Real Estate
WhAT Is rIsk ManageMent AnD hOW DOEs IT Apply TO REAl EsTATE? fall 2008
By Martha S. Peyton, Ph.D. and Steven Bardzik, Ph.D.
IntroductIon
The process of investing is basically all about weighing potential return and the risk associated with it. That simple definition refers to investing in financial instruments such as stocks and bonds as well as hard assets such as real estate, commodities, rare works of art and vintage cars. From this point of view, investors are and have always been “risk managers” as well as “return generators.” As long as investors have only their own money to invest, their dual identity is workable. I weigh the risk; I make the investment decision. The judgment is mine and so are the consequences. In the more complicated real world, where investment managers make investment decisions on behalf of others, the dual identity is less workable. In the jargon of finance research, this is a “principal-agent” problem. Decisions are made by investment managers (agents) but the consequences are shouldered by investors (principals). Over the years, the organizational structure of real estate investment management firms has become generally larger and more complicated including organizational efforts to align the interests of managers and investors. Enhanced performance reporting, “pay for performance” compensation programs, auditing, and research functions are all part of those efforts. The addition of risk managers is the next wave of enhancement. Risk managers are similar to research professionals in skill-set and sensibility; they differ from research staff in their focus on the risk side of the risk-return investment equation. In the sections that follow, we describe the origins of risk management and sketch out the role of risk managers in real estate investment organizations by dissecting the risks that are embedded in day-to-day real estate investing. The content draws from TIAA-CREF’s experience developing the role and responsibilities
By Martha S. Peyton, Ph.D. and Steven Bardzik, Ph.D.
IntroductIon
The process of investing is basically all about weighing potential return and the risk associated with it. That simple definition refers to investing in financial instruments such as stocks and bonds as well as hard assets such as real estate, commodities, rare works of art and vintage cars. From this point of view, investors are and have always been “risk managers” as well as “return generators.” As long as investors have only their own money to invest, their dual identity is workable. I weigh the risk; I make the investment decision. The judgment is mine and so are the consequences. In the more complicated real world, where investment managers make investment decisions on behalf of others, the dual identity is less workable. In the jargon of finance research, this is a “principal-agent” problem. Decisions are made by investment managers (agents) but the consequences are shouldered by investors (principals). Over the years, the organizational structure of real estate investment management firms has become generally larger and more complicated including organizational efforts to align the interests of managers and investors. Enhanced performance reporting, “pay for performance” compensation programs, auditing, and research functions are all part of those efforts. The addition of risk managers is the next wave of enhancement. Risk managers are similar to research professionals in skill-set and sensibility; they differ from research staff in their focus on the risk side of the risk-return investment equation. In the sections that follow, we describe the origins of risk management and sketch out the role of risk managers in real estate investment organizations by dissecting the risks that are embedded in day-to-day real estate investing. The content draws from TIAA-CREF’s experience developing the role and responsibilities