David is the Founder and CEO of Realized, leading the firm’s mission to improve lives through innovative real estate wealth solutions.
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 refers to a property’s position in the economic cycle. There are four components to the cycle: recovery, growth, peak (hypersupply) and recession. Fidelity’s Business Cycle had the country on the backside of economic expansion and heading into a contraction (i.e., recession) in March 2020, prior to the economic impact of the Covid-19 crisis. Digging deeper, however, more localized analysis may reveal varied findings.
Property types may be at different points of the cycle compared to the nation as a whole. Dr. Glenn Mueller, a leading real estate market cycle expert, produces a quarterly report that analyzes occupancy movements in five property types in 54 metropolitan statistical areas (MSAs). In the most recent edition, retail generally appears in the recession portion of the cycle, while office properties generally appear in the growth portion.
Property subtypes may be at different points than their broader property type classification. For example, in his Real Estate Market Cycle Monitor First Quarter 2020 Analysis, Dr. Mueller shows the retail subtypes of regional malls, factory outlets and power centers at the bottom of the curve, while the neighborhood/community subtype is at equilibrium.
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 hypersupply 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.
Despite lower fluctuations in cash flow, STNL properties are subject to binary risk. If the tenant vacates or defaults on its lease (i.e., tenant risk), the property may suddenly transition from 100% occupied to 100% vacant, leaving the landlord responsible for all operating expenses and without revenue. One way to manage this risk is through review of the tenant’s financial strength, creditworthiness and nature of the business.
Conversely, with multifamily properties, tenant turnover is frequent. Market rental rates may change, and the landlord is responsible for operating expenses. Thus, cash flow may experience greater fluctuations compared to STNL. However, with multiple units, one tenant vacating or not paying rent may not have such a drastic impact on the bottom line as with a STNL property.
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. Recognize that REITs may not provide the same (registration required) risk management correlation to equities markets that direct property does.
Entities such as limited partnerships or LLCs may present liquidity risk, requiring investor capital to be tied up for extended periods of time, but may potentially provide illiquidity return premiums compared to liquid options.
For investors who have already accumulated meaningful equity in real estate investing, tax-advantaged entities such as Delaware statutory trusts (DST), which allow for deferral of capital gains taxes, may be appropriate but are subject to risk through limitation on operating activities.
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.
Conduct Your Due Diligence
Awareness of different real estate risks can help improve investment decisions. As you gain knowledge and experience in doing deals, your awareness of risks will increase. It is important to thoroughly evaluate and conduct extensive due diligence on each real estate investment opportunity to make sure you are comfortable with it before investing. Projected returns should be commensurate with the level of risk you are taking and within the constraints of your own personal risk tolerance and risk capacity.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.