REAL ESTATE RISKAs far as the local market risk is concerned, it is important to understand the degree of real estate market segmentation, or in other words the geographical boundaries within which property demand interacts with property supply to determine prices. A preliminary optimal allocation across metropolitan markets can serve as the starting organizing concept that will be continually refined to incorporate the realities and constraints encountered in the marketplace as the portfolio building process moves on. Te derivation of such a preliminary optimal allocation requires the development of a methodology for quantifying expected investment returns and the risk associated with such returns in each metropolitan market. In estimating such returns the impact of mortgage financing needs to be taken into account. The major threats to the income earning capacity of a property are increasing vacancies and declining rents. Increasing vacancies, on one hand are the result of high completions of new space in a market and or low absorption of space. Rent declines, on the other hand, are the result of low absorption and high vacancy rates, as has been shown by empirical studies in the office and industrial market. Given these dynamics, we can identify three factors shaping the differential real estate risk profiles of metropolitan real estate markets. The first factor is the prevailing vacancy rate, which varies considerably across metropolitan markets. The second factor is the probability of unfavorable evolutions in a given metropolitan area during the anticipated holding period of the investment. Such unfavorable developments include unexpected economic downturns or overbuilding. The probability of a local economic downturn may vary across markets because of differences in industrial mix, the current state of their economies, and the strength of their comparative advantage in terms of firm and worker amenities. The probability of excessive construction may also vary because of intermarket differences in the sensitivity of capital flows to increasing rents, the capacity of the local development industry, the regulatory environment that may facilitate or slow down development, and land availability. Given such variations, markets with higher probability for reduced absorption or excessive construction should be considered as having greater real estate risk than markets with lower probability of experiencing such scenarios. Finally, the third relevant factor is the sensitivity of absorption to employment declines and sensitivity of rents to increasing vacancy rates and low absorption. Differences in such sensitivities across metropolitan markets have been empirically verified and are primarily due to differences in a market’s tenant base mix, the composition of its real estate inventories, its locational quality mix and its submarket and spatial configurations. These differences imply that, all other things being equal, the negative impact of unfavorable developments on absorption and rents will be greater in the markets in which these sensitivities are higher. In terms of the second group of risk factors, the main threat to a property’s resale price, beyond those affecting net operating income (NOI), is the risk that the property will be sold at a capitalization rate higher than the one at which it was bought. Empirical evidence has shown that the time path of metro-specific capitalization rates is determined to a significant extent by local market conditions. Since such local market conditions differ in terms of their potential volatility, the capital market risk component should also vary across metropolitan markets.
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