Chasing risks in a changing worldOctober 17, 2011 / By
“Risk, I learned, was a commodity in itself. Risk could be canned and sold like tomatoes. Different investors place different prices on risk. If you are able, as it were, to buy risk from one investor cheaply and sell it to another investor dearly, you can make money without taking risk yourself.” – Michael Lewis in Liar’s Poker.
Peter Bernstein says that risk is one of the prime catalysts driving Western Society. The magnitude of interconnectedness in today’s world implies that occurrences that take place in one part of the world more often than not traverse to the other extreme end, albeit with a time lag. This ‘Butterfly Effect’ has ensured that risk stands to be a crucial catalyst maneuvering Asian economies as well. Risk appetite does, however, vary drastically from one investor to another, and one economy as a whole to another. The theory of decoupling has not proved to be wholly accurate. It was initially perceived that the Asian markets were unscathed by the mayhem in the financial markets of the advanced economies, a while ago. However, there were a number of channels that transmitted this mayhem from the West to the Asian economies, one of them being the colossal reversal in the flow of capital.
Asian economies have been traditionally viewed as not having large direct exposure to securitized assets that are associated with high-risk lending. However, there are certain elements of risk omnipresent in real estate as an asset class worldwide. These include financial risk. The use of debt financing by investors amplifies the business risk associated with real estate. However, the degree of financial risk is dependent on the cost and structure of the debt. Liquidity risk is more pronounced in those markets where many buyers/sellers are not readily available. Liquidity risk heightens the possibility that the seller might have to give the buyer a price concession should the need to dispose off the investment quickly arise. Real estate investments, particularly, can bear high liquidity risk due to the large transaction size, policy constraints such as repatriation to foreign investors and information asymmetry due to low transparency. Special purpose properties would showcase a higher level of liquidity risk than those that can be easily modified for alternative uses.
It is interesting to note that real estate as an asset class has been considered to offer somewhat of a hedge against inflation. In spite of the presence of inflation risk, real estate has historically done relatively well than other asset classes during periods of inflation. Management risk is high in real estate. To that effect, the rate of return that the investor earns can be directly proportional to the competency of the manager. Some properties, however, contain a higher level of management risk than others. For instance, malls would require a viable mix of tenants to ensure strong footfalls and in order to attract a viable mix of tenants, proper mall management is indispensable. Interest rate risk is ubiquitous across all asset-classes. In real estate, in particular, even if an existing investor has a fixed rate mortgage or no mortgage, an increase in interest rates might lead to a fall in the bid-price a potential buyer is willing to pay. Apart from these, real estate is also subject to legislative risk and environmental risk. Legislative risk results from the fact that changes in regulation can adversely affect the profitability of the investment.
In the rapidly changing global real estate environment, the concept of considering potent risk when analyzing investments has assumed new importance. In the past, when investors were looking at the public or private real estate markets, increased emphasis was placed on trading values that were derived from exaggerated future cash flows, rising rents and a positive outlook in general. Today, more and more deals are scrutinized with a far more prudent outlook. Investment risks are being factored using methods such as sensitivity and scenario analyses. In an interconnected world such as ours, uncertainties are rife. Apart from intrinsic risks specific to regional real estate markets, there are always those ‘black-swan’ event risks that might hound markets on the other side of the globe but would create a ripple effect throughout.