There is a trade-off between risk and reward when it comes to investing; in most cases, the bigger the risk, the greater the potential for significant gains and losses of invested stock. We intuitively know that better returns are achievable by taking on more risk in the investment process. However, how much is too much? And how do you determine whether or not it’s worth taking the risk of investing?
The fact that we buy tangible assets in private equity real estate gives many investors a sense of security. Several risks must be taken into account when it comes to commercial real estate. For investors, risk quantification helps ensure that the investment aligns with their needs, goals, and tolerance for risk.
Risk factors that investors should take into account before making a private real estate investment include:
- Market Volatility as a Whole
The economy, interest rates, inflation, and other market factors cause ups and downs in all markets. Investors can’t avoid market shocks but can mitigate their losses with an overall strategy based on current market conditions. “What you don’t know can hurt you,” the Financial Industry Regulatory Authority (FINRA) warns.
- Risk at the Asset Level
All investments in a particular asset class are subject to some risks. Since demand for apartments exists regardless of the economy’s health, multifamily real estate is considered low-risk that often provides lower returns. Because of the short-term nature of their stays and their reliance on both business and leisure travel, hotels pose a greater threat than apartments or office buildings due to their lower sensitivity to changes in consumer demand.
- Idiosyncratic Risk
Individual property is at risk from an idiosyncratic risk. Higher risk equals higher payoff. For example, collecting rent during construction will be limited, increasing the risk. More than just construction risk is taken on by developers when they build from the ground up. There is also entitlement risk, which is the chance that the government agencies in charge of a project won’t give it the approvals it needs to move forward. There are also environmental risks, such as soil contamination and pollution, budget overruns, and political and workforce risks.
Another one of those idiosyncratic risk factor is location. For instance, the property values of buildings behind Chicago’s Wrigley Field used for private rooftop parties went from a boom to a bust when a new scoreboard completely obliterated their views. On the other hand, the property values of buildings near The 606, Chicago’s version of The High Line in New York, continues to rise. Idiosyncratic risks are risks that are particular to the asset as well as the business plan.
- Potential Liquidity Risk
Consider the market’s depth and your exit strategy before making an investment decision. Regardless of market conditions, an investor can anticipate seeing many bidders in Houston. Due to the smaller market size in Evansville than in other parts of the country, it is easier to enter the investment but more difficult to exit.
- Risk of Credit
The longevity and reliability of a property’s income stream determine its market value. The value of a property that has been leased to Apple for 30 years will be significantly higher than the value of a similar-sized multi-tenant office building. However, history has repeatedly demonstrated that even the most creditworthy tenants can go bankrupt. Remember how happy landlords were to have Sears and J.C. Penney as anchor stores in the 1990s?
Property investors may be tricked by the large market for triple-net leases, which claim to be as secure as US Treasury bonds but require renters to pay for taxes, insurance, and upgrades. Investors are willing to pay more for a property with a stable income stream since it acts more like a bond with predictable income. The triple-net lease landlord, on the other hand, is betting that the tenant will remain in business for the duration of the lease and that a ready buyer will emerge. A building from scratch may appear to be better than renting out an old building that has altered over the years.
- Risk of Replacement Cost
It’s only a matter of time before lease rates in older properties justify new construction and create supply risk as demand for space grows. What if a new, superior facility with equivalent rentals replaces your investment property? An investor may not raise rents or even achieve satisfactory occupancy rates.
To assess the scenario, one must know the replacement cost of a property to determine if a new property can economically steal those renters. If you want to know how much it would cost to replace property, look at its asset class, location, and submarket within it. As a result, investors can determine whether or not a new development is financially viable. The competition might come in the form of newly constructed flats if, for example, a 20-year-old apartment complex can lease apartments at a rate that justifies new construction. Rents in the older building may be unable to be raised, forcing occupancy to be lessened.
- Structural Risk
A building’s construction has nothing to do with this; it’s about how an investment is structured financially and the rights it grants to its many participants. A senior secured loan gives a lender a structural advantage over a “mezzanine” or subordinated debt because senior debt is the first to be paid; in the case of liquidation, it takes place. Because equity is the last distribution in the capital structure, equity holders bear the most risk.
Joint ventures are also subject to structural risk. They need to know their rights as an investor in an LLC, which can be either a majority or minority stake. It will determine how much compensation they must pay the LLC manager when a property is sold. If an investor is a limited partner, they must realize that the gross earnings will dilute by the manager’s salary and should know how much of the deal’s profits they will receive if the venture is successful. It’s also vital to understand how much stock is invested by the limited partners in the manager. Are they in sync? Do they have the same “skin in the game”?
A lack of alignment between the manager and the investor might lead to a conflict of interest. For example, the management is more willing to take a risk if you are a limited partner in a contract with a good profit share and the manager has much less money invested in the agreement.
- Risk of Leverage
Investors should seek a higher investment return if they take on additional debt. When things are going well, leverage can speed up the pace of a project and boost returns; but, if the loans for a project are stressed—often when the return on assets isn’t adequate to support interest payments—investors can expect to lose money fast and heavily.
Most of the time, leverage, which includes a mezzanine and preferred stock, shouldn’t be more than 75 percent. It is because mezzanine and preferred stock are paid before common equity. Real estate returns should come from how well the property does, not from using too much debt, and investors need to know this.
It might lead to over-leveraged investments for property investors unaware of the importance of quantifying leverage. To make sure they are getting a return proportionate to the risk, investors should find out how much leverage is being utilized to fund the asset.
Final Thoughts
Investors should ask questions about these dangers and get clear answers to feel more confident about their investment decisions. Look out for investments that don’t clearly outline the risks involved.
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