Assessing and Managing Real Estate Risk in Today’s Uncertain Credit Markets

by Susan L. Stupin, Managing Director, The Prescott Group, LLC

January 18, 2008 - The global real estate market is embarking on a period of greater volatility and risk, as well as significant opportunity for sophisticated and well capitalized investors. Difficulties in the US sub-prime residential market in recent months have triggered a reassessment of risk and pricing in the larger fixed income and debt markets around the globe. As a direct result, and particularly in the US marketplace, borrowing costs have increased, debt market liquidity has plummeted, underwriting standards for commercial mortgages have tightened, and capitalization rates are rising. Investors with moderate debt financing requirements and/or strong balance sheets should be well positioned to take advantage of their relative strength and negotiate attractive terms from sellers of mortgage loans, assets, portfolios and operating entities.

The current real estate capital market’s constrained liquidity, especially with respect to debt refinancing, and its higher equity requirements for even well conceived projects, offers the potential for an array of equity investment strategies. Many investment funds are building “war chests” of equity capital to take advantage of discounted investments arising from recapitalizations and other market discontinuities. Numerous sovereign funds are finding large scale opportunities for the deployment of capital into the financial industry and other sectors. Furthermore, many global investors are once again taking a close look at the US real estate market. Whether current risk premiums and constrained market liquidity are part of a new market order, or are more temporary, the landscape for active real estate investors has changed. Few investors in today’s market will have the luxury of enjoying impressive returns from simply an ever more favorable capital marketplace and narrowing capitalization rates.

Savvy global investors have historically invested in large and established commercial markets, such as the US, UK and Western Europe, and more recently in emerging markets, including Eastern Europe, the Balkans, Middle East/North Africa, India, China, Korea and Latin America. Anticipated and actual returns can be compelling in emerging markets and many institutional, fund, sovereign, fund, and private client and other investors have sought both return and diversification by broadening their global investment footprints. In growth economies, traditional risk factors such as real estate and capital market risk, as well as industry, political, regulatory, and sovereign risk, have been able to be subordinated to the goal of absolute return. In today’s market environment, however, the concept of “risk adjusted return” or, alternatively, a clear understanding of potential risk and reward, must be a critical factor in assessing real estate investment opportunities.

Need for a Realistic Assessment of Risk and Return

The dramatic increase seen in borrowing costs and widening debt spreads suggests that the real estate capital markets are entering a new phase of the market cycle. What had been a “sellers” market is transitioning to a “buyers” market, resulting in more favorable pricing for investors. However, apparently favorable pricing should be carefully examined in light of the investment’s sponsorship, their operating experience in the sector, their ability to execute a turnaround strategy, the underlying capital structure and its suitability to the realistic value and risk of the investment and the timeframe of the investment horizon, as well as underlying assumptions supporting anticipated income and revenue growth or operating efficiencies. As the private equity market has become far more focused on growing income and revenue through operations (versus capitalization strategies), so the real estate market must seek returns through well conceived operating strategies and their execution. The backdrop of an uncertain economic environment, particularly in the US and selected UK and European markets, also suggests that real estate investors should take a particularly close look at local, regional, and national growth generators supporting investment projections. Many property sectors in the US have enjoyed moderate levels of new development and associated additions to supply. Arguably, many markets may be well positioned to enjoy the benefits of excess demand. And dynamic micro markets can exist within many regional economies. Robust rental growth and space absorption assumptions that underpin many investment analyses, however, should be carefully scrutinized. It is also particularly important that investment underwriting carefully project and examine an array of downside scenarios. This analysis assists investors in understanding the risk profile of an investment as well as the type of capital commitment that may be required should the investment not perform as anticipated.

Developing a Real Estate Investment Philosophy

More than ever, investors will be called upon to fine tune their investment objectives with respect to real estate investment strategies. Investors who are utilizing real estate, within the Alternative Investment category, to balance overall investment portfolios must determine whether they are mitigating or compounding overall portfolio risk in their real estate investment choices. Not only can real estate investments be segmented across a spectrum of risk and return, but risk levels can be compared to other more traditional debt and equity instruments.

Furthermore, investors must understand that the risk profile of a particular investment can be impacted by numerous factors, including physical aspects of the property, its surrounding marketplace, its operator, and its capital structure. Investors may further choose to deploy capital as real estate debt or equity, selecting the form of the investment as a means of enhancing return or mitigating risk. Debt investments can take many forms, including first mortgage or senior financing, mezzanine debt, participating debt, etc. and typically offer a fixed current return, greater security, and limited upside. Equity investments similarly follow a spectrum of risk from common equity to a preferred equity structure, while preserving the investor’s more complete participation in both the upside and potential downside of an investment. To the extent that an investor may choose to pursue a “risky” investment opportunity, the form of his investment may be able to moderate the risk to some extent. Hence, for example, “Special Situation” or higher yielding investment funds or concepts often allow for the capital to be deployed as mezzanine debt or preferred equity, thus balancing investment risk via the form of investment.

