Jim MacCrate, MAI, CRE, ASA, has worn many hats in his career. He taught a number of the appraisal classes I have taken through the Appraisal Institute and I think he is one of the few people who actually understands the “J-Factor.” His wife Judy is an SRA and is an accomplished appraiser in her own right, having managed an appraisal panel for a large lending institution throughout its various mergers for a number of years. I can only imagine the riveting conversations at dinnertime. This week, he ponders taking the red eye to Las Vegas or searching the real estate classifieds and risk another purchase. …Jonathan Miller
This is a tough question. The answer lies in knowing your risks.
Real estate investment risk is the probability that an investment’s actual return will be different than expected. Measuring risk is difficult, especially when a turning point in the market is apparent. Yesterday, Bill Gross, bond investment guru at PIMCO Funds, became bearish on bonds, and predicted that rates on ten-year treasury bonds, while expected to dip a bit in the next few years, may approach 6.5% over the next five years or so. That does not bode well for real estate investors, who can no longer expect the high favorable returns achieved during the last five years.
But should investors ever really expect high returns? Smart investors may be able to, if they manage their risks effectively. A qualitative risk profile must be developed for a real estate investment to properly assess the inherent risks before committing equity or debt.
The Appraisal Institute and several textbooks generally list the following types of risks that lenders and investors must consider.
- Business risk
- Financial risk
- Liquidity risk
- Inflation risk
- Management risk
- Interest rate risk
- Legislative risk
- Environmental risk
Each of these risks is a different piece of the puzzle that makes up the whole investment picture
Saggy sectors; Loose lenders? Fix those trouble spots!
At the same time that rents are rising, growth is slowing in many sectors. This is an example of business risk. If a local market relies on an industry that is losing jobs, retail and services will suffer. This makes it more difficult to lease already vacant space. Landlords must decide if it is worth it to release the space to get the higher rents, when there may not be another tenant to take over the space.
To increase loan volume, many lenders reduced their debt coverage ratio requirements and have permitted higher loan to value ratios during the last two years. Lenders reduced requirements in order to take advantage of favorable market conditions and affordability so they can increase the volume of transactions. This has been going on for two years. Combine this with an interest rate increase and financial risk will skyrocket.
Sink or swim?
Then there is liquidity risk. Real estate isn’t soda pop. It is a relatively illiquid asset. In a downturn, you can’t just switch to a healthier asset class without a lot of time, paperwork, fees, oh and lawyers. The real risk is the cost of selling and the missed opportunity. If you are desperate, you can always call up your local real estate broker and who may very well offer to buy the assets at a substantial discount, say 50- 60% of market value.
The Feds have stated clearly that they are very concerned with inflation. If construction costs rise, but rents do not, then, land values must fall. The materials that go into construction have risen, such as copper, aluminum, etc. Some investments that have properly drawn leases may be partially protected from inflationary risk. However, the interest rates that are charged are directly influenced by the inflationary expectations in the marketplace.
Dilbert’s boss buys land
Inexperienced investors have acquired real estate during this financial cycle. These investors often have insufficient liquid assets to ride any dip in the market. Since many lenders have reduced their underwriting criteria, the investor’s profile may not reveal the extent of their financial history or current financial position. This is a big risk, not only to the borrower, who may not be able to pay back the loan, but also to the lender who may end up stuck with a portfolio of non-performing loans.
The talking heads all have opinions. Whether you agree with Bill Gross, or not, you should keep an eye on interest rate risk and hedge your portfolio. Increases in interest rates will negatively impact the value of commercial real estate, all other factors remaining neutral
Also, don’t take Gross’ word for it and don’t follow herd mentality. The “wisdom” of the talking heads is one thing that inexperienced investors are too willing to follow, and often the advice is too late and a dollar short. A lot of people have opinions about where rates are going, but no one knows for sure. Since fed adjustments affect everyone in a single bound, it’s more telling to look at what Bernanke is doing. If he isn’t fixing it, maybe it ain’t broke. .but historically, the Fed has made mistakes.
Sharks in the pool
Legislative risk is always present. Politicians do not always act in our best interests, even though they claim they do. No change noted, but one must always be on the watch for political actions that can adversely affect real estate, such as the Tax Reform Act of 1986, insurance legislation in the Gulf states and real property taxes increasing at an alarming rate in some locales.
while California burns
Accidents happen, and sometimes they are real doozies. Environmental risk is always present. Some environmental risk can be controlled, but most is truly unexpected, so you have to have a contingency plan.
Safety in numbers
So, looking at eight risk factors, six have a real negative impact for all investors and two are anyone’s guess.
Three tools, if properly used, can assist investors and lenders to make informed decisions and minimize risk in the current changing economic environment:
- Real property appraisals that include a sensitivity analysis
- Professionally prepared by qualified and licensed individuals, proper structural and environmental due diligence, and
- A thorough market analysis of the critical factors impacting the local market.
These tools, if prepared by ethical professionals, will help a lender or real estate investor make sound decisions about the investment. In addition value and opportunistic investment strategies should be employed to maintain adequate returns on real estate investments.
Thanks to Noreen Whysel who provided some input and assistance.