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S. Khumpaisal 1
Abstract
Risks generally denote the negative impact to the real estate project’s progression in regard to these will
affect to the construction schedule, project cost and the quality of the products. This article highlights the im-
portance, consequences and impacts of risks in the real estate development projects. This article also classifies
risks in the general business, and then focus specifically on those in the real estate business, then it provides
the academic and practitioners term of risks as well as define the risks those involve in the real estate business.
The risk classifications in this article will be used to support and establish the risk assessment criteria based
on the definitions of Social, Technological, Economic, Environmental and Political factors or STEEP factor, which
is popularly used in the general and real estate business.
บทคัดย่อ
STEEP (Social)
(Technological)(Economic)(Environmental)
(Political)STEEP
Keywords
Risk
Risk Classification
Real Estate Business
Factor STEEP ()
A Classification of Risks in Real Estate Development Business
การจัดประเภทของความเสี่ยงในธุรกิจอสังหาริมทรัพย์
Sukulpat Khumpaisal
สุกุลพัฒน์ คุ้มไพศาล
Faculty of Architecture and Planning, Thammasat University, Pathumthani 12121, Thailand
E-mail: sukulpat@ap.tu.ac.th
JARS 8(2). 2011
2
1. Risk: General Definitions
Risk can be simply defined as a potential
negative impact to an asset, project or some char-
acteristic of value that may arise from a present
process or future event. In everyday usage, risk is
often used synonymously with the probability of a
known loss. However, in its scientific meaning, risk
is defined in various manners, generally as exposure
to adversity or loss, or the possibility of a danger or
threat occurring. According to the definition of the
Royal Society (Crossland, et al., 1992), risks can be
classified into at least three categories:
a) Risks for which statistics of identified
casualties are available.
b) Risks for which there may be some
evidence, but where the connection between the
suspected cause and injury cannot be traced.
c) Experts’ best estimates of the probability
of an event that has not yet happened.
In term of real estate business or investment,
risk also covers the uncertainties related to the
expected rate of return from an investment (Reilly
and Brown, 2002 as cited in Baum and Crosby, 2008).
Using these definitions, risk can be described as
follows. Firstly, risk means loss, damage or any
undesired consequences that impact to the
project. Secondly, risk is scientifically defined as the
probability that a particular adverse event occurs
during a stated period of time, or results from a
particular challenge. Risk in statistical theory also
follows through all the formal laws of combining
probabilities. Thirdly, risk is defined as “the prob-
ability of loss and the significance of that loss to the
organisation of individual” (Mitchell, 1995 as cited in
Harland, et al., 2002). In a business or investment
context, risk is also used to describe the unpredict-
able financial consequences of actions and decisions.
In operational terms, risk is referred to as a set of
unwanted and uncertain events, but in the analytical
sense, risk is regarded as the description of the
extent to which the actual outcome of an action or
decision may diverge from the expected outcome
(Hargitay and Yu, 1993).
By the analytical definitions of investment, risks
are usually expressed in either probabilistic terms
or in terms of variability. In accordance with this,
Hargitay and Yu (1993) defined risk in analytical terms
as follows:
a) The probability of loss
b) The probability that the investor will not
receive the expected or required rate of return
c) The deviation of realizations from expecta-
tions
d) The variance or volatility of returns
According to the aforementioned definition of
risk, risk is simply illustrated by the following equation:
Riskn = Pn x ln
Where P = Probability of loss
l = The significance of the loss
Risk and risk management is at the heart of
every investment decision. Every time an investor puts
money into another asset or investment, rather than
cash alone, a trade-off is made between risk and
return. Cash deposits offer a virtually risk-free return
at any point in time; government index linked bonds
are frequently regarded as the ‘real’ risk-free rate over
the longer term. However, with property investments
the tenants can default, thus affecting the rental
income stream, and there is no certainty over the
level of property values in the future. Changes in
these and other variables can have a marked effect
on the delivered level of returns, resulting in uncer-
tainty and potential volatility (Chapman, 2009).
