What Are Investment Risk Factors?

Understanding various risk factors can help any investor in the management of risks. Risk management is a deep subject, requiring lots of knowledge about assets and their associated risks. 

Every asset that generates a return above the risk-free rate (i.e., treasuries) has risk. Capital invested in these assets can be lost. Investors try to limit their losses through good risk management. Identifying risk factors is part of good risk management. Let’s explore what exactly risk factors are.

Various Investment Risk Factors

Business Risk — This risk consists of operational and regulatory risks. Operational risk deals with the internal operations of a company. Finances can be mismanaged, projects with a low success rate may be chosen, key employees may leave, or an unfit merger can occur. All are related to the internal operational risk of the business.

In real estate, this risk is associated with a sponsor, investment company, or even a single investor that may have a flawed business plan and inefficient operations process.

Regulatory risks also fall under business risk. Legal bodies often enact regulations. These are usually government bodies such as federal, state, or local governments. Depending on the business, a new regulation can limit its profit-generating ability or make it difficult to run efficiently. 

Credit Risk — Risk assumed by a lender. While most real estate investors may not face this risk, those who are involved in lending to developers or even investors will assume credit risk.

One of the largest risks a lender faces is default risk from a borrower not making loan payments. Another risk is that a borrower is late with payments and begins making partial payments.

Lenders manage credit risk through analysis of borrowers. Lenders look at a borrower’s ability to make payments, access to capital, use of loan proceeds, and credit history. Some lenders may also require collateral, which can be used as compensation in the case of default.

Systematic Risk — This risk cannot be diversified away, as it affects all asset classes. Systematic risks include inflation, changes in interest rates, recessionary periods, war, and pandemics. 

We saw during the pandemic how virtually all stocks and real estate classes were adversely affected. Diversification would have had little effect during the pandemic as nearly all asset classes fell. Diversification works well when correlations between assets are varied. However, correlations go to one during a systematic risk event, rendering diversification useless.

Idiosyncratic Risk — Also called unsystematic or specific risk. This is a risk specific to an asset. Unlike systematic risk, idiosyncratic risk can be diversified away. Some examples of idiosyncratic risk include water line repairs, entitlement risk, or environmental risk.

Micro Market Risk — Similar to idiosyncratic risk, but rather than a risk associated with a single asset, it’s associated with a group of real estate assets within a specific economy. For example, a certain area of a city may have an economy that is fairly independent of the larger city. The city may experience an economic decline, while the smaller economy may remain stable and vice versa. Micro market risk is also called submarket risk.

Managing Risk Factors

Two steps precede the management of risks:

1.) Identify Risk

2.) Quantify Risk

3.) Manage Risk

Identifying various risks means being knowledgeable about many different types of risks and the particular asset being analyzed. Quantifying risk can be difficult and, in some cases, impossible. However, the more you know about specific risks, the better you can quantify them. Once risks have been quantified, investors can manage them.

Managing risk involves properly allocating capital to specific projects. For example, a low-risk project may have more capital allocated to it than a high-risk project. The meaning of low or high risk goes back to quantifying risk.

In addition to sizing capital allocations, diversification is another cornerstone of risk management. You probably don’t want to allocate 50% of capital to each of two projects that are similar. Basically, it’s nearly the same as allocating 100% of capital to one project. 

A better approach would be distributing capital across projects with different risk profiles. If one project lags in performance or even fails, the others (low or non-correlated) projects should continue performing, unaffected by the sub-optimal project.

Any investor can learn risk management. Larger investment companies often have teams dedicated to identifying and managing risk. While risk management is a large subject, a great starting point is knowledge of risk factors.