Risks to Consider Before Investing in Private Equity Real Estate
Risk-free investments are nearly impossible to find. Even traditional risk-free investments such as certificates of deposit or government bonds pay a negative rate of return once inflation is factored in, creating a unique risk all of their own
Today, a growing number of investors are considering private equity real estate as a way to increase the returns on capital invested. As of the time of this writing, asset classes such as multifamily and industrial have outperformed in most markets and have a low correlation to the ups and downs of the stock market that prudent investors look for.
Before investing money in private equity, it is important to understand the risks as well as the rewards. In this article, we will discuss in detail the top 10 risks to consider before investing in private equity real estate.
Financial Structure Risk
The majority of large commercial real estate projects require more than one source of capital, such as different types of equity and different types of debt. In one sense, this is similar to the way many publicly held companies have multi-class stock structures, each with different levels of control and returns.
In private equity real estate, investors may reduce financial risk by analyzing the capital stack. A capital stack in investment real estate describes how capital is structured or organized and may include common equity, preferred equity, mezzanine debt, and senior debt.
This analysis should include understanding the position of their capital within the overall financing structure of the investment, the potential risks and benefits of that position, and who benefits if a deal performs better or worse than anticipated.
As a simple example, consider a $1 million private equity real estate development project with a capital stack of 50% debt and 50% equity.
At the end of five years – once the project is completed, leased up, and sold – the exit sales price is projected to be $3 million. Under this scenario, equity investors could expect to receive $2.5 million in return for their initial $500,000 investment while debt holders would receive their original capital back, plus any fees and interest received during the holding period.
On the other hand, if the project does not perform as expected, equity investors may lose part or all of their capital while debt holders are the first in line to get repaid. For example, if the project were worth only $750,000 due to a significant change in general market risk, equity investors would lose half of their capital while debt holders would remain whole while having generated income from interest and fees.
General Market Risk
The global pandemic of 2020 is an example of general market risk.
Using the stock market again as a reference point, during four trading days of March 2020, when the pandemic struck, the Dow Jones Industrial Average (DJIA) plummeted by about 26%. In a little over one year, the DJIA has risen by almost 79% and is and is up by nearly 17% compared to its pre-pandemic plunge level.
Commercial real estate was affected by the general market risk of the pandemic as well. According to Nareit, publicly-traded real estate investment trusts (REITs) reached a low point in mid to late-March 2020, down 41.9% from their peak the previous month.
Since March of 2020, REITs overall rebounded generally in line with the stock market, although there are still some long-term concerns about the impact on some commercial real estate sectors such as retail and hospitality due to the changes in how people live, work, and travel.
Eventually, the market risk from the pandemic will run its course, but the factors that influence the performance of commercial real estate will remain the same.
On a macro level, interest rate levels, a fiscal stimulus such as the growth of public debt, and monetary stimulus such as quantitative easing are three factors real estate investors should consider. On a micro level, local business-friendly governments with common-sense policies, inbound population, and job growth are some of the many things that determine the local demand for commercial real estate investment.
Credit Risk
Commercial real estate debt is serviced by the cash flow the property generates, which explains why some real estate asset classes have higher levels of credit risk than others.
In many markets across the country, office and retail tenants cannot or will not pay their monthly rent. Meanwhile, the revenue streams of leisure and hospitality properties have been decimated due to the lack of business and leisure travel.
On the other hand, the credit risk of multifamily and industrial commercial real estate is generally lower due to rising property values driven by more reliable recurring income streams and credit tenants. As CBRE notes, the industrial sector has been one of the most resilient, with average industrial rents in the U.S. expected to grow by more than 6% this year.
To be fair, rent and eviction moratoriums were an initial concern for commercial real estate investors in the multifamily sector. But as Covid is brought under control and the economy continues to recover, so does the multifamily sector continue to outperform.
According to the National Multifamily Housing Council NMHC Rent Payment Tracker, 95.9% of apartment households paid their rent in March. In fact, beginning in November of last year, the percentage of rent payments made in 2020 and 2021 were within a few percentage points of rent payments made pre-Covid, with more tenants paying their rent in April 2021 compared to April 2020.
Comments