2. Systematic and Unsystematic Risk
Hargitay and Yu (1993), Brown and Matysiak
(2000) and Baum and Crosby (2008) define risks in
S. Khumpaisal 3
property investment as “total risk.” Total risk itself
is associated with several factors, but can be subdi-
vided into 2 major categories: “systematic” and
“unsystematic” (or “specific”) risk. It is simply
described by the equation of “Total risk = System-
atic risk + Unsystematic risk.” In this regard,
systematic risk can be summarised as the risk caused
by several factors that affect the investment: for
example, risk caused by a change in the economic
situation or in government policy towards property
investment could be counted as systematic. This
means that the investors or developers are not able
to control either the probability or the consequences
of risk caused by broader economic and political
issues. But on the other hand, investors and
developers have some degree of control over
unsystematic or specific risk as they are able to
deeply investigate the companies and projects
they are going to invest in, as well as make their
investment decisions based on project or management
team performances. Moreover, developers are able
to control the causes and consequence of such risks
occurring in the invested project, because most
unsystematic risks are caused by internal factors.
Therefore, Hargitay and Yu (1993) summarised
the components that comprise to systematic and
unsystematic risks. Systematic risks may involve the
following:
a) Market risk or risk related to fluctuations
in the market that the investors or developers intend
to engage in.
b) Cyclical risks or risks related to variations
in the business cycle.
c) Inflation or purchasing power risk or risks
related to the uncertainty of the future purchasing
power of the returns produced by the investments.
d) Interest rate risk or risk related to the
fluctuation of interest loan rates, particularly in the
area of real estate development, in which developers
have to loan large amounts of capital from banks or
financial institutions.
On the other hand, unsystematic or specific
risks involve the following:
a) Business risk or risk associated with a
company’s business operations. The factors that
influence risk are to do with the size of the company,
product mix, competition and the general orientation
of the management team in charge.
b) Financial risk is dependent on the way
the company or project’s operations are financed.
This includes the ratio of debt and equity that the
company or the project holds, since the larger the
debt finance, the larger the associated financial risk.
c) Liquidity risk may be caused by the
following aspects: the degree of difficulty associated
with the realization of the capital invested; the
divisibility and marketability of the asset; and the
costs involved with the realization of the capital. In
this regard, the liquidity risk also covers the risk
caused by an illiquidity of project funding during
project processing (Chen and Khumpaisal, 2008).
d) Other specific risks which usually affect
individual investment, such as location concentration,
construction and execution risks.
Furthermore, Fraser (1993) gives the definition
of risk in property investment as the variability of its
annual return (or Internal Rate of Return: IRR). As the
return may vary as a result of changes in both income
and price, this encompasses risk to income as well
as risk to capital. Additionally, he also provides some
sources of risk that may affect the vitality of a par-
ticular investment project:
• Liability matching: The ability of investment
returns to match its liabilities must be addressed by
the investors. The duration and the type of property
invested in will reflect the degree of risk to that
investment.
• Liquidity: Real estate property has less
liquidity in comparison with other investments,
since it requires more time to find the purchaser or
other interested parties. This will affect the risk
and expected return from the property investment
accordingly.
JARS 8(2). 2011
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• Marketability: Due to its illiquid character-
istics, real estate property is less marketable than
other investments as property can sometimes languish
unsold for some time. Property demand may also
frequently fluctuate and not balance with the market
supply.
• Taxation liability: Investors have to factor
in various forms of tax when they invest in property
development, such as income tax deducted from
rental income, property tax, etc.
• Transaction costs: A variety of expenses
appear during the transaction period when the
property is transferred from the investor to the
purchasers, such as legal fees, stamp duty, brokerage
fee, etc.
• Management costs: These are necessary
for a property that needs an annual liability for repairs
and insurance. That cost is distinguished from other
investments since the investors have to employ a
management agency as their representative for duties
such as rent collection, portfolio management and
non-annual negotiations and rent review.
• Investors’ growth expectations: The
expected growth rate of the property investment is
affected by the growth of both income (from rental
or sales) and costs. Income growth may vary due to
fluctuations in rent levels, the broader economic
situation and market conditions. Another concern for
property investors is the physical depreciation of the
property, as this will cause a fall in value throughout
the investment period.
These risks should be considered when the
developers decide to invest in or develop a new
property project or even during the feasibility analysis
process. It can therefore be concluded that the most
significant causes of risk are financial (in term of loan,
illiquidity of cash) or market-related (in terms of sup-
ply and demand, including forecasted market trends).
However, when real estate projects progress to the
construction stage, various risks may occur during
the construction process that are also important
concerns, as these will affect to the project vitality
whether the fiscal or physical attributions. According
to Miller and Lessard (2008), risks occurring at the
construction or execution stage can be classified into
3 major categories:
1. Market-related risks: These are Market risks,
Financial risks and Supply risks, respectively. Market
risks mean the ability of project managers to forecast
demand among mega-project users or customers.
