Thursday, November 29, 2012

Physical Real estate investment risks (even in New Zealand!)

A lot of old-timers I've met believe in brick-and-mortar real estate investments, mainly because of something along the lines of "(ignoring maintenance, tax costs, inflation) my house's value has grown so much since I bought it in 1982... " This has led some to blindly take on heavy mortgages under the assumption that it's an easy, risk-free, leveraged profit, i.e. an indirect bet that hurt guys like Lehman Brothers.

NZ real estate historical returns

NZ Reserve Bank

We can see that of the past 23 years, about 7 (30.4%) had average house prices move negatively. On a leveraged upside bet, this could hurt significantly.

Fungibility and risks in physical real estate

Because real estate isn't fungible, physical property traders must manage a number of risks that do not exist within liquid financial products.

Turnover of US real estate vs. Stocks, Property Derivatives Pricing, Hedging and Applications
  1. Turnover in real estate market is much lower than most security markets, hence forcing traders/investors to take relatively long positions.
  2. In market downturns, the lack of liquidity may force the investor to accept significantly lower bids, if any exists, than desired. 
  3. If financing terms change unfavorably within the mortgage period, the lack of liquidity may force the investor to accept significantly lower bids, if any exists.
  4. Physical real estate requires a ton of due diligence, a hefty implied expense at times
  5. Physical real estate often involves very high transaction costs, again forcing some traders/investors to take relatively long positions.
  6. The bid/offer spreads are significantly large. 
  7. An investor who manages a portfolio of physical properties today would likely find it difficult to shift exposure from one sector of the market to another for the purpose of risk management.
  8. It is usually not possible to take a short position in physical real estate, making market risk hedging very difficult. 
  9. Risk of asset mismanagement is inherent with any 3rd party business, fund (or an uncle who's an alleged expert).

0 Reflections: