Real estate is usually considered as a safe investment haven that offers capital security and guaranteed profits. This misguided view has led thousands of people across the world to lose money and assets after choosing to invest in this market ignoring the most important factor of profitability, risk.
The property market as any other market is based on a risk-return trade off model and the word secure and guaranteed do not exist in the vocabulary of professional real estate players or advisors. Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. This trade off, which an investor faces while considering investment decisions, is called the risk-return trade off. It determines the type of risks that an investor is ready to take as well as the level of expected returns.
Some people claim that real estate market is safer than other markets or asset classes. Usually they like to compare real estate market with the stock market or the forex market as a much safer option. Truth is that, the focus should be more about risk than safety. It is not about how safe a project or an investment is, but the level of risk involved. There are several types of risk. The most popular in the investment spectrum are the systematic or market risk, the systemic risk and the specific risk. All of them can play a key role in the success or failure of a project. Some of them can be hedged, others cannot. Here are some of the risks:
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Specific risk: As its name implies, relates to risks that are very specific to a property or project. It is unique to the asset and independent from one property to another hence is a risk which, when combined with other assets in a portfolio, can be diversified.
Systemic risk: Is generally used in reference to an event that can trigger a collapse in a certain industry or economy. Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered to be a systemic risk are called “too big to fail’.
Systematic or Market risk: This is the risk inherent to the entire market or market segment. Systematic risk, also known as undiversifiable risk, volatility or market risk, affects the overall market, not just a particular project, sector, stock or industry. This type of risk is both unpredictable and impossible to completely avoid.
Idiosyncratic Risk: It is specific to a particular property. The more the risk the more the return. Construction, for example, will add risk to a project because it limits the capacity for collecting rents during this time. And when developing a parcel from the ground up, investors take on more types of risks than just the construction risk. There’s also entitlement risk – the chance that government agencies with jurisdiction over a project won’t issue the required approvals to allow the project to proceed; environmental risks that range from soil contamination to pollution; riparian land laws, budget overruns and more, such as political and workforce risks.
Location is another idiosyncratic risk factor. Trends change quite fast especially for new upcoming trendy areas which in a short time can change from trendy to an indifferent place with low or no demand. Idiosyncratic risks are defined as risks that are specific to the asset and the asset’s business plan.
Liquidity Risk is one of the main, key risks of the real estate market. Taking into consideration the depth of the market and how one will exit the investment needs to be considered before buying. An investor can expect dozens of buyers to show up at the bidding table in a popular location such as Westlands, and believes that this will continue to be the trend regardless of market conditions. However, a property located in a less popular location will not have nearly the same number of market participants, making it easy to get into the investment, but difficult to get out. In the real world, market conditions do change and the market dynamics even in popular areas often face exactly the same liquidity challenges especially when there is a lot of construction activity increasing supply while demand is oppressed.
Replacement cost risk: As demand for space in the market drives lease rates and prices higher in older properties, it’s only a matter of time before those lease rates and sales prices justify new construction and increase supply risk. In several cases a new building makes your investment property obsolete because there’s a better facility with comparable rents in the same area. This will cause prices to drop as the investor will not be able to raise rents and will have to offer a lower rent in order to compete with the new properties. This will finally lead to lower occupancy rates.
Evaluating this situation calls for understanding a property’s replacement cost to know if it is economically feasible for a new building to come along and steal away those tenants. To figure out replacement cost, consider a property’s asset class, location and sub-market in that location. This helps investors know if rent can rise high enough to make new construction viable. For instance, if a 20-year-old apartment building is able to lease apartments at a rate that would justify new construction, competition may very well come along in the form of newly built offerings. It may not be possible to raise rents or maintain occupancy in the older building.
Leverage Risk. The more debt on an investment, the more risky it is and the more investors should demand in return. Leverage is a force multiplier: It can move a project along quickly and increase returns if things are going well, but if a project’s loans are under stress – typically when its return on assets isn’t enough to cover interest payments – investors tend to lose quickly and a lot.
As a rule of thumb, total leverage should not exceed 75%, including any type of debt. In economies where finance is expensive this percentage has to be considerably lower. Returns should be generated primarily from the performance of the real estate – not through excessive use of leverage – and it’s critical that investors understand this point.
Often, property investors don’t realize how important it is to quantify leverage, so they end up in overleveraged investments. Investors should ask about how much leverage is used to capitalize an asset, and ensure they are receiving a return commensurate with the risk. The cost of finance/debt is also critical as higher borrowing costs increase seriously the risk.
Risk is a critical factor in real estate. It is a complex topic and comes in many forms, making it difficult to identify much less quantify and manage. In a pragmatic sense, risk can be defined rather simply as the difference between expectations and realizations. That is, it is a measure of the uncertainty surrounding a current or future event or state of nature. It is the uncertainty that something will not be as it seems today, or that some prediction or assumption about what will occur in the future turns out to be wrong.
Risk is inherent in real estate due to its temporal nature: uncertainty is inherent in anything marked with the passage of time. Real estate risk is more complicated than other asset classes due to: 1) inefficiency, behavioral nature and dual Space-Time, Money-Time dimensions of the market, and 2) the capital-intensive, durable and vulnerable nature of individual assets to external forces. These external forces make real estate vulnerable to unknown forces that can create windfalls (i.e., unexpectedly high returns) or wipeouts (i.e., erosion of capital and exposure to residual risks).
