Top 8 Sources of Real Estate Investment Risk

    In this article, we cover the various sources of risk in real estate investment deals, and how investors can manage risks in real estate.

    Top 8 Sources of Real Estate Investment Risk

    Risk is an inevitable part of any real estate investment deal.

    At RealVantage, our methodology in deal evaluation is to always first identify all the key risk factors, both systematic and unsystematic. The former refers to risk factors associated with the entire market or market segment, while the latter refers to risk factors associated with a particular industry or security.

    Systematic risk is uncontrollable, whereas unsystematic risk is controllable. Systematic risks arise due to macroeconomic factors, such as inflation and an increase in unemployment rate, while unsystematic risks include a high rate of employee turnover, employee strikes, higher operational costs, just to name a few.

    After we have clearly identified and quantified the risk, we proceed to ascertain the returns versus the risks involved. There are various types of risks and it is important to understand how they impact property investment returns and identify how best to mitigate them.

    Real estate investment risk

    1) Physical asset risk

    Physical asset risk is the risk that an investment property will incur unplanned costs or capital expenditure, due to its physical condition. This is especially true for older, poorly maintained properties. These properties may require costly repairs or improvements, which will impact the investment profitability.

    Investors can reduce physical asset risk by undertaking technical due diligence, before closing a deal. The key aspects to consider include assessing its structural stability; condition of the mechanical and electrical equipment, such as lifts, air condition units ascertaining whether the property meets the latest building codes or regulations; environmental inspections, etc. Once the technical condition is established, there could be avenues to negotiate for a price discount.

    2) Geographic or market risk

    The geographic location determines the population, demographics and job growth within the property’s market – all of which potentially impacts the size of the tenant pool and associated demand. Primary markets with a larger tenant pool create a buffer in the event of a market downturn, but may also be tagged with higher prices.

    The market in which an investment property is located is also a key factor. High occupancy rates and steadily growing rental prices are good indicators of a strong market. Market risk factors include a boom in new developments within the market or a slowing economy; these can both affect the supply and demand for property and land.

    Read also: Market Selection in Real Estate - RealVantage’s Approach

    3) Development risk

    When a property requires significant development or redevelopment, there are development risks associated with it. These may come in the forms of construction risk and entitlement risk.

    Construction risk is the risk that the project would not be completed within the expected time frame, thus incurring higher construction costs, or reveal defects after completion. Therefore, it is important to ensure that the sponsor has sufficient experience in construction project management, if an investment includes a development aspect.

    Entitlement risk occurs when you are trying to acquire a property and develop it for a specific use but government agencies with jurisdiction over the property may not issue the required approvals to allow the project to proceed. This is prevalent in new development projects, which often require an extended entitlement process where construction approvals are obtained. This is required before construction is allowed to commence. The length of time before approval is granted is often variable to a large extent and may push back construction timelines; and this could impact the profitability of a property investment.

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    Vacancy Risk (Leasing Risk)

    4) Leasing or vacancy risk

    Leasing risk occurs when units are not leased out within a targeted time frame at a targeted rental rate. As a result, these units remain vacant for an extended period of time. For a property with existing vacancies, the sponsor usually expects to lease the units over time.

    Leasing risk can be mitigated by setting aside a reasonable amount of time and money as a buffer, which can be drawn upon in the event that vacancies are not filled. This ensures that the costs of marketing, incentives for potential tenants, and costs of maintaining the investment property are covered.

    5) Tenant risk

    Tenants of income-generating investment properties can pose a certain degree of risk for investors, in the form of rent roll quality and rollover risk.

    Rent roll refers to the rental income that is generated from a real estate asset. Rent roll quality depends on the stability, creditworthiness and number of tenants of an investment property. Large multinational companies with high volumes of sales contribute to higher rent roll quality, since they tend to be more reliable tenants than smaller businesses. In addition, an investment property with a single tenant is generally riskier compared with a property with multiple tenants occupying a smaller percentage of the total property area. With a single tenant, the occupancy rate is usually either 100% or 0%, which may lead to unpredictable income flow if the tenant leaves.

    Tenant risk can be mitigated by diversifying tenants, so that the departure of a single tenant does not significantly impact the profitability of the property, or by signing longer lease terms.

