Today, investors are looking at a much hazier economic environment for the future than a year ago. There is excessive uncertainty about future profits of both new and old economy businesses. Market expectations govern investment activity in all financial investments (capital chases risk-adjusted returns). Further, expectation levels can reach unbelievable highs (irrational exuberance) before predictably crashing, as witnessed by the dot-coms recently and real estate in the early 1990s.
A close look at the psychology of risk, however, may allow real estate investors to use such doubt to their advantage. In general terms, risk is the uncertainty that an investment will not earn its expected rate of return. The larger the range of possible expected returns, the riskier the investment. Although risk is usually viewed from its volatility around its mean, behavioral finance confirms that investors do not mind upside volatility (but they despise downside movements). When discussing classic decision-making, economist Herbert Simon differentiates between investors displaying completely rational behavior and investors displaying "bounded rationality." According to Simon, bounded rationality is characterized by many factors, including emotional influences and the failure to understand all information (which creates an inefficient market). Exploiting the psychology of the market offers investment opportunities that have the highest return given a specific risk level.
The three types of risk that a real estate investor faces are:
1. Overall market risk (i.e., national market risk of inflation, interest rates, capital flows), which is considered unavoidable;
2. Property sector risk (i.e., inherent risk differences among office, retail, industrial), which is theoretically avoidable and can be minimized; and
3. Individual property risk (i.e., physical characteristics, location, leases in place), which is avoidable.
In efficient markets, investors are not rewarded for the latter two forms of risk because theoretically they can be eliminated by diversifying your portfolio. However, real estate markets are not nearly as efficient as the stock and bond market. For example, managing risk (as opposed to managing the return on investment) in real estate markets is crucial for expected performance. In today's economic environment, and given the inefficiencies in the real estate market, an investor can identify opportunities at the individual property risk level, and thereby outperform the market by doing superior research.
The market's ability to seize on real estate opportunities has clearly shifted from the no-brainer investment phase of the late 1980s to a very selective property level opportunity base (Figure 1). To be successful, investors have to shift their focus to meticulous property cash flow and price analyses, as demonstrated in Figure 1.
Identifying opportunities today, (either selling or buying commercial real estate assets), demands that investors be rigorously grounded in understanding property sector risk analysis-that is, they must be able to develop a credible cash flow forecast and to complete an unbundling analysis of the components of value to measure the relative risk of the asset. Investors also need to apply both fundamental and technical analysis to the property sector risk. By understanding the expected and required returns of a specific property, opportunities can be predicted. For example, a positive factor, such as a 12 percent future return minus 11 percent required return equals 1 percent positive satisfaction, indicates a buying opportunity; conversely, a negative factor indicates a selling situation. A critical piece of this analysis is developing insights into the market regarding investment criteria of available capital, discount and overall capitalization rates, property sector risk levels, and so on. Historically, such information has been limited to large institutional lenders, appraisers, consultants, developers, and advisors. …