Investing involves risks and rewards – and usually the higher the risk, the greater the potential for significant gains and losses of invested equity. Intuitively, we understand that it’s necessary to take more investment risk in order to achieve higher returns. But how much is appropriate? And how can you quantify investment risk in real estate to figure out if it’s a chance you want to take?
In private equity real estate markets, the fact that we buy physical rental properties gives many investors a level of comfort. Yet there are many risks involved in commercial real estate investing that have to be considered in conjunction with the expected value of the investment. Having frames of reference for investors to quantify risk helps ensure that the real estate investment matches their needs, goals and tolerance. At Origin, we use sophisticated risk models and the deep knowledge of our acquisition team spread over 11 markets to account for the many variables involved in evaluating the potential returns of a new property.
Types of Risk in Real Estate Investments
Here are eight risk factors investors should consider when evaluating any private real estate investment:
1. General Market Risk. All markets have ups and downs tied to the economy, interest rates, inflation or other market trends. Investors can’t eliminate market shocks, but they can hedge their bets against booms and busts with a diversified portfolio and strategy based on general market conditions. “What you don’t know can hurt you,” the Financial Industry Regulatory Authority (FINRA) notes.
2. Asset-Level Risk. Some risks are shared by every investment in an asset class. In real estate investing, there’s always demand for apartments in good and bad economies, so multifamily real estate is considered low-risk and therefore often yields lower returns. Office buildings are less sensitive to consumer demand than shopping malls, while hotels, with their short, seasonal stays and reliance on business and tourism travel, pose far more risk than either apartments or office.
3. Idiosyncratic Risk. Idiosyncratic risk is specific to a particular real estate asset. The more risk, the more return. Construction, for example, will add risk to a project because it limits the capacity for collecting rents during this time. And when developing a parcel from the ground up, investors take on more types of risk than just the construction risk. There’s also entitlement risk – the chance that government agencies with jurisdiction over a project won’t issue the required approvals to allow the project to proceed; environmental risks that range from soil contamination to pollution; budget overruns and more, such as political and workforce risks.
Location is another idiosyncratic risk factor. For example, buildings behind Chicago’s Wrigley Field used for private rooftop parties went from a boom to bust investments when a new scoreboard completely obliterated their views, while property values near The 606, Chicago’s version of the High Line in New York, are rising. Idiosyncratic risks are defined as risks that are specific to the asset and the asset’s business plan.
4. Liquidity Risk. Taking into consideration the depth of the market and how one will exit the investment needs to be considered before buying. An investor can expect dozens of buyers to show up at the bidding table in a place like Houston, regardless of market conditions. However, a property located in Evansville, Ind., will not have nearly the same number of market participants, making it easy to get into the investment but difficult to get out.
5. Credit Risk. The length and stability of the property’s rental income stream is what drives value. A property leased to Apple for 30 years will command a much higher price than a multi-tenant office building with similar rents. However, keep in mind that even the most creditworthy tenants can go bankrupt, as history has shown us time and time again. Remember the 1990s, when landlords were happy to have Sears and J.C. Penney anchor their malls?
The huge market in so-called triple-net leases, which are often said to be as safe as U.S. Treasury bonds and require tenants to pay taxes, insurance and improvements, can fool property investors. The more stability in a property’s income stream, the more investors are willing to pay because it behaves more like a bond with predictable rental income streams. However, the triple-net lease landlord is taking a risk that the tenant will stay in business for the length of the lease, and that there will be a waiting buyer. New construction may seem like a better bargain than a 30-year-old structure customized by a prior tenant.
6. Replacement cost risk. As demand for space in the market drives lease rates higher in older real estate assets, it’s only a matter of time before those lease rates justify new construction and increase supply risk. What if a new property makes your investment property obsolete because there’s a better facility with comparable rents? It may not be possible for an investor to raise rents or even to attain decent occupancy rates.
Evaluating this situation calls for understanding a property’s replacement cost to know if it’s economically feasible for a new property to come along and steal away those tenants. To figure out replacement cost, consider a property’s asset class, location and sub-market in that location. This helps investors know if rent can rise high enough to make new construction viable. For instance, if a 20-year-old apartment building is able to lease apartments at a rate that would justify new construction, competition may very well come along in the form of newly built offerings. It may not be possible to raise rents or maintain occupancy in the older building.
7. Structural Risk. This has nothing to do with the structure of a building; it relates to the investment’s financial structure and the rights it provides to individual participants. Regarding financing costs, a senior secured loan gives a lender a structural advantage over mezzanine or subordinated debt because senior debt is the first to be paid; it has top place in the event of liquidation. Equity is the last payout in the capital structure, so equity holders face the highest risk.
Structural risk also exists in joint ventures. In these types of deals, the investor must be aware of their rights relative to their position in the limited liability corporation (LLC), which is either a majority or minority holding. This will dictate the compensation they will have to pay the manager of the LLC when a property is sold. If an investor is a limited partner, they must understand that the gross profits will be diluted by the compensation paid to the manager and how much of the deal’s profits they will receive if the deal is successful. It’s also important to know how much of the equity is being invested by the limited partners verses the manager. Are they aligned? Do they have similar “skin in the game?”
A lack of alignment can create a divergence of incentives between the manager and the investor. For example, if you are a limited partner in a deal that has an advantageous profit split with a manager, and that manager has significantly less money invested in the deal, the manager is incentivized to take risk.
8. Leverage Risk. The more debt on an investment, the more risky it is and the more investors should demand in return. Leverage is a force multiplier: It can move a project along quickly and increase returns if things are going well, but if a project’s loans are under stress – typically when its return on assets isn’t enough to cover interest payments – investors tend to lose quickly and a lot.
As a rule, leverage should not exceed 75%, including mezzanine and preferred equity, because both of these types of debt sit ahead of common equity in payment order. At Origin, our portfolios never exceed 70% leverage, and we do not use mezzanine debt or preferred equity on any deals – only common equity. Returns should be generated primarily from the performance of the real estate – not through excessive use of leverage – and it’s critical that investors understand this point.
Often, property investors don’t realize how important it is to study capital costs and quantify leverage, so they end up in over-leveraged investments. Investors should ask about how much leverage is used to capitalize an asset and ensure they are receiving a return commensurate with the risk.
The Bottom Line for Real Estate Investors
No matter the type of real estate asset, investors should inquire about these risks and receive straight answers to be more confident in their investing decisions. Be aware of any investment opportunities that don’t make all risks involved crystal clear.