Portfolio Optimization starts with a proper understanding of risk management at the property level as well as at the portfolio level. A regular program of portfolio optimization that aligns real estate portfolios with investment and liquidation goals is essential to maximizing value. Every asset needs to be continually evaluated for its contribution to the current portfolio as well as expected future returns.
The need for forward-looking risk management
When defining real estate portfolio optimization it is important to emphasize the forward looking nature of the asset class. Traditional portfolio theory is centered around historic standard deviations which places more emphasis on a backwards looking approach. Forward risk, or more accurately, uncertainty, is not necessarily captured by past movements. Thus a backwards or historical based risk model may be particularly unsuited to real estate for several reasons:
- Real estate cannot be traded instantly. Liquidity constraints force long holding periods that typically average between 3 and 10 years.
- The real estate market does not follow the random walk fluctuations founds in stocks and bonds where price fluctuations may have nothing to do with current market conditions.
- The real estate market is cyclical and slow to adjust. Because of the slow pace by which real estate markets react to random economic shocks the focus on what may happen tomorrow has a lot to do with today’s market prices.
Understanding the variables
A real estate risk model needs to take into consideration a myriad of factors including rents, vacancy rates, construction, local economy and interest rates. To understand the difficulty in forecasting risk, compare Market A to Market B. Market A has a historically high volatility in returns, say 5% but also has a very low vacancy rate, say 3%. Market B has a historically low volatility of returns, say 2%, but is in the midst of a building boom that has driven vacancy rates to 18%. Using the backward definition of risk as a guide, one would say that Market A is without question the riskier market. On the other hand, Market B presents much more future risk as it is much more susceptible to rent decreases and investment deterioration.
The Hipercept advantage
Hipercept will work with you to evaluate risk and return prospects at the asset specific level as well as the portfolio level. Consideration of asset-specific characteristics will not only help with determining risk at the property level but will more accurately assess the risk and return prospects of the entire portfolio.
At Hipercept, we have expertise in developing comprehensive asset and portfolio evaluation solutions to assist with a risk based analysis to determine core portfolio assets, surplus assets, acquisitions, and dispositions.