In private equity real estate, the fact that we buy physical assets gives many investors a level of comfort. That several times is misleading investors to make wrong irrational decisions based on wrong assumptions regarding the safety feeling against a specific project. There are many risks involved in real estate investing that have to be considered in conjunction with the expected value of the investment. It is important for investors to be able to quantify risk in order to ensure that the investment matches their needs, goals and tolerance.
This is not easy. It requires deep and very specialized knowledge. Investment and property experts use sophisticated risk models and the deep knowledge and research of the markets to account for the many variables involved in evaluating the potential returns and risks of a new property. Usually the average buyer or investor simply neglects the potential risks and proceeds to the market or investment based on the general belief that nothing can go wrong when investing in real estate.
Kenya is now becoming a good example of people who ignore the basic rules of investing, rush into irrational decisions and invest in the property market simply based on rumors and expectations without considering the risks or the probability of losses. Since the property market started to rise slowly in 2009, we have seen a completely irrational price increase creating an obvious bubble. The market started to slow down at the end of 2013, went through a period of stagnancy during the election period and now 2019 seems to be the year, which will unveil the property market recession.
Despite the efforts of the Kenya Bankers Association who a few years ago established the House Price Index, there is not sufficient information. Most people make decisions based on inaccurate data. There is no government-clearing house that unambiguously monitors and reports on the real estate market conditions and transaction activity. Thus, the data on lease rates, transaction prices, occupancy levels, operating expenses and other economic factors are based on private, self-report bases. While vendors try to verify data, there is no way to determine the veracity of data mandating decision-makers to rely good faith efforts to ensure accuracy. To that end, the “know thy data” axiom takes on added importance. That is, a decision-maker should understand how data are compiled and the checks and balances that are put in place to avoid biases and subjective reporting driven by some underlying self-interest.
The inaccurate provided data together with lack of understanding of market fundamentals is usually creating bubbles after a short temporary period of growth and profits. Real estate is a distinct asset class with a number of distinguishing features that differentiate it from other assets or industries. It is also a complex asset, in which the product is in a constant state of evolution brought about by changes in the static, environmental and linkages elements of the product. At the same time, the drivers of value emanating from the spatial, capital and regulatory side of the equation tend to converge over the long term, but due to market inefficiencies are in a dynamic state of imbalance.
Finally, real estate is a behavioral science, wherein individual, companies and entities acting in their own best interest make decisions, with varying levels of social consciousness. Given these dynamics, a major risk in real estate is the failure to understand the asset class by players both within the industry and those who set the rules and make other decisions that have a material impact on the market. Since real estate investments are forward looking, decision makers, buyers, sellers and investors must depend on an understanding of market dynamics as well as a crystal ball that can help predict future market conditions over an appropriate planning horizon.
In the beginning of 2019 all market reports point to the same direction. The Real Estate Market in Kenya is going down. Even those who blamed the last elections and the interest rate cap for a temporary slowdown now realize that the problem is deeper and it is based on the market fundamentals. All available data from Kenya National Bureau of Statistics, the Kenya Bankers Association, The Central Bank of Kenya as well as local and international private entities and organizations who analyze the market display a market that is not sustainable at these levels with a slowdown in demand for property amid growing supply.
The currently nonexistent financial sector of the property market is sealing with the most obvious way the weakness of the property market sector. Banks kept a quite safe attitude during the period of the market boom issuing a limited number of mortgages while they carefully supported via finance developers. Today the only numbers that keep increasing with an impressive ratio are the Non-Performing Loans related to the property markets and loan defaults. According to CBK latest annual report commercial banks in Kenya recorded Sh63 billion in non-performing loans in the last financial year. The value of bad loans was more than 80% of the profit before tax made cumulatively by commercial banks, with the ratio of non-performing loans doubling from 6% three years ago to 12%. CBK data indicates non-performing loans went up from Sh234.6 billion in June 2017 to Sh298.4 billion recorded as at June 2018 with the manufacturing, trade and real estate sectors leading in the losses. The report indicated that for the real estate sector NPLs increased by Sh14.4 billion, which equals to over 48+% as a result of slow uptake of developed housing units and property market slowdown.
This NPL increase is marking clearly that real estate is not the only sector that is facing challenges. Most of the economic sectors are under pressure and are not performing well creating a negative environment and fading out future expectations.
Market and political risk remain key factors affecting the real estate market.
For 2019 the property market outlook will be dominated by the economic developments, the effect of property demolitions and the fragile legal environment over ownership rights, an excessive property market slowdown and the beginning of a long recession which will unveil the real dynamics of the property market which are far below the average expectations. The risk trade off in investments comes always with a premium.
Those who made rational decisions have nothing to worry about as they know how to take losses same as they know how to enjoy profits. The rest who rushed into irrational decisions have to get prepared for the upcoming market developments and try to minimize their risk exposure. Follow up with the markets and revaluate your position and strategy.
Always remember: “It ain’t what you don’t know that gets you into trouble. It’s what you think you know for sure that just ain’t so.”