Defensive and Offensive Risk Adjusted Investment Opportunities

Investors are considering different investment opportunities as a defensive component of their portfolio in an increasingly uncertain investment environment, or, alternatively, as a means of significantly enhancing overall returns. Either scenario can be attractive on a risk adjusted basis. Each scenario should also be carefully evaluated with respect to the investor’s risk and return, net of associated fees, promoted interests, and other costs. Furthermore, diversification across multiple assets and/or geographies can enhance risk adjusted returns for both sets of strategies.

Defensive Strategies

Net leased office and industrial properties with credit tenants in the US and global marketplace can offer solid and relatively secure current returns along with appreciation. Net leased properties are unique in that, unlike other real estate or alternative investments, they combine an enhanced bond-like annual yield with the long term returns associated with real estate investment. Many other real estate/alternative investments generate lower annual returns and/or rely more heavily on value realization at the time of sale. Single tenant, net leased commercial real estate properties consistently provide an attractive and secure risk adjusted return, producing stable long term cash flows combined with potential property appreciation. Net leased properties have long been a valued component of institutional real estate portfolios. Their balanced returns have historically been appealing to institutional investors, as well as endowments, foundations, private investors and fiduciaries responsible for trust oversight. The current turmoil in the capital markets is creating opportunities to acquire attractive core, net leased corporate office and industrial assets while potentially generating core-plus returns or better.

These predictable, annual returns should be especially appealing to: (i) financial institutions and sovereign funds seeking to own a balanced and/or diversified portfolio of real estate investments, (ii) institutional investors seeking to fund current liabilities or other operating needs, (iii) endowments and foundations seeking to fund annual distributions, (iv) fiduciaries responsible for trusts where these income streams may benefit different parties, and (v) individuals seeking a solid risk adjusted real estate return as a component of their investment portfolio. Net leased property investments are also regarded as yield enhanced fixed income investment alternatives. Annual returns on a net leased property portfolio may provide a total return that is several hundred basis points higher than an equivalent bond portfolio, with similar underlying credit risk characteristics. Furthermore, this product represents an alternative for historic investors in the CMBS/CDO market, where new investment flow is constrained, that is a potentially less risky and more available proxy investments.

Other defensive strategies may include a focus on certain product sectors that tend to perform well in times of economic uncertainty, such as healthcare related investments or value retail properties, offering discounted merchandise and serving as cost effective distribution channels for manufacturers. Multi-family assets can also offer broad geographic diversification, strong current cash flow, and counter-cyclical performance characteristics.

Offensive Strategies

Numerous high return/higher risk approaches can be undertaken in the current marketplace. These investment strategies are often characterized by lower current cash flow in return for higher overall returns that are typically “back end loaded”. The success of these strategies can be heavily dependent on effective execution, skilled operators, access to capital, buying at the right price and time, and matching the timing of a sale to supportive capital market conditions. Within the US, as well as globally, each product type, geography, associated real estate market conditions, investment and capital structure, and sponsor or fund manager should be carefully assessed in evaluating the particular strategy and its likelihood of success, as well as the size of the investment relative to the overall investment portfolio. As a result, these strategies may be best suited to investors of an institutional scale with strong balance sheets and the ability to spread risk.

Current distress in the credit markets is benefiting investors with capital who can recapitalize outstanding debt with equity, preferred equity, or mezzanine financing. Many well conceived properties and portfolios have become capital starved in recent months and spreads/margins have risen to reflect illiquidity in the debt marketplace. As this distress works its way through the financial system, investment may be able to be made at the property or portfolio level, as well as through the acquisition of debt instruments. Strategies may also include targeting product types or market sectors where opportunities are highly specific to the circumstances and risk of the market environment. In emerging markets, for example, sectors such as housing and retail, can serve increasing demand from a growing and increasingly wealthy population. Investment in US and other markets can be made in less traditional locations, such as secondary or tertiary markets where competing capital may be less saturated and both risks and returns are higher; in product types that are experiencing overbuilding and distress, such as overbuilt condominium markets in selected Southeastern markets in the US; and in niche investment products or strategies, such as military housing, or out of favor regions. In some markets, development projects or programs may be well justified and can offer premium returns (alongside lease-up and completion risk) compared to existing assets. Investors may also consider corporate investments or operating entities that offer well conceived strategies but may be lacking sufficient ingredients for success, such as capital, expertise, or other characteristics.