Today, investors are looking at a much hazier economic environment for the future than a year ago. Market expectations govern investment activity in all financial investments as capital chases risk-adjusted returns. A close look at the psychology of risk, however, may allow real estate investors to use such doubt to their advantage. In general terms, the risk is the uncertainty that an investment will not earn its expected rate of return. The three types of risk that a real estate investor faces are:

1. Overall market risk (i.e. national market risk of inflation, interest rates, capital flows), which is considered unavoidable;
2. Property Sector risk (i.e. inherent risk differences among residential, office, retail, industrial), which can be minimized;
3. Individual property risk (i.e. physical characteristics, location, quality, leases in place) which is avoidable.

In efficient markets, investors are not rewarded for the latter two forms of risk because, theoretically, they can be eliminated by diversifying your portfolio. However, real estate markets are not as efficient as the stock and bond market. Property markets are illiquid, trading is infrequent, assets are not homogeneous (no two assets are similar by location and type), transaction costs are high and information is imperfect because there is no central exchange.

In today's economic environment, and given the inefficiencies in the real estate market, an investor can identify opportunities at the individual property risk level, and thereby outperform the market by doing superior research. The market's ability to seize on real estate opportunities has clearly shifted from the no-brainer investment phase of the early 1990s to a very selective property level opportunity base. To be successful, investors have to shift their focus to meticulous property cash flow and price analyses. Identifying opportunities today, demands that investors be rigorously grounded in understanding property sector risk analysis - that is, they must be able to develop a credible cash flow forecast and to complete an unbundling analysis of the components to measure the relative risk of the asset. Investors also need to apply both fundamental and technical analysis to the property sector risk. By understanding the expected and required returns of a specific property, opportunities can be predicted.

Overall Market Risk

Factors that determine the market risk are:

• Demand Supply - In a well-functioning market, the price of a property should bring demand and supply into equilibrium. If a surge in demand pushes the price of existing property above its replacement cost, developers have an incentive to build more. But the new properties take years to complete. By the time buildings are built, demand may have fallen, so prices will slump. Worse still, because of the lags, supply will for a period continue to increase even as prices decline, pushing them lower. This lag between demand growth and supply response is a major cause of volatility in real estate cycles. Understanding the demand supply situation is a key to successful real estate investing.
   

• Interest rates & inflation - The level of interest rate and inflation rate determines the state of activity in real estate market as it affects the cost of borrowing and expectation of return. Further inflation has an impact on property prices and level of rents.
   

• Capital flows - There is a new capital order of discipline in the real estate market. Capital is rationally priced and allocated along the risk spectrum. Investors must have a clear understanding of the relative discipline of capital flows to the market. A determination has to be made if capital is being rationally allocated (capital is chasing risk-adjusted returns) or if it is being thrown at the investment (capital is chasing the product). As we saw in the early boom of 1990s in real estate, and in the late 1990s for the technology sector, if capital is chasing the product, then the market is doomed for large corrections later on. But for real estate today, capital is chasing risk-adjusted returns, which means that investors should look at real estate as solid investment opportunity compared to alternative investments.
   

• Yields - have decreased in past few years, mainly due to drop in interest rates. Required total returns usually follow the trend of interest rates, as investors and lenders are accepting a lower rate of return as deals become positively leveraged.
   

Property Sector Risk

With the various property types (office, residential, retail, industrial, hotel); comes different property cycles. Economic dynamics directly affect each of the property types differently. Real Estate is relatively slower to respond to changes in the economy as compared to many other businesses. Knowing the background of a market and property type within a market can help to determine the risks and cycle length of a market.

Office sector

Office properties have been the underperforming sector due to technology meltdown, a weaker business environment, closures, layoffs and mergers, absence of fresh demand, emergence of multiple business districts. As a result vacancy levels have risen resulting in falling rents and prices. Further, this sector is still facing a supply overhang as new properties started during the commercial boom of year 2000 and 2001 are now being marketed.

The outlook for this sector looks promising with the economy gaining momentum and prices of both rent and capital values looking reasonable from historical and international standards.

Residential Sector

Lower interest rates, favourable taxation treatment on mortgage payments, easy availability of finance has contributed to the success of this sector. The average return has been more than 10% in residential sector over last two to three years. This has led to a large development pipeline with developers wishing to cash in the rising residential boom. The prices in new projects continue to rise so does the gap between new and resale properties.


Retail Sector

The emergence of organised retailing and entry of foreign retailers has brought cheers to the retail sector. Retail sector continues to provide positive returns.

Individual Property Risk Analysis

Property selection (tactical) decisions should take precedence over strategic decisions (asset allocation and property sector) in today's market. An improved understanding of markets and property economics can be obtained through research, market analysis, and property-specific due diligence. While obtaining information on individual properties (income and expenses, conditions, location, quality of construction, title, etc) requires work, it can be accomplished through a fairly simple and straightforward process. The understanding obtained through this process substantially reduces risk.

Conclusion

Real Estate is by far the world's biggest single asset class. Investors have much more money tied up in property than in shares or bonds. Real Estate is just as prone to irrational exuberance as is the stock market. It should not be viewed as an easy way to make money. People buy property in the expectation that its price will continue to rise strongly over time. Such expectations lie at the core of all bubbles. Bubbles form when the price of any asset gets out of line with its underlying value.

The price you pay for a property should reflect the future rent at which you could let it. Just as in the stock market, the prices in real estate are also driven by sentiments. All that is required to reverse a price movement is a change in sentiment.

Real Estate also lends itself to research and market analysis that can greatly increase an investor's understanding of the economic fundamentals affecting a potential investment in a specific property. Research and analysis, properly done, substantially reduces risk. This is essential to successful real estate investments.

About the author:
Sorabh Jain is a Chartered Accountant and holds a Masters degree from London Business School, UK. He is a Director of Mymakaan Limited. The views expressed above are personal. He can be reached at sorabh@mymakaan.com

This article appeared in Times Personal on September 23, 2003.

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