Avoiding Risks in Real Estate Investment
By Percy Nikora, Owner, Co-Founder
Risk is a fact of life if you want to make returns. Even US treasury bonds hold some level of risk, but a small one. As an investor, your goal should be to identify those risks before acquiring any type of asset, whether it is shares of stock, precious metals, or yes, real estate assets.
Is Real Estate a High-Risk Investment?
Investing in any sector, whether it be stocks, commodities, or real estate, will carry different levels of risk on an individual basis. For instance, buying shares in the latest dog food delivery company to be listed on NASDAQ is a riskier bet than picking up a few shares of Amazon or Alphabet. Investors are willing to take on the risk from the dog food delivery stock because they expect that their risk will be rewarded with higher returns, which, of course, is by no means guaranteed. The same concept holds true of real estate assets. To answer the question at hand: yes, real estate can be a high-risk investment- but the levels of risk and reward vary dramatically between projects just like other investment classes.
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General Market Risks
Markets rise and fall constantly, due to a wide variety of factors including the government policy, general economic trends like inflation or deflation, or “black swan” events, like our current COVID-19 predicament. As the ability to move markets is limited to political actors or high-level institutional investors, most investors will have to deal with the effects of general market risks, which will likely be out of their control.
How to Avoid
With that being said, an ounce of prevention is worth a pound of cure, and astute real estate investors have several tools at their disposal to mitigate the downside of broader market risks. Like most other investment classes, diversification is a phenomenal tool for reducing exposure to general market risks, as some property types within the commercial real estate realm offer up a countercyclical resistance to most downturns, with multifamily and self-storage counted among those that may possess that resistance. Strategic planning based on accurate market data can also help investors to avoid or even profit from recessions down the line.
Asset level risks are those that are shared by all investments within a designated asset class. For instance, hospitality properties that rely on seasonal demand may be more vulnerable during a downturn compared to a multifamily building. This is because people can put off vacations, but they will still need a place to live. Each asset class will have a different level of inherent risk, with essential properties like apartments, medical centers, and critical industrial facilities sitting above things like hospitality properties, restaurants, specific retail shopping, and others.
How to Avoid
The simplest way to avoid this type of risk is to stay away from asset classes you do not understand, or that you are not sufficiently capitalized for. Practically this means don’t bite off more than you can chew- if you aren’t particularly well-versed in self-storage facilities or restaurants, take the time to do a deep dive into how these properties generate income and what the potential risks down the line could be. Performing rigorous due diligence and cultivating a firm understanding of the asset class should be enough to keep you away from the most unwarranted risk.
Idiosyncratic risk refers to any risks carried by a specific, individual investment. Idiosyncratic risks stand in direct opposition to market risks, which affect an entire market or economy. Examples of this in the broader economy could be something like a company losing a long-term and well-loved CEO, and how that affects their shares and performance. The same idiosyncratic risks are seen in the real estate industry and individual properties. For instance, let’s say you own a gas station property, and you have a fuel tank that leaks, potentially causing millions of dollars of fines, legal fees, and renovation/rehabilitation costs. In simple terms, idiosyncratic risk is one that is unique to a particular investment or property.
In real estate and other sectors, entitlement risk is incurred when a government agency like a state, federal, or local government is directly responsible for the approval or disapproval of a project. For example, if you’re developing a large multifamily complex, but local NIMBYs or other stakeholders manage to convince local politicians to block the deal, you may lose a lot of time and money. This could be through legal fees, permitting processes, or simply having to walk away from a potential deal.
In the context of real estate investment, the term environmental risks typically refer to any risks that arise from the environmental conditions of a property. This includes any of the oversight-related environmental issues that may occur as a result of the entitlement risk mentioned above. It can also refer to any risks that are based on the regulations relating to the property or natural resource limitations, such as issues with water or surrounding natural areas. Resource and use restrictions should be looked at by investors to hedge risk in this regard, as well as historical records and any relevant regulatory files.
Location risks are a form of idiosyncratic risk. While you can control your property, you only have so much influence over the neighboring city, county, and private land. If you’ve got a property with phenomenal riverside views and a large coal power plant gets built right in front of your view, your property values will suffer as a result.
How to Avoid
Investors can avoid location risk by Investing in areas with well-developed land-use rules. Additionally, longstanding neighborhoods in dense urban cores are less likely to see severe issues relating to a location as the communities are relatively settled- fewer buildings are going up to change the characteristics of the area.
Determining how liquid a market is, and how quickly you can get in and out is another critical component of the risk assessment process. A property in a low-cap rate, highly desirable urban area, will likely be easier to sell than a niche agricultural property a few hundred miles outside of Helena. The higher the number of market participants, the more opportunities investors will have to get out of investments. Conversely, those high barriers of entry markets like Manhattan or San Francisco will be harder to get into compared to the low participant/low liquidity markets with fewer buyers.
How to Avoid
Real property is an illiquid asset by nature, but you can take some steps to mitigate these issues. Avoiding liquidity risk can be achieved with proper planning, and going into a situation well-capitalized enough to hold for your desired horizon, 5 years, 10 years, etc. You can often trade liquidity for stability, and vice versa- though the two are not necessarily mutually exclusive.
