How does risk assessment influence investment strategy in real estate?

Introduction to Risk Assessment

Risk assessment is a crucial aspect of developing an investment strategy. An investor's willingness to accept risks directly impacts both the overall volume of investments and the expected returns on capital investments.

If investors view real estate investments as relatively safe, they may agree to higher costs for every dollar of expected profit, which in turn leads to a decrease in overall returns. In general, there is an inverse relationship: the safer the investments are considered, the lower the profits they are likely to generate.

Definition of risk

Risk can be interpreted as the likelihood of losses arising from various changes. The higher the probability of a negative outcome, the more risky the investment becomes.

In the real estate sector, there are two main types of risks:

• Risks associated with the characteristics of individual countries.
• Risks related to specific projects.

Country risks

The risks associated with specific countries include the threat of economic, political, and social disasters in those states where real estate is located. The level of country risk can be determined based on reports published by rating agencies and consulting firms.

For example:

• Austria, the United Kingdom, Germany, and the USA are characterized by the lowest risks.
• Increased risks are recorded in countries such as Afghanistan, Belarus, Ukraine, and several other states.

Economic factors influencing risks

One of the major economic factors that significantly affects the level of country risks isinflationThere is a direct correlation here: the higher the level of inflationary changes, the greater the risk for investors.

If inflation does not exceed 5% per year, it can be consideredsafeHowever, when the inflation rate exceeds 100%, it poses serious threats to investors.

Protection of the real estate market from inflation

Nevertheless, the real estate market is protected from inflation risks, as rental prices are regularly reviewed.

• Rental rates generally correlate with the consumer price index.
• More frequent changes in rental rates make the property more sensitive to inflation, which contributes to increased income for the investor.

For example:

• Hotel services,
• Retail spaces,
• Industrial warehouses,
• Short-term rental of housing.

These assets are often seen as having a high degree of sensitivity to inflationary processes. At the same time, office spaces and real estate investment funds may be assessed as moderately risky, while land plots and long-term residential leases are characterized bylow sensitivityto inflationary fluctuations.

Investment risks in Germany

Germany is generally considered a country with low investment risks in real estate; however, some of its regions may represent areas with a higher degree of risk. This is especially true for the eastern states, which may attract investors due to the associated risks.

Currency volatility

Another important economic parameter that also affects country risk iscurrency instabilityRegardless of whether the national currency's exchange rate is increasing or decreasing, any significant fluctuation poses a risk for investors.

Sharp changes in exchange rates exceeding 20% can have significant consequences for the market, creating additional challenges for investors.

Risks in commodity economies

In countries with resource-based economies, there is a serious threat associated with fluctuations in oil prices. The lower the oil price, the greater the risk for the economies of these countries. Situations where the cost of hydrocarbons drops by more than 20% are particularly dangerous. For instance, according to data from Savills, during the period from 2007 to 2009, when there was a sharp decline in oil prices, apartment prices in Moscow fell by 51%.

Since the beginning of 2009, we have seen a recovery in oil prices, which in turn contributed to the rise in residential real estate prices. However, in 2015, there was another drop in oil prices, which also negatively affected housing costs, which continued to decline.

Economic factors

In addition to the instability in the oil market, there are other serious economic issues, such as:

• abbreviation of gross domestic product (GDP);
• a slowdown in production activity;
• decrease in export volumes;
• decrease in the purchasing power of the population.

The greatest danger comes from any decline in these indicators by more than 10%. We should not forget about the socio-political risks that are relevant to certain countries. In particular, demographic changes, such as a decrease in population or its stagnation, can affect the housing market, which can pertain to both entire countries and specific cities.

For example, residents of the eastern part of Germany often migrate to the more developed western regions, which helps reduce risks for real estate investors in these more developed areas. An exception is made for small settlements, such as the Ruhr area, where there is an outflow of people due to a lack of jobs.

Political factors

The political situation in the country also plays an important role in the perception of risks and investment strategies. According to a study by "Tranio," 17% of realtors note that the stability of the political situation, along with economic factors, has a significant impact on the choices of Russian-speaking buyers of real estate abroad.

This trend is most noticeable in countries such as:

• United Kingdom;
• USA
• Germany;
• France.

