportunities that suit their risk tolerance and availability of capital.
  • Descriptive analytics: A type of analysis that uses historic data to understand the changes of the recent past. Descriptive analytics answers the most common real estate performance questions to enable investors to take proper investment decisions.
  • Diagnostic analytics: An analysis that studies historical and current datasets to explain the reason for a past trend. A CRE investor can use data drilling and data mining to analyse data using diagnostic analytics. This helps investors gain an insight into the data patterns that will help solve problems.

Conclusion:

Many investors believe CRE is an important investment class. Despite fluctuation in the market cycle, some commercial properties remain a desirable investment option because of their stable nature. The low correlation with other assets and the stable nature of CRE help investors diversify their investment. Although CRE is a healthy and fair investment option, significant risks are associated with it. However, efficient investment management can help mitigate these risks. Therefore, an investor should be able to manage risks by avoiding, controlling and transferring them.

A well-diversified portfolio is essential for investors to increase their wealth, and a smart investor understands the importance of owing a diversified portfolio and the importance of CRE in a diversified portfolio.

How Acuity Knowledge Partners (Acuity) can help:

Acuity has multi-sector expertise in the areas of financial analytics, valuation and advisory services. The CRE sector is one of our key focus areas, and we have a large team of CRE analysts and subject matter experts who support global financial institutions, brokers, investment firms and service providers. We provide support across the CRE deal lifecycle — from loan origination, lease analysis, loan underwriting and valuation, guarantor analysis, covenant monitoring and testing, post-closing and portfolio monitoring to asset management. Our proprietary suite of Business Excellence and Automation Tools (BEAT) gives clients leverage, and we provide them with bespoke products and services customised to their requirements.

About the Author

Abhijith is an Analyst at Acuity Knowledge Partners and has an years’ experience in lending services. He currently supports one of the leading insurance companies, providing support in commercial real estate asset portfolio management. He has good knowledge of structured debt, fixed income securities, equities, and alternative investments. He holds an MBA (Finance) and Bachelor’s degree in commerce.

Originally published at https://www.acuitykp.com.

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We write about financial industry trends, the impact of regulatory changes and opinions on industry inflection points. https://www.acuitykp.com/