Risk and uncertainty pervade the real estate sector like few others. Construction companies face pressure to deliver on time and on budget, businesses must deal with complex regulations and leases, and investors worry about income and capital returns. Choosing which property to buy can be devilishly difficult, not only for a couple buying their first home but also for a company searching for new offices. Indeed, in real estate “everything is relevant”, as David Geltner, professor of real estate finance at Massachusetts Institute of Technology (MIT) has said.
But in an industry where everything matters, how can you effectively identify and mitigate risks? This is an important question for investment funds, pension funds, and other large property investors, as well as owner-occupiers.
Idiosyncrasies amid the investment boom
While the appetite for real estate is clear, attempts to forecast returns are shrouded in uncertainty. Investors need to make an array of assumptions not only about the physical assets but also about the wider property market. Furthermore, while classifying properties by sector and region may seem natural, neither provides a sound basis for risk reduction.
“Spreading a portfolio across sectors or regions does not work very well because these factors don’t explain enough of the difference between properties,” said Tony Key, Professor of Real Estate Economics at Cass Business School in London. “Simply buying more assets is effective, however, because so much of the risk is related to idiosyncratic differences between buildings.”
Heavy exposure to just one region may call for some diversification, but so would bunching of lease termination dates. Studies suggest that holding between 30 and 50 properties substantially reduces risk. But full risk diversification requires a portfolio of 200 or more. The UK’s Investment Property Forum has suggested that while there “may be no silver bullet” for portfolio risk, new approaches could enable better future management.
Many corporations are owner-occupiers of large amounts of real estate. These businesses are sure to consider cost and convenience when deciding where to buy or build offices, warehouses, and retail spaces. But what about risks that could severely disrupt business operations? Globally, the annual average of 335 weather-related disasters per year between 2005 and 2014 was 14% higher than in the previous decade, according to the United Nations.
Yet businesses and investors could receive far more detailed insights into climate and weather-related risks to real estate than is currently the norm. A 2017 report for the UK-based Royal Institution of Chartered Surveyors (RICS) looked at flood risk management across commercial property in Australia, China, Germany, the UK and the US. It found “substantial potential” to increase the role of built environment professionals, who deal with creation and modification of e.g. buildings, parks, and transportation systems, in mitigation and called for a better understanding of how climate change is altering the risk. The report also suggested legislation could encourage insurance uptake in flood-prone areas.
Depreciation: the life stages of buildings
Demand for technical due diligence reports on the physical condition of buildings has been increasing in Europe. With the globalisation of the real estate market, financial institutions, investors, and owner-occupiers want a better understanding of what they are buying and selling.
MIT’s Professor Geltner undertook research that found commercial buildings in the US tend to last around a century. This ‘lifetime’ can be divided into three stages: youth lasts 30 years and involves a sharp initial drop in value; middle age, during which buildings may need more maintenance but their values vary relatively little; and old age, whereby values decline rapidly after 65 years since construction.
Together, this decline and spending on routine improvements amount to annual ‘gross depreciation’ of seven per cent of a building’s remaining value, according to MIT. Professor Geltner says this is higher than the real estate investment industry generally assumes.
Risk engineering the details
Whatever a building’s age, surveyors and risk engineers can assess any hazards and help prevent or minimise business interruptions. Risk engineering experts can not only identify and quantify risk areas but also develop smart and pragmatic solutions to technical issues and health and safety challenges. Digital technology is helping risk professionals hone their approach in a range of areas. For example, building control surveyors can use 3D digital models to manage fire safety plans.
But technology cannot replace a risk engineer who understands the local laws, codes, standards, customs and language, and will be able to offer bespoke solutions. Whether they are looking at machinery, water supply, fire safety or anything else, risk engineers must be attuned to the details that make all the difference. In this respect, their expertise offers lessons for anyone with a stake in real estate; remember that everything is relevant, that risk can be reduced but not removed, and focus on what you can control.