Explaining Value at Risk (VaR) in Commercial Real Estate

The equation for value at risk

All investors are subject to credit, market and operational risk. No matter how and where an investor is putting their investments, there is a risk attributed to the nature of the industry. To calculate exactly how much risk there is for a certain investment, an individual investor or investment firm can use the value at risk statistic and determine whether a potential investment is worthy of acquisition.

You can also use our acquisition calculator for more insight.

What is Value at Risk?

Value at risk is a number that quantifies the possible financial losses for a single investment or an entire investment portfolio over a certain period of time. To make this estimate, an investor must consider the potential for loss in a particular investment opportunity and the probability of how often that loss will happen. When modeling VaR, not only are risk managers estimating how probable a loss an investment could become — they are calculating whether an asset is worth taking.

The use of VaR is common in investing firms, where VaR is essential in calculating the probable losses or gains on behalf of the entire group. VaR helps reduce the risk of unintentional exposure from a bad investment. For risk managers, using VaR can save the necks of everyone on the team by preparing the firm to allocate appropriate capital reserves to cover any cumulative risks that could result from the investment in the worst case scenario. However, there is still room for error, as VaR only counts the minimum loss expected over a period of time.

How to Calculate VaR

VaR can be calculated in several ways, including a historical method based on prior returns recording worst losses and highest gains. There is also a variance-covariance method that assumes gains and losses are normally distributed within a frame within a standard deviation. No matter how you choose to calculate it, you can follow a formula that incorporates the standard deviation, confidence intervals and portfolio value into the ultimate value at risk:

VaR = [Expected Weighted Return of Portfolio – (Z-score of confidence interval x standard deviation of the portfolio)] x portfolio value

While this formula can work on paper, you can also calculate VaR using a computational spreadsheet.

How Does VaR Work for Commercial Real Estate?

Like any other investment opportunity, investing in commercial real estate has its own risks and returns. While there is a higher risk in high-potential returns, there is low risk in properties with low expected returns. VaR can point to all risk opportunities in the industry, but cannot calculate the mitigation tactics to combat such potential results.

The most common forms of commercial real estate risk center on the ever-fluctuating real estate market cycle. Market, liquidity and asset risk can be influenced by the price of commercial properties based on inflation and only mitigated by diversification, while debt, credit and property-determined risk depend on the careful analysis of such markets.

It is worthwhile to note that not all VaR determinations are accurate to real-life risk. The 2008 financial crisis exposed several problems in which VaR failed to estimate future risk, resulting in extreme leverage ratios in subprime investment portfolios and underestimates of risk magnitude for major institutions. Despite the chances of failure, VaR is still the best way to determine the threats posed to potential commercial real estate investments.

Risk is unavoidable in commercial real estate markets. However, a potential investment can still elicit a positive return, despite a high risk rate. The solution to any high-risk investment circumstance is to calculate and prepare for such a situation.

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