event risk housing

Accounting for Event Risk in Real Estate Investing Across the U.S. and Nashville’s Housing Market

Event risk can take on various definitions in different contexts. For example, the term event risk can refer to risk events that can be somewhat predictable and recurring. The cyclical changes in the financial/housing market are such an example.

In other contexts, the term can refer to random, unpredictable events. The terrorist attack of 9/11/2001 was an unexpected random event, which had widespread political, economic and societal implications.

Finally, event risk can also refer to risks associated with the completion of a project or special event.

For the purpose of this blog, event risk is generalized to the possible occurrence of any event – geopolitical, natural, technological, financial or legal – that is unpredictable, unexpected or disruptive, and has a negative impact on an individual, company, industry, city, region or country’s ability to operate.

Given that event risks are random, unpredictable and beyond our control, how can we plan to mitigate the negative impact?

Although event risks are not entirely predictable, the negative impact of such risks can be mitigated by monitoring some key risk factors that can signal a rising probability of event risks. The risk factors we monitor at Beacon Property Solutions include:

  • The Geopolitical Cycle
  • Macroprudential Overconfidence
  • Liquidity

A risk event attributable to any risk event may be low; however the probability of an event risk will increase when risk factors combine synergistically.

Geopolitical Cycle:

Harry Dent, who is noted for his research on cycles, includes the geopolitical cycle among his hierarchy of four cycles. The geopolitical cycle is a long-term cycle (34 – 45 years), which pointed down after 2010, and is expected to remain down through 2020.

Within the current cycle, we have seen Arab Spring Uprisings, the rise of ISIS, and the Ukraine conflict.

Macroprudential Overconfidence:

Macroprudential changes include all the things that government agencies and central banks have done, and continue to do, in order to mitigate systemic financial disasters:

  • Higher capital requirements
  • Decreased leverage
  • Less aggressive valuation of assets
  • Greater loan loss provisions
  • Etc.

Macroprudential changes have allowed central banks to aggressively stimulate global economies, based on the assumption that consumer spending, durable goods purchases, and meaningful employment would collectively increase to drive inflation to the targeted 2% level.

To date, the expected gains have not materialized, although the price of financial assets (real estate, stocks and bonds) continues to increase.

It’s possible that central banks are setting the stage for greater financial instability in the future. Will the regulatory agencies and central banks that created the changes hold the large financial institutions accountable, or will they allow them to circumvent the changes using loopholes, which allow them to remain too big to fail?

In addition, will the global central banks be able to stay coordinated when the next financial crisis presents, or is the overconfidence fostering the mindset that systemic has been eliminated indefinitely?

Liquidity:

The rise in asset prices since 2008 has been fueled by liquidity. When liquidity is abundant, asset prices rise. When liquidity falls, asset prices fall.

Richard Duncan has a proprietary liquidity gauge indicator that monitors liquidity. This gauge is currently signaling an imminent contraction.

Liquidity is affected by three factors:

  • The borrowing of dollars by the US government to finance its deficit – this drains liquidity. The CBO (Congressional Budget Office) provides estimates for the deficits.
  • The creation of dollars by the Feds through quantitative easing – this adds liquidity to markets.
  • Dollars accumulated as foreign exchange reserves. Dollars accumulated as foreign exchange reserves are the results of dollar purchases by foreign central banks, based on trade surpluses with the US – this adds to liquidity. Estimates of the US current account deficit can be used as a proxy for foreign currency reserves.

When total liquidity (total amount of quantitative easing + US dollars accumulated as foreign exchange reserves) exceeds the budget deficit, excess liquidity exists and asset prices rise.

The Nashville Event Risk Situation

While the above risk factors are applicable to many US cities, Nashville has some additional unique event risks, including:

  • Flooding – The risk of flooding, resulting in catastrophic losses that exceed the May 2010 $2 billion in damages for Davidson County, has not been eliminated.
  • Unaffordable housing – Nashville’s population and land development boom is beginning to drive real estate prices to extremes. Analyses of Metro Social Service data reveal that request for assistance is dominated by housing-related costs.
  • Widening income disparity – Metro Social Service data has demonstrated a poverty rate (income for a family of four that is equal to or less than $24,250) ranging from 2.3% for Metro Council District 34 (Forest Hills and Oak Hills), to 41.8% for Metro Council District 19 – the highest in the city. Metro Council District 19 includes downtown and neighborhoods to the North and South. You can read more about this in this April 2015 article from The Tennessean.
  • Transportation congestion – Nashville’s transportation infrastructure is in need of an overhaul to accommodate both future expansion and the changing preference of an urban population for commuting by cars. However, the middle Tennessee terrain makes a subway type mass transit system cost prohibitive. NashvilleNext advocates “dedicate transit right of way that provides quicker, and more efficient bus service, queue jump lanes at intersection, or even a light rail corridor linking Nashville’s centers.” You can read more about this in a March 2015 article on the Nashville BizBlog.

As a real estate investor, you already know that due diligence is key to a profitable cash flow return over the long term. Should you have any question about a potential real estate investment in Nashville, our experts at Beacon Property Solutions will be happy to address your concerns and particular situation. Contact us by phone or email.