Idiosyncratic risk is a critical factor in private-market real estate investing. The converse of idiosyncratic risk — idiosyncratic return potential — is just as important. As a real estate investor, it’s essential to understand the various risks associated with investing in this phase of the market cycle.
As a self-directed investor, it is key to understand the difference between idiosyncratic risk and systematic risk. In this article, we will explore what idiosyncratic risk is, the difference between systematic and idiosyncratic risks, and how understanding particular types of idiosyncratic risk in real estate can help you manage overall portfolio risk.
Idiosyncratic Risk Definition
The risk inherent in an asset or asset group due to specific qualities of that asset or asset manager.
What Is Idiosyncratic Risk?
Idiosyncratic risk refers to the risk that an investment will experience a decline in value due to factors that are unique to that particular investment. These risks can include things like natural disasters, poor management decisions, or unexpected changes in the market.
Risk Factors in 2024 (and Beyond)
Following a period of rapidly rising interest rates, many asset classes have been challenged broadly (an example of market-wide, non-idiosyncratic risk). However, leverage issues for any particular real estate asset, exacerbated by rising interest rates, may serve as examples of idiosyncratic risk. In time, rising interest rates may create distressed asset opportunities for forward-looking operators (an example of idiosyncratic opportunity).
This may be particularly true as record real estate debt maturities come due in 2024 and 2025.
That said, the Fed’s decision to drop benchmark interest rates in September of 2024 changes the game. This may allow formerly distressed asset operators to refinance and hang on. It may also decrease the level of risk inherent in new projects, as the Fed has telegraphed future interest rate cuts in the future, and at least we do not expect any increases to borrowing costs in the near term.
Unlike systematic risks, which affect the entire market, idiosyncratic risks only affect individual investments. For this reason, idiosyncratic risks are also known as unsystematic risks.
Specific Types of Idiosyncratic Risk
Here are some other specific types of idiosyncratic risks that may impact distinct real estate assets or investments:
- Financing risk: The risk that the capital structure of a particular offering could pose a threat to the return prospects of the investment, particularly if conditions change. If the sponsor/borrower is operating at high LTV or high LTC, or at a low DSCR, this risk could be heightened. Floating rate debt could also be a risk, especially if interest rates are on the rise (as they are as of early 2023).
- Construction risk: This is the risk associated with construction projects, including the possibility of delays, cost overruns, and construction defects.
- Tenant risk: This is the risk associated with tenant turnover, including the possibility of lease defaults, evictions, and property damage.
- Market or submarket risk: The metro area or specific neighborhood the asset may pose idiosyncratic risks. A lack of diverse demand drivers (over-reliance on one industry or employer) could pose risk. Crime or environmental issues could pose risk. These risks are typically much lower in Tier I markets and established neighborhoods, such as much of Manhattan. On the other hand, investors are typically rewarded in terms of return potential when investing in less established neighborhoods that may be gentrifying or increasing in cache.
- Liquidity risk: All private-market commercial real estate investments pose some degree of of liquidity risk. These investments are, by definition, illiquid. However, investments will entail varying degrees of liquidity risk. Investments with shorter terms and more certain cash flow will entail less liquidity risk. For example, a senior debt investment secured by the underlying property. Conversely, a ground-up development investment with an uncertain timeline will entail significantly more liquidity risk. The return potential should be appealing, but the timing of your principal repayment will be very hazy.
- Sponsor risk: The risk that the GP (sponsor) will fall short in execution of the investment’s business plan. You can reduce this form of idiosyncratic risk by investing alongside highly vetted sponsors with an establish track record and good reputation.
As a self-directed investor, it is important to understand these and other potential idiosyncratic risks when considering any CRE investment.
The Walker Webcast covers a range of macroeconomic trends that impact commercial real estate markets, including factors that may introduce idiosyncratic risk and opportunity. (Do yourself a favor, listen to it on 1.5x speed!)
