The failure of real estate risk management: Proposing an alternate approach
“It is better to be approximately right than to be precisely wrong.” — Warren Buffett
“The most important questions of life are, for the most part, really only problems of probability.” — Pierre-Simon Laplace
“The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk.” — Peter Bernstein, Against the Gods: The Remarkable Story of Risk
What typically passes for real estate risk analysis is at best simplistic sensitivity analysis — perturbing one variable, while holding other variables constant, to see the effect on the IRR or the equity multiple. This approach is deeply flawed. It is incapable of properly assessing downside risk, valuing embedded options or calculating risk-adjusted return — itself one of the most abused terms, observed in the breach and too often deprived of analytic substance. The state of real estate risk analysis is abysmal.