Investing in real estate entails risk and reward, and the larger the risk, the greater the potential gain or loss of invested wealth. With our instincts, we know that if we want to make more money from our investments, we must take on greater risk. But how much is too much, and how much is too little? Also, how do you measure investment risk in order to choose whether or not you want to take a chance on it? The fact that we acquire tangible assets in private equity real estate offers many investors a sense of security. Commercial real estate investing, however, has several dangers that must be weighed against the potential rewards. Investors are better able to assess the risk of a certain investment if they have a reference point to compare it to.
Many factors must be taken into consideration when analyzing the prospective profits on an investment at Origin, which is why we use sophisticated risk models and an acquisition staff with extensive experience in eleven markets.
Risk considerations that investors should take into account before making a private real estate investment include:
General Market Risk:
The economy, interest rates, inflation, and other market movements may cause ups and downs in all markets. A diversified portfolio and strategy based on general market circumstances may help investors protect themselves from booms and busts, but market shocks cannot be eliminated. “What you don’t know can hurt you,” the Financial Industry Regulatory Authority (FINRA) notes.
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.
Knowing the local market is more important for real estate investment success than having a complete understanding of the national market. The factors at play in your local real estate market are likely to have the most influence on your acquisition and its successful completion. If you want to succeed as a real estate investor, one good rule of thumb is to stay away from hot markets.
Real estate markets, driven by the pursuit of financial gains, move in cycles, with each market experiencing its own unique phase of the housing cycle. Find markets that are still in their development phase, where growth may be expected in revenue and expenses, in addition to capital investment and development.
Before making a purchase, evaluate the liquidity risk and the market depth as well as the method by which you want to exit the transaction. In Houston, regardless of market circumstances, an investor can anticipate scores of bidders to come up at the bidding table. A property situated in Evansville, Indiana will have fewer market players, making it easier to get into the venture, but more difficult to get out.
The value of a property is driven by the duration and reliability of its revenue stream. The value of a property that has been leased to Apple for 30 years will be much greater than the value of a comparable multi-tenant office building. Consider that even the most creditworthy renters have gone bankrupt in the past, as history has shown.
Replacement cost risk:
Rents in older homes will eventually rise to the point where new development will be justified and supply risk will grow. What if a superior facility with equivalent rentals is built that renders your investment property obsolete? In certain cases, it may be impossible for an investor to increase rents or even achieve a reasonable occupancy rate.
It is necessary to know the replacement cost of a property in order to assess whether or not a new property can afford to evict these tenants. Consider the asset class, location, and sub-market of a property to determine its replacement cost. Investors may use this information to determine if rents can climb high enough to justify additional building. To put it another way, competition may come in the shape of newly constructed flats when a 20-year-old apartment complex can lease units at a cost that justifies new construction. Rents in the older building may not be able to be raised, and occupancy may have to be reduced.
A building’s construction has nothing to do with this, but rather the financial structure of the investment, and the rights it grants to individual participants. Unlike “mezzanine” or subordinate debt, a senior secured loan is paid first in the case of liquidation, giving the lender an advantage over the latter. Because equity is the last to be paid out in the capital system, those who own it are subject to the greatest amount of danger.
A lack of alignment between the management and the investor might lead to a conflict of interest. As an example, if you’re a limited partner in a business with an attractive profit split with a management, but the manager has considerably less money involved in that deal, the manager is encouraged to take risk.
An investment with a high level of leverage is more dangerous than one with a low level of leverage. Once the project’s loans are under stress—typically because its return on assets isn’t adequate to support interest payments—individual investors tend to lose fast and a lot. Leverage is a force multiplier.
Because mezzanine and preferred equities are paid off before common equity in the payment hierarchy, leverage, including mezzanine and preferred, should typically not exceed 75 percent. At Origin, we never utilize more than 70% leverage on our portfolios, and we never employ mezzanine or preferred stock in any of our transactions. Investing returns should be derived largely from the performance of real estate, not from the excessive use of leverage, and investors must grasp this concept.
Investors in real estate sometimes fail to see the importance of accurately calculating the amount of leverage they are using, which leads to overleveraged positions. To make sure they are getting a return that is proportionate with the risk, investors should find out how much leverage is being utilized to fund the asset.