Risk analysis uncovers how new fundamentals impact asset values

Risk is an intrinsic feature of commercial real estate investment, yet quantifying it is surprisingly elusive. Without risk, investors wouldn’t generate returns; despite this key role in an investment, more owners than you might think fall short in accurately measuring risk or its impact on investment quality. Traditionally, the cap rate has represented the summary of a property’s downside exposure. It is used as an all-in-one expression of market demand, asset quality, property value and return. Cap rates offer a clear path to making side-by-side comparisons between prospective investments—but as a measurement of risk, it falls short. No single criteria can fully capture the nuances of so many factors. For this reason, it is important to do a multi-factor risk assessment.

To go beyond cap rates and provide better insight into risk exposure, valuation professionals have begun analysing a robust list of characteristics that affect investment performance individually then quantifying how each category impacts a property’s valuation. This approach is a powerful tool that gives investors both a deep understanding of the investment’s vulnerabilities and the opportunity to develop targeted defensive strategies to drive value and enhance returns.

Value and risk are inextricably linked together. Value is an estimate of a property’s market price and defines the exit return on an investment, while risk is the potential for complications or for an investment to underperform. Value represents an analysis of a property in the current market, and risk estimates how the property will perform in the future, as market dynamics change. You cannot see an accurate picture of one without the other.

Although value and risk are intertwined, they are ultimately separate metrics. A valuation analysis gives investors a monetary expression of their property or portfolio; it is effectively a price tag. A risk report, on the other hand, is an in-depth explanation of the many factors that could explain why the property’s value could be negatively impacted both now and into the future. Knowing the ‘why’ arms investors with an opportunity to be proactive rather than reactive in making investment decisions and managing assets throughout the investment lifecycle.

This relationship between value and risk is an established principle of commercial real estate investment, but defining risk and its impact on value has been a subjective undertaking. “Valuers have traditionally taken a qualitative approach, based on their professional opinion,” says Tyrone Hodge, Global Head of Risk Advisory, Value and Risk Advisory at JLL. “We are starting to look at it in another way, by developing a spectrum of factors that impact value. To collect and assess those factors, we lean heavily on data and analytics.”

A risk analysis evaluates multiple factors that influence property value, both currently and in the future. There are seven key factors in the analysis: market, location, property, cash flow, ESG, health and safety. Within each category is a well of insightful data, and those insights expand exponentially when analysed all together. Location, for example, can explore crime statistics, proximity to public transit or access to daily needs amenities, like grocery stores and restaurants; climate defines exposure to extreme weather events and natural disasters as well as the long-term effects of climate change, like sea level rise and air quality; and market data illustrates broader trends, digging into employment growth, inward and outward migration and local regulatory barriers. Each bucket explores nuanced contributors to investment quality that can exist today or manifest in the future.

Technology is contributing to improved quality in risk assessments and increasing data accessibility for investors. The analysis is automated to incorporate timely data insights and reflect a property’s most up-to-date exposure, even as fundamentals change. By leveraging technology, risk assessments are not a snapshot in time but an ongoing analysis of liability that illuminate weak spots—and strengths—in a property portfolio.

As Hodge says, “the inverse of risk is opportunity.” Ultimately, the power of knowing your weaknesses is to have the opportunity to improve your position. Risk assessments grant investors that power. “This is quantifiable data that can point to the cause or multiple causes impacting value of a property,” says Hodge. “Once an investor knows the specific factors impacting pricing, they can make strategic adjustments.” Those adjustments include modifying lease terms, pursuing a re-zoning strategy or investing in property-level upgrades.

Investors can also tailor the analysis to reflect their internal business strategy, which might include a high tolerance or even an appetite for some challenges. An industrial developer, for example, is likely to have deep experience working on land sites with environmental hazards. If a specified analysis shows a vulnerability due to a problematic land site, the investor will likely still pursue the deal or even target similar deals. Likewise, investors can also pinpoint and avoid common emerging market challenges. Office sector stakeholders are a great example. Post-pandemic, they are more sensitive to migration patterns and employment trends and are looking to highlight these trends and how they affect specific properties in risk assessments to narrow exposure.

Investors have historically focused on tolerating a certain degree of risk; a customised analysis of downside exposure helps investors become even more risk conscious. By understanding the nuanced characteristics that influence asset value, investors are empowered to make strategic adjustments that drive returns.