Economic and social crises can significantly reduce the attractiveness of the local housing market for investors.

Changes in legislation

In addition to the mentioned issues, potential changes in legislation pose a serious threat to the real estate market. Such changes may include:

• increase in tax rates;
• introduction of new taxes;
• increased regulatory pressure on construction and investment;
• control over capital movement.

Risk classification

The risks that projects face can be divided into two key categories:

• Risks associated with creating added value;
• rental risks.

These factors require careful analysis from investors and market participants, as their consideration is crucial for the success of long-term investments and stability in the real estate market. Increased attention to potential risks and changes in the political and economic environment significantly enhances the chances of successfully executing investment projects and protecting the interests of all market participants.

Value-added projects

Projects related to added value cover various areas, including construction and repurposing of real estate. Despite the significant risks associated with these initiatives, the expected profit in such segments can range from 14% to 25%. Therefore, it is crucial to pay attention to the risks associated with the construction process, as they can have a serious impact on the project's success.

Important aspects of risks

The first thing to note is the likelihood of inflated land prices or the cost of the building itself. This situation can lead to an increase in initial expenses. Additionally, there is a risk that the construction or renovation processes may be prolonged, creating difficulties in meeting the predetermined deadlines. It is equally important to consider that the final expenses may significantly exceed the amounts that were initially planned. At every stage of project implementation, there may be concerns that actual costs will fall short of expectations, and the sales level may lead to disappointment.

Risks and their consequences

Such risks can significantly impact the expected profits, and as a result, investors may find themselves in a situation where their investments do not yield returns or even lead to losses. Construction projects are more susceptible to risks compared to traditional rental businesses, and generally, the level of these risks increases with the developer's debt load. This means that the more borrowed funds are used, the higher the likelihood of encountering the aforementioned difficulties.

Project development scenarios

Experienced developers study various scenarios in advance that may unfold during the project's implementation. The most favorable options, where the investor can exit the project with a profit, are those where the return is:

• from 15 to 20% — a classic scenario
• 20 to 25% - an optimistic scenario

Risks at the preparation stage

Risks can manifest even at the preparation stage, before the actual construction begins. For example, there is a possibility of not obtaining construction permits, so-calledrisk of permissionsThis risk lies in the fact that before starting any investments in repurposing, major repairs, or new construction, various approvals must be obtained after acquiring the land or building. Typically, calculations include the likelihood that the necessary permit may be absent or that obtaining it may take longer than expected.

Rental business: key aspects

The rental business includes many factors that help reduce the risks associated with investments. The least risky properties are those that have certain characteristics: they should be located in prestigious areas, be in excellent technical condition, and the tenants are most often middle-class individuals for residential properties or reliable companies with high ratings for commercial real estate. The level of rent is also critically important, as it should be affordable for most potential tenants.

Additionally, the ability to change the purpose of real estate, such as converting a hotel complex into a residential building and vice versa, is of significant importance. On top of that,rental incomeIt should be significant enough to cover the loan expenses.

Location of the property

The location of real estate plays a crucial role in successful capital investment: properties situated in well-developed areas have minimal risk of profit loss and can be quickly sold on the market. However, one should not forget about the possibility of changes in the status of the area, as this can, in turn, affect the value of the asset.

Before making a purchasing decision, it is important to analyze the development plans for the area. Activities such as:

• new construction projects
• infrastructure enhancement

They can either increase or decrease the attractiveness of an asset. For example, if an investor decides to purchase an apartment in the center of New York with a beautiful view of Central Park, this will significantly increase the likelihood of preserving and growing the invested funds, as such opportunities are rare.

Condition of the building

It is also worth noting the impact of the building's condition and the level of its equipment on investment risks. Poor quality of structures, architecture, and engineering systems reduces the competitiveness of the property in the market, which affects its value and level of demand.

Old buildings that require significant funds for restoration can yield good profits in the short term, but they pose a greater risk to investments compared to modern and well-preserved properties.

Quality of tenants and rental agreements

The quality of tenants and the types of rental agreements also significantly affect the level of risk. Investors who are not prepared to face tenant loss often prefer properties with long-term lease contracts. At the same time, if such a loss is not critical, short-term agreements that are nearing completion can also be considered.