    Tenant risk also comes in the form of rollover risk, which refers to the risk that tenants leave at the end of their lease without renewing or ‘rolling over’ the lease, or that no replacement tenants are found, or even that new leases are on less favourable terms than before for the landlord.

    Rollover risk can be mitigated by having periodic tenant meetings to determine their plans for the lease, and ensuring that there is sufficient time and budget for the marketing process, if there is a need to look for new tenants.

    6) Cap rate risk

    The cap rate helps to calculate the potential rate of return on the investment and is a critical assessment benchmark in all real estate investment decisions. Thus, cap rate risk can pose substantial risks to a real estate asset’s selling price. This is because a relatively small change in the cap rate can have a disproportionate impact on the property’s value and the profitability of your investment.

    In order to mitigate this risk, investors should look at the cap rate when entering into a real estate investment (entry cap rate) as well as the projected cap rate at the end of the intended investment period (exit cap rate), and ensure that they are relative to the current market, and that the projections do not show too much of a decrease in the cap rate from entry to exit without proper justification, which may at times be overly aggressive to project higher returns.

    7) Debt risk

    Taking on debt to finance a real estate investment is a common occurrence in the overall investment process. However, it is important to understand the risks associated with taking on such debt and the potential foreclosure that may arise as a result of overleveraging, debt maturity risk, or both.

    Overleveraging is when a property takes on more debt than it can service. While banks typically do not lend below a debt coverage service ratio of 1.0, this can occur when the property loses tenants to the point that the interest or amortisation payments required exceeds the income generated by the property.

    Read Also: What is Debt-to-Equity (D/E) Ratio and What is it Used for?
    Read Also: What is Loan-To-Cost (LTC) Ratio?

    Debt maturity risk occurs when a property’s debt matures at a time when the property’s net operating income is lower than expected, or when the market is down. If debt matures at such a time, investors may face difficulty securing a new loan that covers the amount of the outstanding debt. This puts investors at risk of a default, and it is a significant contributor to failed property investments during a financial crisis.

    8) Sponsor risk

    The expertise and skill of the operator, developer, or lender play an important role in determining whether a sponsor can successfully plan out a property investment, and achieve target returns. Sponsor risk can be in the form of asset management risk or property management risk.

    The asset manager has the responsibility to carry out the strategic business plan for the real estate investment. Asset management risk refers to the inability of the asset manager to materialise the project in accordance with the business plan.

    Property management also plays an important role in executing a property’s business plan, depending on the real estate asset class. In asset classes, such as hospitality or storage facilities, where day-to-day customer service is pivotal to the property’s performance, property management can have a direct impact on the property investment’s success.

    How real estate risk analysis is conducted

    The foundation of risk analysis is risk identification, and it is one of the most crucial and difficult steps. Only through proper risk identification can you proceed with risk assessment and risk mitigation. The risks involved are dependent on the nature of your project and the real estate asset itself. There are several methods used to conduct real estate risk analysis; these include financial index analysis, quantitative analysis, and break-even analysis, among others.

    How to mitigate real estate investment risks

    Real estate investment risks are present in every real estate venture. While it is not possible to eradicate risks, we will have to try our best to mitigate as much risk as possible. The common ways to do so would be through diversification, due diligence, and controlled leverage.

    Diversification is a risk management strategy that combines an assortment of investments in a portfolio. A diversified portfolio consists of a variety of asset types or classes, in an attempt to limit exposure to single asset risk. Real estate diversification is one of the most common ways to lower exposed investment risk, as it is a very localised investment. Owning a variety of property types, in different sectors and in different markets, would significantly help to reduce your risk exposure.

    Real estate due diligence usually refers to analysing the financial performance of the property, checking for encumbrances on the underlying assets, physical inspection, as well as investigative work on venture partners and market conditions. Failure to do your due diligence can be costly, as you may end up investing in a money-losing investment or even worse, caught in a scam.

    Do not over-leverage your real estate investment portfolio. Real estate markets are unpredictable and when a market downturn occurs, you must make sure that you have sufficient liquidity to maintain your assets. Otherwise, you would be forced to liquidate your position, which will usually be at a loss.

    Is there such a thing as zero or no risk in real estate investment?

    There is an inherent risk in any investment and each investment return varies with the risk involved. We can only minimise our risk exposure, but it will not be possible to completely eliminate it.

    Find out more about real estate co-investment opportunities at RealVantage. Visit our team, check out our story and investment strategies.

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    Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.