What’s the Difference between Systematic and Idiosyncratic Risk?
Systematic risks are the risks that affect the entire market, such as changes in interest rates, economic recessions, or geopolitical events. These risks cannot be diversified away and are inherent in the market. Economy-wide shocks, or “black swan” events, are the clearest examples of systematic risk. The Great Financial Collapse of 2008 or the outbreak of COVID-19 serve as examples.
On the other hand, idiosyncratic risks are risks that are specific to a particular investment and can be diversified away by investing in a diversified portfolio. By diversifying your portfolio, you can reduce your exposure to idiosyncratic risks and protect your investments from a single event’s negative impact.
“Diversification is the only free lunch in finance”
— Dr. Harry Markowitz
Why Idiosyncratic Risk Can Be Appealing
Yes, you read that right — this type of risk could actually be appealing for investors. Remember that risk and return potential hold an inverse relationship; investors are compensated for taking risk. Idiosyncratic risks are highly associated with “alpha,” or returns derived from strong management and asset selection.
Private-market CRE investments entail idiosyncratic risk, but also hold idiosyncratic return potential. Because private markets are slow-moving and less efficient than public asset markets, real estate sponsors can derive returns from buying at the right time, selling at the right time, and unique experience within a market or type of business plan.
Put differently, the stock market is a highly efficient market. You may win or lose, but you’re generally competing against thousands and thousands of other actors who benefit from near-perfect information (as well as sophisticated big data models and trading tools). You may reduce idiosyncratic risk by investing in index funds, but you do not benefit from the opportunity to exploit market inefficiencies as you potentially can in private markets.
Real estate investments may have varying exposure to idiosyncratic risk depending on the position in the capital stack.
Investing in a diversified portfolio of private-market CRE investments can also help balance risk in your portfolio overall. While individual CRE investments may hold more idiosyncratic risk, they may be less impacted by macroeconomic shocks. In other words, less susceptible to systemic risk. In other words, diversifying across public and private-market assets may help you weather volatility and enhance total return potential.
The Spectrum of Risk and Return in Real Estate
Real estate investing offers significant opportunities for investors to achieve higher returns than traditional investment vehicles like stocks and bonds. However, as with any investment, there are risks involved, and investors need to understand how to manage these risks to maximize their returns.
One of the essential things to consider when investing in real estate is the relationship between risk and return. Generally, the higher the risk, the higher the potential return. This is why investments like high-risk development projects or distressed properties offer the potential for higher returns. However, these investments also come with a higher level of idiosyncratic risk.
Investors can mitigate the risk associated with idiosyncratic risks by diversifying their portfolio. By investing in a variety of properties across different markets, you can reduce exposure to any single event’s negative impact. Additionally, conduct your own due diligence on each asset and have seek a solid understanding of market fundamentals and potential risks.
Diversification across CRE investments with relatively low idiosyncratic risk (like senior debt opportunities) as well as more opportunistic assets can help you balance risk overall.
The Importance of Due Diligence: Identifying and Assessing Idiosyncratic Risks
Conducting thorough due diligence is a critical step in identifying and assessing idiosyncratic risks associated with a real estate investment. By carefully examining the property, its location, market conditions, and other factors, you can gain valuable insights into potential risks and make better-informed investment decisions.
Key Elements of Due Diligence
- Property Inspection: A comprehensive inspection of the property will reveal any structural issues, potential maintenance concerns, or compliance issues that could pose a risk to your investment.
- Financial Analysis: Reviewing the property’s financial records, including income statements and balance sheets, can help identify any discrepancies or red flags that may impact the asset’s performance.
- Tenant Evaluation: Assessing the creditworthiness of existing tenants and analyzing lease agreements can help you understand tenant-related risks such as defaults or high vacancy rates.
- Market Research: Investigating local market trends, demographic data, and employment statistics will provide insights into potential market risks or opportunities for growth.
