The following is the first of a multi-part lecture series on real estate risk presented by Randy Zisler, PhD at the Encore Wealth Breakfast on 4.9.13.
During both my faculty tenure at Princeton and my career in investment banking and institutional real estate capital management, seasoned veterans and novices alike have sought guidance on the nature and complexities of real estate risk. People have a visceral appreciation of risk but few understand how to measure, much less manage risk. I think of risk as the probability that an actual return will deviate from the expected return. Of course, most people seek to avoid downside risk. There are many types of financial risk: Capital, country, default, macroeconomic, exchange rate, interest rate, liquidity, political, refinancing, reinvestment, settlement, and sovereign.
I want to address two kinds of risk: Portfolio risk and deal level risk.
Diversification is a central portfolio management concept. There are two kinds of diversification: One is true or economic diversification and the other is naïve diversification—“Don’t put all your eggs in the same basket.” With regard to true diversification, a portfolio manager seeks to enhance overall portfolio performance by combining assets with low return correlations. Through diversification, an investor can enhance return without bearing additional risk. Conversely, the investor can reduce risk without sacrificing return. However, at a point where the investor obtains all the benefits of diversification, there is no way to increase returns without incurring additional risk. Real estate, be it public or private real estate debt or equity, is a good diversifier in the context of a multi-asset portfolio. By contrast, naïve diversification comes in two forms. The “Don’t put your eggs in one basket” investor believes that a diversified portfolio consists of a variety of distinguishable assets. Unfortunately, this investor ignores the return covariance among assets. As a result, the portfolio, rather than being diversified, could harbor significant latent and highly concentrated risks. A not dissimilar investor may attempt to diversify—50% office properties and 50% apartments, all in San Jose—but fail to realize that the assets are indeed correlated.
Investors should be aware that there are systematic and nonsystematic risks. The former are not diversifiable. While an investor may be able to hedge interest risk at a cost, as an example, a domestic investor cannot shed interest rate risk through diversification. However, the capital markets will reward the investor for bearing systematic risk. By contrast, nonsystematic risk, such as the risk that a single tenant out of hundreds will default, is diversifiable. Hence, the capital markets will not reward an investor for bearing diversifiable risk.
Even though diversification is the closest an investor will get to a free lunch—remember, nature hates perpetual motion machines and markets abhor free lunches—diversification is not free; it takes time and expense to evaluate and implement effective diversification strategies. At some point, there are diminishing returns to diversification. For example, if real estate comprises 5% of an investor’s portfolio, the need for real estate diversification to the investor (but maybe not to the real estate advisor) is probably less than the need to diversify the investors 70% allocation to domestic common stocks.
Developers and owners, unfortunately, assume risks which they can and should shed. For example, developers bear a number of risks which can include interest rate risk, entitlement risk, leasing risk, and construction risk. While developers should be able to manage entitlement, leasing and construction risk, they should not assume interest rate risk. However, many chose to hold long term assets (leases with long durations) while financing with short term debt. This is equivalent to owning a badly managed savings and loan without giving away toasters to depositors. The developer should consider hedging (or shedding) the risk, especially if the owner contemplates a long term hold. Some developers might argue that the deal is no longer viable if they hedge. If that be the case, the capital markets may be delivering an important message: The deal does not work. Of course, the developer or owner may have other assets and liabilities which might minimize this concern.
At the deal level, there are many risks which include those pertaining to entitlements, completion, tenant default, leverage, etc. Leases, which are a fundamental component of commercial real estate, for example, are bond substitutes. As such, leases present re-leasing risk at the time of expiration and the potential for releasing risk is a function of the contract rent in relation to prevailing market rents at the time of expiration. Additionally, leases, much like corporate bonds, are subject to tenant default and are therefore priced implicitly at a spread over Treasuries to reflect this risk. Oddly, the real estate industry is much less sophisticated than the fixed income markets in managing lease credit risks.
Deal structure, which is an important component of any deal, pertains to the architecture of the capital stack, which can include sponsor equity, co-investment equity, preferred equity, and senior debt. Leverage increases return variability and the probability of owner default.
Leverage can increase the nominal investment return, but seldom does leverage alone increase the risk-adjusted rate of return. Why use leverage then? Some investors and their managers have impressive performance records and are quite adept at timing the market or identifying mispriced assets. A sponsor may have ample capital with which it provides capital immediacy to financially weak sellers; it may have special, non-public information and a uniquely effective way to process that information. In those cases, leverage can be an excellent return enhancer.
However, for those investors or managers lacking such tactical skills, leverage can be destructive; it may simply be a way to increase gross assets under management and thereby boost investment manager fees. Hence, when considering leverage, investors should seek a record of superior timing skills and alignment of sponsor-investor interests.
The poster child for the misuse of leverage is a pension fund with fixed income or bond-like assets that elects to buy through its real estate investment advisors highly leveraged real estate as a way to maximize its expected real estate return. The leverage on the property is effectively a liability on the pension fund’s balance sheet. (If the leverage is non-recourse, presumably the pension fund through its advisor has paid for the non-recourse option.) Thus, the property leverage partially offsets the desired portfolio impact of bond-like assets and distorts the pension plans overall asset allocation strategy. The lesson is not that leverage is bad; rather the lesson is that leverage and other risk attributes should be carefully evaluated in the context of the investor’s overall portfolio—assets and liabilities.
Why are liabilities important? An asset, like T-bills, widely considered to be a low risk asset, may be risky in the context of long-dated liabilities. By contrast, a high risk asset may be positively correlated with the liabilities and therefore reduce the overall variability of the pension fund surplus (assets minus liabilities).
Conclusion. There is more to risk than meets the eye. All risks should be carefully evaluated in the context of the investor’s liabilities and assets.
Randy Zisler, PhD currently serves as Senior Managing Director of Encore Institutional Capital. For his full biography, please click here.
Watch Dr. Zisler’s full presentation below: