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Engel & Völkers Licence Partner Hong Kong, Real Estate Agency > Blog > How to Mitigate Risk in Commercial Real Estate Investment in Hong Kong

How to Mitigate Risk in Commercial Real Estate Investment in Hong Kong

 Hong Kong
- Commercial Real Estate Investment

Risks are prevalent in every investment or business venture. Actually, there is no business venture that is immune to business risks as well as other external risks.  Real estate investment is not to be spared. The extent of the risks varies from one type of real estate investment to the other. It is the percentage of risks involved that dictate the suitability of a specific type of real estate investment. Like the common adage goes ‘the higher the attractiveness of the returns on investment, the higher the risks involved'.  Real estate investment attracts higher rewards and consequently higher risk.

1997-2003 can be remembered as the worst economic period of the real estate market in Hong Kong. It was a period that led to the real estate bubble in the country which was largely attributed to the financial crisis in Asia. The property market has since recovered. But, this cannot be used as a metric to rule out future risks. Investors should always manage their investment in readiness for the inevitable which is not easier to predict.

It should be noted that prior to the 1997 property bubble in Hong Kong, there were some investors who foresaw, the housing crisis and they were able to avert the risks and losses associated with it before the market crashed. Yet, risks are known to take even seasoned investors by a surprise. You never know what the future holds and that why you need to be prepared for the eventuality.

In the mitigation of risks in real estate investments, investors need to understand the risks involved in the type of investment that they prefer. Property investment is categorized in various types that include retail real estate investment, residential investment, commercial investment, industrial investment and office investment. In these different types, there are various activities that take place in the investment that includes land assembly, property development, lease agreements, financing, and the sale of the property. All these activities pose different types of risks.

Several types of risks are common in property investment in Hong Kong and across the globe including:

Revenue risks-these represent the dangers that may threaten the revenue generated from an investment causing a drop in income. Some determinant includes economic factors such inflation rates, fluctuation in prices, changes in taxation policies, fluctuation of interest rates, changes in rent levels and sales/ costs of sales.

Land exploitation risks- these risks are primarily related to the environment and the depletion of the resources obtained from the investment such a depletion of resources mined.

Legal risks- these entail potential lawsuits that may arise due to non-compliance to agreements/ contracts between parties, adjustments of land zoning and the risks of having to buy assets from the third party in order to acquire a land position.

Valuation risks- these concerns risks that may devalue real estate assets lower than the acquisition costs. The determinant could be changed in market preferences, insecurity etc

Development risks- these concerns the risks that pertain to the building and construction of real estate property such as the price, architectural design, quality etc

Political risks- these are brought about by changes in government policies, political regimes and regulations such as taxation

Duration risks- these are usually influenced by other risks and may stall a project or the sale of real estate property such as a lawsuit pending determination.

Generally, commercial investment is considered as the riskiest investment in the property market. Unlike other types of real estate investments where it is common for one player to own the equity of the investors, commercial investments attract multiple financiers, hence multiple equity players; and, consequently, multiple market influencers because individual investors have their own unique risk profile and investment strategy which has an important significance in the overall investment. The players in commercial real estate may involve individual persons, corporations, trusts, pension funds, the government and foreign investors. The financing of the equity involved is also widely varied and the variations include private financing by individuals, mortgage financing, public financing, government funding, pension funding etc, which may affect the market volatility and variables of the investment.

When you are looking forward to investing in commercial real estate in Hong Kong or you have already invested, you need to be able to avoid risks. But, it is rather difficult for an investor, especially a first-time investor to avoid risks. Therefore, the investors should be ready to undertake a calculative risk. A calculative risk is one that enables the investor to factor in the probabilities of success while investing.  It is critical for you to understand the variables of the types of risks associated with commercial real estate investment in Hong Kong. You also have to research and evaluate the exposure of the risks involved.

The risks can be mitigated by understanding how the determinants of the risks affect the investment assets. There are two strategies that have been proven effective in mitigating risks associated with real estate investment and they include a stringent monitoring and evaluation system as well as adopting a stringent monitoring policy.

This article explores some of the measures that can be used to mitigate real estate investment risks in Hong Kong.

Stringent Investment Policy

    • Making Due Diligence in Property Valuation

The basis of success in property market lies in the ability of an investor to accurately and confidently determine the current and future value of the real estate assets that are traded in the market. However accurate valuation of the assets should never be construed as the prediction of the market dynamics. Market dynamics in commercial investments are determined by market shifts that involve a mix of several variables such as market fragmentation, changes in investors and a mix of assets of heterogeneous quality, just to mention a few. These variables contribute to the volatility of the market and affect its cyclical nature. Thus the market is highly unpredictable arguing that the best strategy is to take precautions even after accurate valuation of the assets.

One of the best ways of avoiding risks is to make a good inspection of the property that you intend to purchase. Of course, most investors research and do their homework before investing. They have to analyze different variables and market influencers so that they are certain that there are little pressures and minimal risk exposures to their portfolio. Yet, the changing dynamics of commercial investment may be immune to the investigation done and still expose the investment to risks. You need to research and carry out a through property valuation exercise.

Property valuation falls under the strategy of deploying a stringent investment policy. It calls for the involvement of various professionals who have expertise in various variables of commercial investment. You have to bring on board investment managers and real estate professional managers. Investment managers have the role of investing in a manner that promotes the growth of the equity value of your investment portfolio. They undertake to investigate and value a commercial investment and develop investing strategies before deciding on the manner in which they will allocate money to a set of investment assets. On the other hand, they have the sole duty of managing your investment assets and giving sound advice according to the performance and value objectives of the investment assets after property valuation. They help in enhancing the operability utility of investment assets by predicting or determining the occupancy rate.

You need to realize that property valuation is the initial step of the real investment. If you go wrong at this stage, you definitely may face difficulties in managing your assets profitably.  During this stage, you need to be well informed of what you staking your money at. You will have to evaluate the cost-benefit of the investment. With reliable professionals on board, you don't have to worry much about going wrong.

  • Carry Out a Proper Financial Investigation

Commercial investments require huge funding and thus multiple shareholders may be involved in a single investment. Before investing, you need to evaluate the costs involved as well as your financing options available. It is prudent to bring in a pool of professionals to assist you in doing the proper investigation. Two professionals are needed at this stage: a mortgage broker and a real estate accountant.

The mortgage broker has the responsibility of advising and securing the best terms of mortgage financing. They have a duty of researching the best financing option available n the market and assisting you in the application as well as repayment of the mortgages. It is imperative that you do not go wrong here because you could end up stuck with high-interest rates than your returns on investment. On the other hand, you need to bring on board a property accountant. The accountant will help you in the analysis and interpretation of financial data as well as in the preparation of necessary financial reports and simulations that will guide your investment decisions.  They also should help you in the development of taxation strategies for your investment.

The accountant is also helpful in ensuring that you use the most suitable objective measurement metrics such as the internal rate of returns, net present value etc to make conclusions on the feasibility of an investment. The accountant should determine accurate total costs involved taking into account economic changes that induce inflation, price fluctuations and demand & supply of the investment assets.

You should not be easily convinced to believe any financial documents or pro forma provided by the seller unless your accountant has verified them after a thorough examination.

  • Carry Out a Legal Investigation

Commercial property can attract potential legal risks that you need to be aware of before purchasing the property. You need to get in touch with an attorney who can help to detect any legal threats that the property poses. Among the things that you need to consider include:

  • Any abnormalities on the title and survey of the property
  • Potential environmental hazards that could attract legal implications
  • Encroachments that threaten the property
  • Discrepancies in the agreement contracts
  • Tenants' leases and the leasing periods- For the tenant leases, ensure that they are reviewed and updated because you will also be purchasing the leases when you buy the property.

An attorney has the responsibly of undertaking thorough investigations to determine any potential legal risks that may affect your investment. They have to evaluate the other stakeholders involved in the investment and ascertain the suitability of the investment by ensuring that it is not subject, presently and in the future, to legal sanctions.

The attorney has a responsibility of ensuring the completeness and accuracy of any agreement contracts that include lease contracts, pre-lease contracts, sales contracts, pre-sale contracts, tenancy agreements etc. They must ensure that the contracts and agreements are well drafted and comply with all set regulations.

Monitoring System

  • Phasing Strategies

One of the most valuable methods of mitigating risks involves the monitoring and evaluation of the market with the intention of deploying the phasing strategy according the stages of the market cycles.  This strategy involves a gradual process of deploying the equity capital in relative manageable rates/installments periodically rather than investing the full amount at once.

The essence of this model is to invest in stage whiles studying the market. Each investment installment is deployed after the former has proven successful. Using this method, you are able to determine the indicators that affect investment in different stages. Remember that we said that real investment risks are cyclical and thus, you will be studying their effects during the various cycles before planning on the next investment model.

Additionally, commercial investment assets have their life cycles too. You need to investigate and evaluate the profitable life cycles and the triggers of the profitability at a given cycle. You will also have to classify the risks involved in the different lifecycles and determine the influencers of the risks. This strategy will help you manipulate the risks to your advantage.

When monitoring the cycles of the investment one variable that you need to keenly investigate is your leverage. You need to be able to establish if the money that you borrowed for the investment is making any meaningful impact by providing good returns as well as being able to service the financing. Through the different lifecycles, try to establish if the leverage is growing by evaluating the equity value of your real estate property. Identify the times when returns are high as well as when the market shrinks. This helps you to know the best times to exit and liquidate assets profitably without affecting the amount of financing that you had acquired.

  • Portfolio Diversification

Another important method of mitigating commercial investments risks in Hong Kong is through portfolio diversification. Essentially, this is the spreading of risks through investing in multiple commercial investment assets rather than in a single asset. You need to develop a clear investment strategy that will enable you to spread the risks involves in your investment through having a number of assets in your portfolios. It is advisable for you to work closely with experienced property management professionals or a real estate investment company that will help you in the management of risks through the acquisition of various assets. The ability to reduce the liability that results from disasters is beneficial in helping you grow your investment without the worry of future losses.

You need to have clear objectives that enable you to invest in various profitable assets after a certain period. You should never have all your eggs in one basket no matter how profitable the investment is presently. The future could always change thus portending doom to your investment in case a risk strikes and your current investment becomes affected hence resulting in massive losses.

Through the lifecycle of the property assets, you need to monitor how the various assets that you have acquired are doing in the market. Establish those that are better performing as well as those that are poorly performing; also establish the assets that seem profitable in the long-run as well as those profitable presently and in the short-term. This will help you determine the less risky assets that should largely comprise your portfolio.

Also, remember to always liquidate assets that you find are not profitable and instead of divulging the cash to other assets that promise long-term returns. By so doing, you will be in a position to cushion you entire investment from a shock that could potentially reduce the value of an asset when disaster strikes.

Provide an Insurance Cover for Your Investment
One mistake that most investors make is failing to insure their investment against risks. Of course, insurance expenses usually reduce the returns on investment but it is worth it. Insurance helps to cushion your investment against market crashes and shocks that could potentially affect the investment. The ability to be indemnified after a disaster strike makes sense on the reason why it is vital for you to seek a comprehensive insurance cover for your investment.

Final Words…
Although property investment has been making a killing in Hong Kong, an investor should never fall for get-rich-quick investment opportunities made up by rogue people. Being too greedy to get good returns on property investment can lead to frustrations because it does not work that way. As a matter of fact, property investment requires a lot of money and years of patience especially during the first years when an investor will be realizing negative income as one pays for the financing and other expenses before the property breaks even. This means that during these years, one should have an alternative source of income to depend on and not on the real estate property income.

Proper due diligence is an ideal tool that can help you to mitigate the risks that are involved in commercial real estate investment. It is important to use the services of professionals who have wide experience in the specific fields. For instance, if you need to get an attorney to help you in legal investigations, do not hire a family attorney, but you need to be specific about hiring an attorney who has specialized in the field of land and property law.

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