Risk factors: what determines the profitability of real estate investments

Risk assessment plays an important role at the stage of formation of the investment strategy, as to how the investor is willing to take risks, largely depends on the budget, and the expectation of return. So, if investors consider future real estate investments as low risk, they are willing to pay more for every dollar of projected income, thereby lowering the rate of return. That is, the lower the risk, the lower the yield.

Risk is the probability of losses as a result of any changes. The more chance that will happen negative event, the greater the risk. For real estate investment the most typical are two groups of risk — country risks and risks associated with a particular project.

Country risks

Country risks first is the likelihood of economic, political and social upheaval in a country where property is located.

The level of country risk can be obtained from the reports of rating agencies or consulting firms. For example, in the ranking of The Economist Intelligence Unit the smallest country risk in Austria, the UK, Germany and the United States, the largest is Afghanistan, Belarus, Ukraine, etc.

One of the economic factors country risk — inflation. The dependence is as follows: the higher the inflation, the greater the risk. The lowest risk is inflation less than 5 % per year, the largest is over 100 %. The property market insured against the risk of inflation because the cost of rent is revised monthly or annually, rents are tied to the consumer price index, which reflects the dynamics of inflation. The more often rates are revised, the higher the sensitivity of the object to inflation and the greater the income of the investor. For example, hotel rooms, shops, industrial warehouses and housing, leased for a short term, traditionally considered to be objects with a heightened sensitivity to inflation, the office REIT average, and land and apartments for long term rent, is low.

Germany — in General, low-risk country for investment in real estate, however, there is the risk regions. In particular, these include the Eastern lands

Another economic factor is the country risk associated with the instability of the national currency. Regardless, increasing its rate or falls, any significant deviation represents the risk. The greatest danger for markets is more likely to occur when the rise or fall of a currency is more than 20 %.

For commodity-based economies are also characterized by such risk factors as the decline in oil prices. The lower the price, the greater the threat to the economy; the greatest risk reduction in hydrocarbon prices more than 20 %. Thus, according to Savills, amid falling oil prices from 2007 to 2009, apartments in the Russian capital fell by 51 %. In January-February 2009, oil prices started to rise, and the cost per square meter also went up. In 2015, the oil shows a negative trend, and housing prices are also falling.

Other economic factors — the decline in GDP, the decline in production, decline in exports and the decline in the purchasing power of the population. The greatest risk reduction for each of these indicators more than 10 %.

Country also include socio-political risks. In particular, the real estate market may adversely negative population growth, and this is true not only for the country as a whole, but for a specific locality and a particular region. For example, the population of East Germany moved to the more developed and promising Western lands, so the latter are considered less risky markets for real estate investment (with the exception of a small city in the Ruhr region, which is losing population because of lack of jobs).

The political situation also has a significant influence on investor behaviour and on their perception of risks. According to the study “Tranio”, 17 % of polled realtors believe that the political situation (on a par with economic stability) is one of the main reasons why Russian-speaking buyers choose a particular country to purchase the property. This factor is especially pronounced in countries such as the UK, Germany, USA and France.

Socio-political and economic turmoil in the country can permanently scare off investors from the local real estate market

Another important country risk — potential changes in legislationthat may affect real estate markets. It can be changes in the tax legislation (increase in existing taxes and the introduction of new), the introduction of restrictive laws concerning the construction and investment, as well as the imposition of restrictions on the movement of capital.

Project risks

Risks associated with the project can be divided into two categories:

• the risks of the projects Added Value, which aim at creating added value;
• the risks of rental business.

1. Projects Added Value

The projects Added Value (added value) include construction and redevelopment. The risk of such projects is quite high, but the yield is also high: from 14 to 25 %.

The main risks associated with the construction of:

• the value of the land or object on the input can be inflated;
• construction or repair may be delayed;
• the estimate of construction or repair may be exceeded.
• the sale price may be lower than planned;
• sales may go slower than planned.

All of these risks can “eat” the yield, with the result that the investor will be without profit or even with loss.

Construction projects are more risky than rental business

All of these risks grow exponentially in proportion to the debt load of the developer, that is, the more credit money it uses, the higher each of these risks. In the worst case scenario, such as high debt load of the building and the correction value may be that the developer or the investor will suffer loss. Experienced developers always calculate different scenarios of development of events, and acceptable are those in which the investor exits the project, earning 15-20 % (classic scenario) or 20-25 % (optimistic scenario).

Project risks occur before the start of work. In particular, there is a risk of not getting a building permit (Permit Risk). Its essence is that in the case of investment in redevelopment, major repairs or building from scratch to implement after the purchase of the land or object must pass approval and get permission. Usually the price takes into account the risk of failure to obtain appropriate permission or that it will take a long time. In some countries developers are willing to take the risk of not receiving permission.

