We all know real estate values rise and fall.
But how likely is a move in either direction and by how much? And is the expected performance of the investment worth the risk?
Here’s how I explain it to potential investors: If one portfolio manager returns 20 percent on a real estate investment but takes two times the risk of the manager who returns 15 percent, the smaller return is better. Because the fund earning 15 percent is taking half the risk, the investment is more likely to hold its original value in a volatile market.
The larger the risk, the larger the expected reward.
The question becomes, how does one measure risk when evaluating one investment opportunity against another? Every real estate investment has its own risk-reward profile. I suggest looking at three types of risk to judge a real estate investment.
Real Estate Risk Categories to Assess When Investing
1. Leverage Risk
Borrowed money is a risk-reward magnifier. A mortgage makes it possible for families to buy sooner and stretch their finances beyond savings at hand. But borrowing locks future earnings into paying off the loan, and a change in circumstances, such as a job loss, doesn’t let one off the hook on payments.
In commercial real estate, risks and rewards rise with the amount of debt used to buy and improve a property. Projects that are capitalized with more debt should, in general, be projecting a much higher return on equity.
To really compare two investment opportunities, strip out the debt and then compare them on what’s known as an unlevered basis. Generally, the one with the higher unlevered return is going to provide the better risk-adjusted return once debt is applied.
Leverage can be a valuable tool in real estate investing but needs to be used wisely. Run away from situations where the debt is high but the returns are average. As a benchmark, at Origin, we put down 30 percent to 35 percent of a building’s purchase price in cash upfront and secure loans to cover the rest.
2. Asset-Type Risk
This is best illustrated with an example. An apartment building relies on tenants while a hotel relies on overnight and often seasonal business. A healthy economy contributes to the success of both but to different degrees.
I view a hotel as a much more complex investment and more of an operating company than a real estate play. Thus, I would need a much higher expected return to convince me to invest in a hotel vs. an apartment building.
3. Project-Level Risk
Similarly, ground-up development has a much different risk profile than a building that has existing cash flows with tenants in place.
That doesn’t mean Origin avoids ground-up development. Quite the contrary. But when doing such deals, we make sure that our investors are being fairly compensated for the additional level of risk.
All three factors need to be taken into consideration when evaluating any opportunity. A ground-up apartment building using 75 percent leverage may, in fact, be less risky than a stabilized hotel that uses only 50 percent leverage.
Go for a Value-Added Component
At Origin’s core, though, we favor buying apartment and office buildings with a value-added component. Rather than rely solely on a steady stream of rental income or a broadly improving economy, Origin looks for buildings with problems; problems it can solve. Origin renovates the property, often puts in new management and controls, and then raises rents.
In a downturn, this lowers our downside risk. In an upturn, this enables us to outperform the market.
We tend to underestimate returns and overperform. We have been way off on our projections at times but always off on the good side.