The first rule of investment is diversification, but having high conviction is important too. Spreading risk and having confidence in the investment decisions we make are a strong combination. Being able to identify, measure and navigate risk is a challenge we should overcome if we are to achieve both these objectives. Most investors typically underestimate market risks, which can lead to unintended and low-conviction outcomes.

Real estate risk is multi-dimensional, fluid and impossible to accurately measure in terms of returns. However, we know broadly where most risks come from, and we can try to predict their potential impact.

What is country risk?

Real estate risks can be broadly split into property-specific risk and market risk. Country risk is one element of market risk. The risks to cashflows and valuations are different for each country. For example, the legal relationship between landlord and tenant is different in each country, which leads to a range of security in cashflows. Some countries have a unique monetary and fiscal policy environment that can directly affect real estate returns. Furthermore, environmental, social and governance (ESG) risks also differ from one country to the next, and this is likely to have an increasing influence on relative performance.

Assessing country risk

Although country risks can’t be precisely quantified, investors can form a view on the relative risks they are taking when choosing to allocate to one country over another. This point is important. As investors, we need to know how certain we are of executing a strategy as close to the target outcome as possible, whether that is a 5% core or a 15% opportunistic return strategy.

The global investible universe offers a range of conditions where the outcome could differ materially, based on fundamental risks in the markets. Lower-risk strategies, which depend on consistent and robust cashflows and higher liquidity, can find better conditions in more mature economies. Those strategies looking for higher returns might find pricing and implementation easier in a broader range of markets.

The abrdn RE:GlobalRiskNavigator (GRN)

It is designed to help us and our investors make more informed decisions and to understand the risks to which they are exposed. The full paper can be found on our website.

We break down our GRN index components into two groups: real estate risk and ESG risk. As we watch countries battle the effects of extreme weather events, it is unsurprising that we now view ESG risk as being increasingly important to future real estate performance, and this has become a key element of our country-risk evaluations. ESG risk factors carry a 50% weight in our index.

What does the index measure?

The GRN uses robust third-party industry data and abrdn’s proprietary in-house data to score and rank countries. For real estate risks, these datasets measure market transparency, liquidity, the scale of the market, and economic resilience. For ESG risks, we measure exposure to climate change (physical risks) and each country’s ability to transition to a lower-carbon economy (transition risk), their approach to social responsibility, and the strength of governance. Each of the individual datasets has an equal weighting in our index, with an equal share between real estate and ESG risks. We believe that the structure of the index and the weighting of the ESG components are sufficiently forward-looking to enhance long-term allocation decisions.

What does the GRN tell us about global market risk?

The global average GRN risk score is currently 4.4 in our model. Large, well-developed, transparent European markets have the lowest level of country risk (a 3.2 GRN score), closely followed by the North American markets (4.5). With a GRN score of 5.4, Asia-Pacific markets have a moderately higher amount of country risk than the other regions. Across all regions, there is a broad spread between countries (see chart).

Europe carries a substantially lower level of ESG risk compared with the other regions. This is reflected within each country, too, apart from Spain where climate risk is higher. The US scores well on real estate risk factors, being a large and transparent market, but it is significantly penalised from an ESG perspective. As such, it ranks in the middle of the index.

Taking this a step further, we can determine whether the expected level of return from a particular country looks reasonable in relation to the underlying country risk. For Europe, we have compared our proprietary country-level total return forecasts against the GRN scores to see where risk-adjusted returns might be most positive over the next five years. Our analysis finds that France, Germany, Netherlands, Sweden and the UK offer the highest returns per unit of GRN score. The weakest markets on this basis are the Czech Republic, Poland, Portugal, Italy and Ireland.

A tool for challenging strategy and investment biases

Our proprietary index can offer greater insight into the risks of each country allocation. While these risks are well established from a real estate perspective (transparency, liquidity and economic risk), the ESG risks are perhaps the newest amendments to our framework. Given that our index is designed to guide a strategy over a five- to seven-year period, climate change and climate resilience are important factors. With 2030 targets for energy performance certification now within that investment timeline, the costs and potential issues around attaining the necessary accreditations are a real risk today.