To determine the risks associated with a specific object, helps comprehensive check — Due Diligence — which includes four types of expertise:

• legal expertise (Legal Due Diligence): the lawyers check the lease and permit for construction;
• financial and tax due diligence (Financial & Tax Due Diligence): the tax adviser establishes the real costs of the contents of the object, calculates profitability and the size of tax deductions;
• risk assessment (Chance & Risk): the examination of prospects of development of locations as well as the impact of existing and future competitors;
• technical assessment (Technical Due Diligence): examination of technical condition of real estate (usually not done when you buy new objects).

2. Rental business

The least risky objects for lease, have the following characteristics:

• located in prestigious areas;
• good technical condition;
• tenants — middle-class (for residential properties) or the companies of the first echelon (in the case of commercial buildings);
• the average level of rent available to the average tenants;
• the possibility of converting the object (for example, transfer of hotel properties to residential or Vice versa);
• the rental income will not lower fees for the loan.

Location is the most important characteristic: if the property is located in a good area, then the risks will be minimal, and the object — liquid. However, the risk may be due to the further development of the area, so when choosing a profitable object should ask the plan and to see if the coming and already-implemented changes (the expansion of the transport network, the emergence of new institutions, etc.) over time to increase the capitalization of the investee or, conversely, reduce its profitability. For example, if a person bought an apartment in new York with beautiful views of Central Park, it is a priori ensured the safety of the investment, as apartments with this type are few and new no more.

Risk is also bad the object’s state and insufficient technical equipment. The worse space-planning decisions within the building, the availability of modern engineering systems and the quality of supporting structures, the lower competitiveness in the market, the lower its value and demand from tenants, and the risks higher. Despite the fact that old and worn out objects can give a good yield at the moment, they are always more risky for investment than buildings in good condition.

The quality of tenants and the type of rental contract can also raise or lower risks. Investor who is not willing to take the risk of losing the tenant is likely to invest into the property with long term lease contracts. Conversely, when the risk for the investor is acceptable, he will consider the property suitable to an end or short-term lease.

When choosing a rental property should pay attention to how trusted the tenant

Another risk is associated with the choice of method of financing and manage borrowing of funds. As a rule, the higher the proportion of borrowed capital, the higher the risk.

The leverage effect is when the cost of debt financing is cheaper than the profitability of the project. The investor can negotiate with the Bank so that to pay interest on the loan, but to pay a minimum of the loan. This method it is possible to increase its operating income from investments. But this method of increasing profitability leads to another risk. If the price of the object will decrease when you need to extend the loan agreement, the Bank will require proportionally to capitalize the loan and to provide additional collateral (margin call). Therefore, it is important to find the correct balance lever of return and risk is the ability of professional investors.

The capital borrowed for investment must make a profit in excess of cost for its use. If the real estate below the fees for the loan, the investor bears the loss, which is greater, the greater the value of the borrowed funds.

According to experts, the real estate market there is another risk: as interest rates on loans in 2014-2015 in many countries reached the lowest level in history and almost close to zero, then in 3-5 years they can grow significantly, and when that happens, property values will decrease.

The risk is also remote control object: the remoteness of real estate weakens control over it, so attempt to engage in the management of foreign project from Russia is connected with big risks. Instead of a remote self-control is recommended to hire a specialized company.

Equally important is the risk associated with the structuring of the transaction. There are various schemes that allow you to optimize your taxes — for example, a joint loan or applying through a series of companies. This increases the yield, but reduces the transparency and increases the risk of ownership. The IRS may not accept the structure optimization and charge additional taxes and penalties. In the world increases the transparency of the banking system, the OECD has introduced measures to combat erosion of the tax base, and Russia requires its residents to pay taxes on income earned abroad. All these changes increase the risks of excessive structuring of objects with the aim of tax optimization. Our recommendation for customers: firstly, to consult with tax advisors, and secondly, not to overdo the optimization, as it is fraught with problems with the tax authorities in the foreseeable future.

The above mentioned points define the main risk — the risk of reduction of liquidity, that is, lowering the potential of a quick sale without loss of value and reduction potential of growth of capitalisation in case of a positive scenario of development of the market. Accordingly, the lower risks of the aforementioned points, the higher the liquidity and, consequently, lower the starting yield of the object.

In the end

The main risks when investing in property are:

Country risks
Economic	inflation; currency instability; the decline in oil prices; the decline in GDP, the fall in the rate of production and decline in exports; the decline in the purchasing power of the population.
Socio-political	negative population growth; the unstable political situation; the introduction of legal restrictions.
Project risks
Added Value	inflated the purchase price of the land or facility; the excess of estimates; failure to meet deadlines; the risk of selling at a lower price; Permit Risk.
Rental business	construction in the vicinity of the object, reducing its cost; the poor condition of the facility; the low quality of the tenant; short-term lease; a large share of borrowed capital; remote control; the structuring of the transaction.

What to choose — high yield or low risk — depending on the investor and his attitude towards risk. The main problem with many buyers is that they start the conversation with the question “What is profitability?”, and the first question really should be “What are the risks and how can I sell this facility in the future?” If the investor wants to make big returns, it needs to be willing to accept greater risk.

Yulia Kozhevnikova, “Tranio”