- Legal Review: Ensuring that all legal aspects are in order – including zoning regulations, building codes compliance, title review, and environmental assessments – can help minimize legal risks associated with the investment.
Each real estate investment entails its own unique set of idiosyncratic risk factors and potential for “alpha.” Here’s a sneak peek of the types of real estate assets EquityMultiple brings to individual investors, with minimums as low as $5k.
By taking these steps to conduct thorough due diligence on each prospective real estate investment opportunity, you’ll be better equipped to identify idiosyncratic risks and assess their potential impact on your portfolio. This knowledge will ultimately empower you to make more informed decisions about which investments to pursue and how best to mitigate their associated risks through diversification strategies or other risk management techniques.
How to Minimize Idiosyncratic Risk
Just like picking individual stocks, the idiosyncratic risk of individual real estate assets is highly specific. Each company (and its stock) carries its own set of risks, as well as upside. The same applies with individual properties. As with stocks, minimizing idiosyncratic risk largely comes down to diversification. Stock market investors can diversify and minimize idiosyncratic risk by “buying the economy,” i.e. by allocating to ETFs or buying an overall index. Similarly, real estate investors can minimize idiosyncratic risk by investing in a fund.
Here are a few other ways that real estate investors can potentially guard against idiosyncratic risk:
- By diversifying across a large number of properties. EquityMultiple investors, for example, benefit from minimums as low as $5K, which can help facilitate diversification.
- By diversifying across property types, positions in the capital stack, and markets across the U.S.
- By investing through a platform (like EquityMultiple) with dedicated asset management and underwriting services.
- By looking closely at the track record and experience of the sponsor behind each investment you consider.
Ultimately it is impossible to remove risk when investing (in real estate, or any other asset class). Diversification can help mitigate idiosyncratic risk.
Investing across the capital stack, e.g. via EquityMultiple’s three pillars, can potentially mitigate idiosyncratic risk.
Idiosyncratic Risk — Related Concepts
A number of investing practices, macroeconomic concepts, and current trends relate closely to idiosyncratic risk. When considering your real estate portfolio, the following concepts may also be worth studying up on:
Modern Portfolio Theory >>>
The 60/40 Portfolio (and current challenges) >>>
Strategic Asset Allocation >>>
Considering building a more diversified portfolio with real estate? Don’t hesitate to reach out to ir@equitymultiple.com with any questions.
Idiosyncratic Risk — The Bottom Line
Idiosyncratic risk is an essential consideration for any real estate investor. By understanding the difference between systematic and idiosyncratic risks, you can develop a diversified portfolio that helps balance risk. Additionally, by understanding risk and return in real estate, you can make informed decisions that maximize returns while minimizing exposure to risk.
If you are interested in learning more about real estate investing, sign up for a free account on equitymultiple.com. Our platform offers investors access to a variety of investment opportunities. EquityMultiple also provides tools for making informed investment decisions. Our Investor Relations Team is standing by to help you understand the potential idiosyncratic risks of any investment.
Idiosyncratic Risk FAQs
What is idiosyncratic risk?
Idiosyncratic risk refers to the risk specific to an individual asset or a narrow group of assets, arising from factors unique to that asset or group.
How can idiosyncratic risk be mitigated?
Idiosyncratic risk can be mitigated through diversification, thorough due diligence, and, for sophisticated investors, hedging strategies.
Why is diversification important in managing idiosyncratic risk?
Diversification spreads investment across various assets, reducing the impact of any single asset’s performance on the overall portfolio.
How does EquityMultiple help investors manage idiosyncratic risk?
EquityMultiple offers a platform for investing in a diversified portfolio of commercial real estate opportunities, along with detailed information and analysis to support informed investment decisions.
Can idiosyncratic risk be completely eliminated?
While it’s impossible to eliminate idiosyncratic risk entirely, it can be significantly reduced through strategic investment choices and risk management practices.