Market volatility is a fact of life in real estate investing. There are many risks by investing in real estate, from taking the liquidity risk of investing in an illiquid asset class known to the cashflow exposed to tenants’ credit risk. Real estate market risk can impact the property’s capital value and income.
Where Does Real Estate Market Risk Come From?
Real estate market risk can come in many forms. We have listed out the various markets that can affect any real estate investment, whether commercial vs residential property.
There are overlaps between the various threads as no single real estate market risk stands out by itself. Therefore investors need to understand what these risks are and how they interact.
- Cyclical market risk
- Structural market risk
- Capital market risk
- Credit market risk
- Tenant market risk
Cyclical Market Risk
The main risk of investing in real estate is taking the cyclical market risk. This comes from the real estate market’s ups and downs driven by the market’s supply and demand dynamics where the asset is located.
- The key factor in this instance can be the area’s demographic shifts where increasing population growth or demand to live in the area can raise property prices.
- But also what is as important is the market response to the increase in demand. From an investing point of view, a shortage of supply in addressing ramp up in demand is the perfect example of where we want to be.
A good real estate strategy is investing in neighborhoods that are heavily leaning towards NYMBISM as we know there are limits to future supply to meet the rental demand! This actually protects the landlord’s financial interest just as much as the “neighborhood characteristics”.
The cyclical nature of the market can also present opportunities for investors with patient capital as some of the best risk adjusted investments were made during downturns where there is no light at the end of the tunnel, and distressed sellers toss in the towel in sale negotiations.
At the end of the day, the property’s location and area can magnify the cyclical risk as some areas are more susceptible than others.
Structural Market Risk
Going from real estate cyclical market risk, structural market risk is a very different beast. Structural market risk can be difficult to adjust for or avoid if the structural change comes in force during the investment period.
Research shows asset allocation can have just as big an impact on long term returns as security selection. This is the same in real estate investing, where the structural trend can be just as important on the returns as picking the right property or local market.
You could have picked the best mixed use or retail asset in the real estate context but would have faced the headwind of the onslaught from eCommerce.
Similarly, a sub-grade industrial asset in an ordinary location would have outperformed a decent office building or definitely a well located retail strip mall with the tailwind seen from industrial asset class.
Structural change can come in other forms, such as location re-rating or other macro trends outside of the investor’s control. An example of location re-rating is seen in pockets of Pittsburgh in the 1990s, where the transition from an industrial and the steel capital of the United States to technology and medical hub meant certain pocks were highly attractive as the prices at the time did not reflect the full potential of the transition. While it is no doubt risks remained, it was a calculated risk in investing in the market when the upside outweighed the downside.
Sectors or areas undergoing structural changes can be exciting from an investing point of view. However, this requires work done ahead of time and truly understand the location or asset class to take full advantage or mitigate the risk of this on our investments. Structural change is an important driver of the emergence of alternative real estate assets.
Capital Market Risk
Capital market risk for individual investors is mostly a tailwind in our view. Capital market risk refers to the rate of institutional or private equity capital flow into the sector. During periods where it is easy for the bigger real estate managers to raise funds to buy real estate assets, the weight of capital flows lifts all boats.
Similarly, on the downside, as we have a glass half full approach. When there is a trough in capital flows, it presents an opportunity for us to restock or invest at attractive prices as the tide goes out.
An example of capital market risk is the multi-family sector post the GFC. Several private equity funds raised dedicated strategies or allocated capital in aggregating multi-family housing portfolios. The amount bought and the consistency of capital flow meant the prices stabilized and the capital flow tailwind boosted prices’ recovery.
Some of the largest listed apartment and multi-family property REITs in Top REIT ETFs have resulted from the private equity exits. While the tailwind is now mostly gone, it shows the emergence and dissipation can be quick and it is worthwhile to keep an eye on what the capital market is doing and get ahead of it.
In this instance, a capital market is a tool used by investors to drive the catalyst, which results in turbocharged returns.
Credit Market Risk
An offshoot of capital market risk is access to credit. Credit market covers access to debt capital, and the tightening and loosening of credit can directly impact pricing. As you can find the best deal, but if you can’t access credit to finance the deal, it will not happen.
There is also an interactive effect between capital and credit market for highly geared opportunities as high LTV investments by definition, require an open credit market for the lenders to provide the financing.
Tenant Market Risk
You cannot talk about real estate market risk without touching on the leasing market. The underlying demand by tenants is whether they are office tenants driven by employment growth or residential tenants driven by income or consumer confidence. Changes in the tenants’ financial conditions or tenant market can affect the property’s current and future cash flows.
It pays to keep an eye and understand what the main drivers’ tenants are looking at when choosing to lease your property vs. competing products are.
Some of the questions on tenant market risk include what the value propositions are? Is it location, pricing or amenities? By knowing the value drivers, you can leverage off and maximize the fact by highlighting it better. As a mitigating force, if the tenant focuses on pricing, there is no use in spending money on amenities. If they need to be located in that area, then there is room to move on pricing. All of this feeds into the leasing negotiation, and the best outcome is by knowing what the other party wants and try to get there with the least cost to yourself.
Real Estate Market Summary
The list of real estate market risks outlined above presents a good summary of the main market risks which can affect real estate investment. The points raised apply to commercial real estate risks as much as other real estate asset classes.