Assessing Three Types of Risk in Real Estate

A fundamental principle of investing is the risk-return trade-off: The greater the risk, the greater the expected return, and vice versa. Investments in real estate are no exception, but quantifying risk in real estate can be extremely difficult. Stocks and bonds have widely accepted, standardized metrics for measuring investment risk. Stocks have beta, which measures expected volatility (risk), and bonds have ratings. Unfortunately for real estate investors, there is not a widely accepted metric of investment risk largely because individual properties have unique attributes that make it difficult to apply “standard” methodologies. Because of this difficulty, there is a tendency for real estate investors to focus on expected returns while underestimating or ignoring the associated risks. While we may not be able to quantify all risks associated with real estate investing, we can at least identify them.

While we could talk about risks all day, we’ve narrowed our discussion down to three areas: market, property type and investment structure.

• - Market Risk

Market risk refers to a property’s position in the economic cycle. There are four components to the cycle: recovery, growth, peak (hyper supply) and recession. Property types may be at different points of the cycle compared to the nation as a whole. Property subtypes may be at different points than their broader property type classification. Metro markets likewise may have significant differences in the stage of cycle across the same property type. The same report shows that while office properties are generally in the growth stage, certain markets, such as New Orleans, are in the hyper supply stage.

• - Property Type Risk

Not all property types exhibit the same risk characteristics. For example, single-tenant net lease (STNL) properties may have a high certainty of cash flow. STNL properties are 100% leased to a single tenant that has a contractual obligation not only to pay rent, but also to pay for property operating expenses such as property taxes, insurance and maintenance shifting operating risk from landlord to tenant.

• - Investment Structure Risk

An often-unrecognized risk to real estate investors is investment structure risk. This risk has several considerations including:

Legal Entity: All investment vehicles have their strengths and limitations. The appropriate legal entity should be utilized relative to investment strategy and investor objectives. For investors seeking exposure to real estate but wishing to mitigate liquidity risk, a publicly traded real estate investment trust (REIT) may be appropriate.

Capitalization: An investment with plenty of capital available may be better equipped to weather unexpected property issues or downturns in market conditions. Evaluation of real estate investment opportunities should consider sources and availability of capital, if needed. For example, cash reserves raised upfront may have a higher certainty of being available as needed compared to a structure requiring capital calls from multiple investors.

Alignment of Interest: For investments with multiple investors, the offering sponsor may have significantly different control and decision rights than its investors. While that is a positive in cases of accessing experienced operators and projects beyond the scope of most individual investors, it is important to understand how and when the sponsor is compensated and their incentives to produce positive outcomes for the investors.

Topics: Real Estate Investment, Assessment of Risks

Work cited: David Wieland, Forbes, August 05, 2020

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