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Risk-return factors on commercial real estate investment

An investment can be simply defined as expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying a net inflow of cash or its equivalent in some future time period. In view of the limited resources and divers’ investment alternatives available to an investor, investment decisions are necessary. Investment decisions are made as a result of assumptions, expectations and predictions of the future.

Consequently, there is usually inherent uncertainty about future returns and risk complexities. Therefore, it is very important for investors to first ascertain the risk-return factors of an investment asset as good as possible before committing investment funds to such investment. Investors’ informed decisions with respect to the risk-return strategies of real estate investments provide many benefits. It can provide diversification benefits; as low historical correlations to other asset classes; provides current income and the potential for capital appreciation; hedges inflation with returns that equals or exceeds the rate of inflation over longer periods of time; and has the capacity to produce superior risk-adjusted returns relative to other investments asset classes.

Commercial real estate investment is usually rental properties intended to generate a return from rental income or capital appreciation. Commercial property types are: office, retail, multi-family, industrial and hotel, self-storage, seniors housing and health care among others. Investments in these real estate assets are associated with multiple risk complexities which includes: investment illiquidity, asset value volatility, asset valuation inaccuracies, leverage-amplifying negative performance during falling markets, limited/ imperfect benchmarks to gauge closed-end fund performance, combination of a large lot size (capital intensive investments) and high transaction costs.

Besides, direct real estate investments are management intensive over the whole property cycle, which is demanding expertise regarding a range of fields from the investors.

Similarly, due to lack of frequent transaction data, real estate marketplaces generally have low transparency which induces information asymmetries between the market participants. All these challenges are further reinforced considering trans-national investments, since different market practices, laws, taxation, currency, inflation rates, and cultures must be considered.

However, measurement issues, market opacity, and other aspects of uncertainty affecting both direct and indirect real estate investments, combined with the above mentioned drawbacks makes commercial real estate investments a very risky business for investors.

Despite its inherent risks, commercial real estate presents a compelling opportunity for investors. Not only does the sector provide many long-term investment benefits, including healthy income returns and a hedge against inflation, but fundamental factors such as the improvement of the risk/return characteristics of the overall mixed asset portfolio. The case for investing in commercial real estate looks particularly attractive when viewed in the context of the current market environment, although it is not without risk. Perhaps the most obvious reasons why commercial real estate merits inclusion in a management portfolio are derived from both cyclical and noncyclical factors – specifically, the favorable long term outlook for real estate demand, from both users and investors, property cash flows and real estate’s potential inflation hedging characteristics.

The liquidity of commercial real estate provides investors the most efficient means to obtain exposure to property markets globally. The ability to trade daily not only provides a useful tool for investors to create tactical allocations to the sector and global regions, but it also provides a means to efficiently re-balance allocations as market conditions change.

Credit: European Journal of Business and Management

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