When choosing commercial or residential real estate, it is very important to conduct a detailed analysis of the reliability of tenants, as this significantly reduces the likelihood of losses.

Funding and management

Another important aspect is the method of financing and managing borrowed funds. Generally, there is a direct correlation: the larger the share of borrowed funds an investor uses in their capital structure, the higher the risks.

Therefore, it is essential to carefully consider the choice of financing methods for transactions and managing cash flows. Thus, the rental business can generate a decent profit if all the aforementioned factors are taken into account and risks are managed effectively.

Conclusion

A successful choice of rental property, a reliable tenant, and the right financial strategy can significantly increase the chances of successful investments and stable income.

The leverage effect and its impact on investments

The leverage effect is based on the fact that the cost of credit is lower than the profit generated by the investment project. An investor can negotiate with a lending institution for terms that allow them to pay only the interest on the loan, without including the principal amount of the debt. This significantly increases the operating profit from the investments.

Nevertheless, this method of increasing income is associated with risks. If asset prices start to decline during the need for debt refinancing, the bank has the right to demand an increase in capital and the provision of additional guarantees, which is calledmargin callTherefore, it is crucial to accurately assess the balance between the impact of leverage and the associated risks, which is an important aspect of an investor's professionalism.

Long-term investments and borrowed capital

Long-term investing with borrowed funds should generate profits that exceed the costs of servicing the debt. In a situation where income from real estate is less than the loan payments, the investor will incur losses, and the higher the amount of borrowed funds, the more severe the financial losses will be.

New risks in the real estate market

Some analysts highlight a new type of risk in the real estate market: in 2014-2015, interest rates on loans reached record lows and approached zero in several countries. In this case, an increase in interest rates is likely over the next 3-5 years, which could lead to a decline in property prices.

Risks of remote asset management

It is also important to consider the risks associated with remote asset management. The physical distance makes it difficult to monitor the condition of the property, which can make managing a foreign project from Russia a rather risky endeavor.

Instead of self-managing, it is more practical to hire a professional management company that is well acquainted with the local market situation.

Structuring deals and tax risks

Additionally, it is important to pay attention to the risks associated with deal structuring. There are various schemes that can help optimize taxation, such as:

• Use of shareholder loans;
• Creating a network of companies for making deals.

These methods can indeed increase profitability, but at the same time, they reduce the transparency of financial operations and increase the risks associated with asset financing. Tax authorities may not recognize the proposed optimization schemes and, consequently, impose additional taxes and penalties.

Trends in taxation

Currently, there is a trend towards increasing transparency in the banking sector on a global level. The Organisation for Economic Co-operation and Development (OECD) is implementing measures to combat base erosion and profit shifting, and in Russia, residents are already required to pay taxes on income earned abroad. All these changes increase the risks associated with excessive structuring of assets for tax purposes.

Recommendations for clients

Our recommendations for clients in this situation are as follows:

• Be sure to consult.with qualified tax consultants;
• Be carefulwith tax optimization, as it may lead to significant complications with tax authorities in the future.

Conclusion

In conclusion, I want to emphasize that risk assessment is a key stage in forming an investment strategy. As an investor, I understand that the level of risk determines which strategy I will choose, as well as affects the expected return and budget. Real estate investments may be perceived as low-risk, which, in turn, leads to higher prices for predictable income.

It's important to remember that risks can be both country-specific and project-related.Country risksIn particular, economic and political factors are included, and aspects such as inflation, currency instability, and socio-political trends can seriously affect investment returns. Based on the above, I understand that when choosing a country for investment, one should rely on the reports of specialized agencies and analyze the current state of the market.

Equally significant areproject risks...which can be divided into categories related to added value and the rental business. Each project has its unique risks, and a thorough analysis of each of them is the key to successful investment activity.

The main factors influencing the level of risks:

• Economic factors: the level of inflation, the stability of the national currency, growth or decline of GDP.
• Social and political factorspolitical stability, population growth or decline.
• Legislative changesPossible changes in tax legislation and construction restrictions.

Ultimately, to achieve optimal results, it is essential to carefully weigh all the risks and opportunities that may impact the decision made. I hope this information helps both novice and experienced investors better understand the world of real estate investment and directs their efforts in the most profitable direction.