Misunderstood risk

Perhaps nothing in investment causes more confusion or raises more questions than a discussion on investment risk. In part, this because there is no complete agreement on its definition. Academics will typically refer to it as the pricing volatility of an asset. That accords very much with the Capital Asset Pricing Model, which suggests that there is a strong, and linear, relationship between returns and risks. You can take this sort of logical relationship to the obvious next step. As a former senior colleague once said to me: there is a great advantage in investing in private property debt. There is no secondary market, at least with any degree of liquidity, and therefore it cannot be revalued (meaning devalued) on the investors’ balance sheets. The result is that it is shown at cost. This means that it is a safe investment. This is exactly how Lehman Brothers treated its (usually geared) real estate assets, although it used to add 5% to its ‘value’ to cover nominal acquisition costs. Theoretically, these assets would have zero volatility, implying little or no risk. The reality for Lehman Brothers and many other investors was somewhat different when they were forced into realising their assets. Similarly, the VIX, a measure of the market's expectation of 30-day volatility of the S&P 500 index, has recently been at very low levels, implying that risk expectations are low. Yet, investor surveys (eg Bank of America Merrill Lynch) indicate that investors believe that equity markets, particularly US ones, are over-priced. That suggests that that there is an above-average risk of a fall. Historically, low VIX measures often precede market falls, but that hardly accords with the theory of risk, particularly when it is currently possible to hedge one’s portfolio against a fall in value unusually cheaply – as indicated by the low VIX. I attended a talk in London recently by CBRE’s Head of Americas Research, Spencer Levy, who gave an excellent presentation. In that he mentioned that US investors have had an expectation of unleveraged returns from real estate of 7%. In a recent survey, however, that expectation had increased to 8%. The reasoning was that risks were perceived as having increased. Higher risk implied an higher return expectation. That struck me as odd. I say ‘odd’ not because I believe that risks have not increased. The CBRE research team’s own central forecast was for a recession in about two years, and that strikes as being quite plausible. But real estate does very badly in recessions, mainly because new tenant demand drops away very rapidly and existing tenant failure slowly increases. If a recession occurs, rental values will fall and capitalisation yields (and market yields) will increase, driving down values and prices. The falls are usually not modest, and 30% to 40% falls in value are not uncommon. Ahh, investors may respond, but it is precisely because of the increased risk of a recession that I am seeking an higher return – as compensation. But this raises the question as to how can such an higher return can be achieved. There are essentially only two methods. First, the purchaser raises his expectations of returns for a given asset, perhaps by way of higher rental values or lower yields in the future. That would seem a bizarre response to a perceived increase in the increased risk of movements in the opposite direction. Second, that the counter-party vendor provides a significant reduction in its pricing, which if nothing else changes, increases the returns for the purchaser. But that would imply that the investor-purchaser believes that current pricing is unsustainably high, and vendors will have to reduce prices. In that case, why is the investor-purchaser not selling its existing holdings or, at least, hedging its position? After all, if a recession does occur, a 1% point difference in return pricing is not really going to be sufficient compensation. I would argue that the correct response of investors to an increased risk is to reduce their return expectations. That would reflect two things. First, recessions are almost inevitable in cycles and what is being priced is the proximity of the recession and not the ‘shock’ of it. Second, properties do not leave a recession in the same state in which they entered them. Recessions are, for property, a period of rapid depreciation in economic value and sometimes physical value, which can only be remedied by capital expenditure. The real risk is the reduction in optionality – the ability to sell – before the recession occurs. Calculating the return expectations over, say the next three, or five, or ten-year period, perhaps on a weighted basis, will provide a figure or a range of figures which can be compared with other assets that are not subject to the same risk or perhaps not to the same extent. The difference between that expectation and the previous one – before the risk became an issue – gives guidance on the potential loss of performance. A decision can be made as to whether it is appropriate to hold over the elevated risk period or sell before the risk becomes a certainty (or not). That surely is how risk should be perceived and utilised in investment decision-making. d when you instruct a valuer