This is because each mega-project has its own
customers. A wide variety of customers creates more
difficulties to forecast demand accurately. Financial
risks include shortages of available funding sources
to continue the project. In this regard, supply risks
are similar to market risks in that both risks are
associated with price and access uncertainties. These
arise from an ill-prepared contract, limited contract
and procurement management, or from an inappropri-
ate project organisation structure (Khumpaisal, 2007).
2. Completion risks: These encompass
Technical risks, Construction risks, Execution risks
and Operational risks. Technical risks are caused by
technical factors, such as engineering difficulties
and degrees of innovation, as well as risks caused
by miscommunication or poor integration between
design and construction units. On the other hand,
Construction risks refer to the difficulties that project
owners, sponsors, contractors and vendors confront
in the construction process. Execution risks refer to
issues that arise from errors or conflicts that delay
the project schedule. Operational risks refer as to
the possibility that the project will not function as
expected, for example if the availability, capacity or
efficiency is lower than expected.
3. Institutional risks: These are mostly caused
by external factors such as legal, political, and com-
munity issues, social acceptability and environmental
regulation. In this regard, any policies issued by
regulators which affect the overall project progress
are included in institutional risks.
S. Khumpaisal 5
Huffman (2002) has identified risks in real
estate development at the project management level
or using brainstorming techniques. These include
events that may arise and affect critical aspects of
the project. By his definition, the major risks associ-
ated with real estate development can be catego-
rised as:
• Financial risks: These can significantly
increase the corporation’s risk exposure. For example,
they may affect the overall financial structure of
the investment, including the availability of funding
injections during the project development process.
• Physical risks: These are associated with
the physical space, as well as the site itself and its
surroundings. These also include design risks and the
communication between designers, contractors and
owners of the property. Poor or inadequate design
(functional obsolescence) can result in decreased
productivity and/or increased real estate operating
expenses. Poor workplace design can also increase
employee dissatisfaction as well as increase
employee turnover.
• Regulatory risks: These are incurred as a
result of governmental oversight, legislation and new
regulation. For example, if a government issues a
policy to reduce hydrocarbon emissions, this can
reduce transport options and make commuting more
expensive for investors. At the local level, changes in
land use regulations can affect expansion plans, while
increases in property tax assessments can raise the
costs of property management.
3. Objective and Subjective Risk Definitions
Even though risks can be classified by their
characteristics and causes, as described above, risks
are also determined by the perceptions of developers
or decision makers. Additionally, risk perception is
arguably multidimensional, with a particular hazard
meaning different things to different people and
in different contexts. In some situations, risks are
not only physical, but also social and organisational
factors such as project management, risk manage-
ment, etc. Therefore, it also means that risk
perception can not only rely on mathematical or
statistical calculations such as the probability
and consequences of its occurrence, because risks
are also caused by human, social and political
phenomena.
According to a Royal Society investigation,
Pidgeon, et al. (1992) classified risk into the “objec-
tive” (or statistical) and “subjective” (or perceived)
categories. By this classification, objective risk is
specific, substantial, physically measurable or
identifiable, and can be determined precisely by
quantitative risk assessment.
In contrast, Spaulding (2008) terms subjective
risk as what an individual perceives to be a possible
unwanted event. However, most people realise that
risk is a part of everyday life: for instance, that it’s
possible to have an accident or a heart attack or
some other health problem, or gambling. The degree
of subjective risk depends on a person’s experience
and their expected possibility of its occurrence. For
example, an investor who has lost a lot of money in
the stock market will probably feel more risk averse
when speculating than one who has not. Subjective
risk may alter the behaviour of the risk taker if
the potential outcome is relatively likely or highly
undesirable. Subjective risk also involves the
perception of the decision maker about the likelihood
and consequence of the event.
4. A Classification of Risk by Steep Factors
Determinations
This article mainly supports the assumption
that risk in real estate development is mostly
caused by the effect of STEEP factors. In this regard,
STEEP is an acronym for Social, Technological,
Economic, Environmental and Political implemented
by Morrison (2007). These are the major factors that
may severely affect the development process of a
project or investment. Therefore the decision makers
JARS 8(2). 2011
6
and project managers must concern themselves
with these factors prior to taking any particular action
to ensure that the full range of risks, whether
systematic or unsystematic, subjective or objective,
have been considered. For instance, risk may relate
to the separation of design from construction, a lack
of integration, poor communication, uncertainty, a
changing environment, increasing project complexity,
economic changes such as inflation and deflation,
regional economic crises or political pressure
(Gehner, et al., 2006; He, 1995). Thus, the risks caused
by STEEP factors and their consequences must be
considered and should not be underestimated,
because these will impact on the overall project
management processes - for example, through
project schedule delays, cost overrun and reduced
project quality, which then adversely affect both the
project stakeholders and public interest. Putting
it another way, risks may compromise the project
management backbones of Time, Cost and Quality
(PMI, 2004).
