Investing involves both risks and rewards, and the larger the risk, the greater the potential for significant gains and losses of invested capital. Intuitively, we understand that in order to get bigger returns, we must accept more investing risk. But how much is too much? And how do you calculate investment risk to see if it’s a risk worth taking?
The fact that we buy tangible properties offers many investors a sense of security in private equity real estate. However, there are other dangers associated with commercial real estate investments that must be weighed against the investment’s expected return. Investors that have frames of reference to quantify risk are better able to ensure that the investment meets their objectives, goals, and tolerance.
When analysing any private real estate investment, investors should consider the following eight risk factors:
- General Market Risk. The economy, interest rates, inflation, and other market developments all cause ups and downs in all markets. Market shocks can’t be avoided, but investors may protect themselves with a diversified portfolio and a plan based on overall market conditions.
- Asset-Level Risk. Every investment in an asset type bears some risks. Because demand for apartments is constant in both good and poor economies, multifamily real estate is considered low-risk and so often provides lower profits. Hotels, with their short, seasonal stays and dependence on business and tourism travel, provide significantly more risk than either apartments or offices, as they are less sensitive to consumer demand than shopping malls.
- Idiosyncratic Risk. Idiosyncratic risk is risk that is unique to a certain property. The more the risk, the higher the reward. For example, construction will increase the risk of a project because it reduces the ability to collect rentals during this time. Investors take on more sorts of risk than only construction risk when developing a plot from the ground up. There’s also entitlement risk, which refers to the possibility that government agencies with jurisdiction over a project will fail to issue the necessary approvals to allow the project to move forward; environmental risks, which include everything from soil contamination to pollution; budget overruns; and political and workforce risks.
- Liquidity Risk. Before purchasing, it is necessary to analyse the market’s depth as well as how one will exit the transaction.
- Credit Risk. Value is determined by the length and consistency of the property’s income stream. Because it performs more like a bond with predictable revenue streams, the more investors are ready to pay for a property with a more stable income stream.
- Replacement cost risk. As the market’s need for space drives up lease prices in older properties, it’ll only be a matter of time before those lease rates justify new construction, increasing supply risk. What if a superior facility with comparable rentals becomes available, rendering your investment property obsolete? It’s possible that an investor won’t be able to raise rents or even achieve adequate occupancy rates.
- Structural Risk. This has nothing to do with the physical structure of a building; it has to do with the financial structure of the investment and the rights it grants to individual investors. Because senior debt is paid first and has top priority in the case of liquidation, it gives a lender a structural advantage over “mezzanine” or subordinated debt. Because equity is the last payout in the capital system, it carries the most risk.
- Leverage Risk. The higher the debt on an investment, the riskier it is, and the higher the return investors should expect. When a project’s debts are stressed – generally when the return on assets isn’t enough to support interest payments – investors might lose a lot of money rapidly.
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