Credit risks are a part of every business, including commercial and residential tenancies. Tenant creditworthiness is used by lenders and investors to determine the value, stability, and earning potential of a property. If your tenants are unable to pay their bills regularly, you will have cash flow and related problems with your operations.
How to Avoid
During stormy economic weather, even the best, highly sought after tenants can have trouble making rent, as evidenced by the Cheesecake Factory’s recent announcement that they were unable to meet their rent obligations. Still, working with long-term net lease tenants, who often sign multi decade leases, should always be a way to lower your risk in this space. Additionally, proper vetting of tenants is a must- skimping a penny here may cost you big down the road in damages, legal fees, sweat equity, and more.
Replacement Cost Risks
When you own a commercial property, there is always the risk that competition can spring up nearby, threatening your valuation and your bottom line. This phenomenon is particularly active in high-demand areas with ever-increasing lease rates. At some point, the higher leases will create a space for new construction, which can detract significantly from the value of older, less relevant properties nearby. It may constrain you from charging the rent you need, or from filling up your property with tenants.
How to Avoid
Before acquiring a property, you can determine the property’s replacement cost to figure out if it is likely for new construction to go up in the surrounding area. To come up with the replacement cost, you need to look at a few property attributes, including the location, market, sub-market, asset class- like multifamily, self-storage, etc. See if a new construction project in the area is feasible, and at what numbers. This will show you what the property’s names are concerning the market that needs to remain profitable.
Structural risks relate to those risks involved with the financial structure or capital stack of the deal, and how those risks relate to the individual participants within a deal. Different levels within the capital stack hold various positions in terms of when people get paid, and who gets paid in foreclosure or insolvency. Senior secured loans give lenders preference over subordinated or mezzanine debt. Senior debt gets paid first in the event of property or portfolio liquidation as well. Equity holders hold the highest risk in most deals in the capital stack since they are the last to get paid after senior and mezzanine participants.
How to Avoid
First and foremost, investors need to understand the capital structure going into a deal. It is essential to realize that the structure determines the compensation paid to the manager of the effort when a property is sold. Gross profits will be diluted by the compensation paid to the manager, so make sure you know how much of a deal’s profits they’re entitled to upon completion of a successful deal. Also, look at how much equity is being invested by limited partners and the manager. You want to make sure that their interests are in harmony, and that they have financial incentives for success.
Leverage risks must also be accounted for before acquiring a commercial real estate asset. Remember that debt=risk—the more debt attached to an investment, the more risk for investors. Consequently, investors should demand more returns for the additional risk. Leverage has tremendous power when wielded effectively- it can keep a project going and amplify returns under reasonable circumstances, but when loans are under stress, or return on assets will not cover interest payments, leverage can lead to quick and tremendous losses.
How to Avoid
In the vast majority of cases, the leverage on a deal should not be more than 75%, including both preferred equity and mezzanine debt, since they retain a privileged place over common equity. Returns should ideally be generated by the individual performance of the assets in question rather than the debt related to the deal. Before investing a deal, take a close look at how much leverage is being used to capitalize the asset, and to make sure that your risk and reward is balanced as much in your favor as possible.
Different Ways to Invest in Real Estate
While each deal or investment is unique, different real estate investment avenues come with their own risks and rewards.
Rental Property: The Risks
Rental properties are often the first step new investors take into the real estate markets. However, many underestimate the skill it takes to run a single rental property successfully, let alone a portfolio of multifamily properties. Many of the risks listed above, including general market risk, idiosyncratic risk, and even leverage risk, are present when acquiring a rental property. You never know which way the market will go, and unless you are highly capitalized or willing to sacrifice portfolio diversification, you will likely need to take on debt to acquire the property.
Real Estate Investment Group: The Risks
To potentially avoid many of the risks and headaches that come with direct ownership of rental properties, you may consider working with a real estate investment group. These professionally managed real estate funds leverage their professional experience in finance and commercial real estate to acquire, manage, and develop properties across real estate property types, from medical centers to multifamily towers, to fast-food restaurants.
Risks involved with real estate investment groups are heavily dependent on the firm you decide to work with, so choose wisely. Furthermore, different real estate investment groups work in different spaces in the real estate sector, with different risk/reward options depending on your personal tolerances.
Interested in investing in real estate? Contact Penn Capital today
Real Estate Investment Trust: The Risks
Real estate investment trusts, or REITs, are real estate investment vehicles that own and operate properties and return 90% of the generated income to their shareholders. Publicly traded REITs have a wealth of data online, as they are legally required to publish documentation about their operations. One risk for REITs that do not exist with most other forms of real estate is its risk of losing value due to rising interest rates, which may cause capital flight from equities into the bond market.
Risk is inevitable. How you manage that risk makes the difference between a well-performing portfolio and one that lags behind the rest. Each individual investment vehicle and asset class in the commercial real estate space offers pros and cons in terms of risk and reward. The first step to mitigating risk and defending or growing your capital is to have an understanding of the risks that are out there, and you’re well on your way.
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