STEEP factors analysis has been widely used
in business decision making, but is also known
alternately name as PEST, TESP and STEP.
However, they share similar Political, Economic,
Sociological and Technological concerns. This form
of analysis was developed to analyse both the
risks that arose from these related factors and their
consequences, as well as to measure the market
situation, particularly growth or decline, and thereby
the attractiveness, suitability and business potential
of the investment. PEST analysis uses four perspec-
tives, which together provide a logical structure
to help the investor to understand, consider and
decide on a project based on these four dimensions
(Chapman, 2009).
The STEEP classification of investment risks
is pragmatic as well as simple enough to be clearly
understood by all project participants. This is also
supported by Nezhad and Kathawala (1990), who
conclude that the risks that affect the decision-
making process in an international investment relate to:
• Socio-cultural factors: These include the
conflict between the host country’s norms and the
investor’s own belief and cultural outlook.
• Economic/Financial factors: The investors
should be concerned with the economic system and
current situation of the country they are investing in,
as well as the economic infrastructure of the invest-
ment area, including access to human resources,
product standardisation and the existence or absence
of a particular technology, as these may vary the
development cost. For instance, licensing, acquisition,
and joint ventures may be restricted severely by a
certain host country. In addition, in most countries
inflation and currency exchange rates create further
difficulties for investment (Wheeler and Hunger, 1986
as cited by Nezhad and Kathawala, 1990).
• Political risk: These may exist when
discontinuities occur in the business environment due
to political instability, which is difficult to anticipate.
Political risk also covers risk which may affect the
investment atmosphere due to a change in fiscal or
trading policy.
• Legal factors: These cause a risk to the
investor and may depend on the country’s legal
system, the degree of legal enforcement and the
regulatory body which responds to legal issues with
regards to investment.
• Technological factors: These include, but
are not limited to, the availability of the appropriate
technology for construction or manufacturing and the
ethnocentric orientation in the investment area.
• Physical factors: These include physical
attributions such as transportation, natural resources,
climate, topography, and the territorial size of the
invested area.
• Availability of resources: The decision
makers shall make decisions regarding the range
of responsibility management towards employees,
labour union, training and development of employee,
payment and welfare. However, this factor also causes
risk when the developer have more competitors in
the same market.
S. Khumpaisal 7
• Market factor: the investors have to
consider the competitive condition of the market,
the opportunities for product orientation (including
the channels to distribute the product to customers),
as well as the barriers to entry due to other market
restrictions, the supply demand cycle and fluctuation
of overall market trade area.
5. Conclusions
According to the extensive literature review
presented above, it could be concluded that decision
makers should be concerned about the risks to their
projects as these may affect a project’s vitality through
income loss, increased time consumption resulting in
project delays, and reduced customer satisfaction
with the quality of the product. Risks also affect
the return of investment (IRR), which may vary or
fluctuate despite the investor’s expectations, because
the longer period of investment would result in a
greater opportunity cost for other investments as well.
This article also proposes general and specific
classification of risks in the real estate industry. This
could be achieved through a range of approaches.
Firstly, risk can be regarded as systematic or
unsystematic in accordance with its origin, whether
external or internal. Secondly, depending on how
it is perceived, the risk may also be classified as
“Subjective” and “Objective”. this classification also
relates to the method of risk assessment: if the
risk can be mathematically or statistical assessed,
then it is counted as objective. On the other hand, if
it cannot be readily quantified, it is regarded as
subjective. Thirdly, risks could also be classified by
their sources of origin, or their “causes”, using STEEP,
PEST, PESTIE or other similar criteria.
Finally, this article proposes the use of STEEP
factors to classify risks in real estate development
projects. These are already popularly used in business
decision making prior to investment in or development
of a project because their principles are uncompli-
cated and simple to understand. The other advantage
of STEEP factors is that they cover the widest area
of risks and other issues that may affect the project
development process and investment.
JARS 8(2). 2011
8
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