Dear Investor, Here Is How To Understand Real Estate Risk

In a pragmatic sense, risk can be defined as the difference between expectations and realizations. It is an uncertainty that is inherent in anything marked with the passage of time.

For instance, the COVID-19 pandemic has brought about unprecedented changes in global economies and accelerated the need for significant changes in sectors such as real estate.

In the investments world, risk and return are positively correlated as most people tend to be risk-averse, thus, the higher the risk than the higher the return.

As a general rule of thumb, investors should always be aware of the various risks involved with an asset class before deploying their capital. In this article, we focus on five of the risks that are inherent to the real estate sector:

Market risk:

The risk associated with real estate investments is primarily determined by the uncertainty of the value of the property involved. Property and property-related assets are inherently difficult to appraise due to the individual nature of each property and due to the fact that there is not necessarily a clear price mechanism.

As a result, valuations may be subject to substantial uncertainties. There is a risk that the estimates resulting from the valuation process will not reflect the actual sales price. As such, a property market recession could materially adversely affect the value of the property.

Liquidity Risk:

Real estate as an asset class has relatively low liquidity. It will normally take months both to invest in and realize direct investments in real estate. Real estate projects are not listed on any stock exchange or other regulated market place.

Potentially poor liquidity is one of the most problematic qualities of real estate projects as an asset class in a financial portfolio, but at the same time they may yield potential liquidity bonus which long-term investors may be able to benefit from.

Regulation Risk:

Regulatory amendments may affect prospects for the future lease of the premises, or prospects for the future sale of the property. New technical or other requirements (including health and environmental requirements) pertaining to the property may also impose costs on the company or individual that cannot be recouped from the tenants.

Time to time, relevant tax rules, or the application of rules may change. Amendments to tax rules may result in investors being faced with new and different investment conditions, including reduced profitability of the project.

Time Risk:

In general, exceeding the planned project timeline leads to two main risks: cost of capital such as interest increases with delays reducing project returns, and market conditions may change over time for the worse. This is especially relevant as usually, top of the market conditions trigger developers to pursue marginal opportunities. As markets turn and consolidate, delays in the completion of such projects aggravate losses.

The time risk can be addressed by professional best practice project management including, selection of experienced and qualified project management teams, clear documentation, coordination, and communication between project parties, and timely commencement of marketing. An overall understanding of market forces and dynamics is also critical.

Stakeholder Risk:

Also, delays in the planning approval process increase the above mentioned time risk. At a time like this when government parastatals such as land registries remain closed due to the ongoing novel coronavirus pandemic, projects are set to be delayed indefinitely prolonging set project timelines and ultimately leading to increased development costs as debt costs continue to accumulate.

Additionally, all development is subject to planning, and while developers, in general, apply for permissions that are in line with official planning rules and development plans, the multitude of affected stakeholder interests can lead to specific conditions that affect the cost and feasibility of a project. The approval process should be project managed professionally to minimize this risk.

In conclusion, real estate is susceptible to a multitude of risks owing to its temporal nature. Real estate development is a speculative and entrepreneurial activity and factors such as unknown future demand, risks, and uncertainty are key elements of real estate development.

As such, risk management is of paramount importance, especially during economic downturns. Investors should always consider the risks to a project, attempt to quantify them within a feasibility analysis, and potentially adjust the project so as to minimize them, where possible.

Written by Wacu Mbugua, a real estate research analyst at Cytonn Investments