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, security or property
Systematic risk is uncontrollable and cannot be diversified away, whereas unsystematic risk is controllable and can be reduced through diversification. Examples of systematic risk in real estate investment include fluctuations in interest rates, economic cycles, and changes in government policies and regulations such as changes in zoning laws and property taxes (Additional buyers stamp duty, ownership taxes). Examples of unsystematic risks in real estate investment include property location, property condition and tenant risk.
It is important to understand the various property investment risks impact on property investment returns and 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 and air condition units and ascertaining whether the property meets the latest building codes or regulations; 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 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.
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. Moreover, the longer the project drags on, the more likely the developer will incur higher interest cost on the loan used to finance the development.
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.
4) Leasing or vacancy risk
Leasing risk occurs when units are not leased out within a targeted time frame at a targeted rental rate. Poor leasing performance will have a negative impact on the investment return, For a property with existing vacancies, the sponsor usually expects to lease the vacant 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. 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 having a diversified tenant base, 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 that replacement tenants are on new leases with less favourable terms
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 carry out a cap rate sensitivity analysis. Various cap rates are imputed into the financial model to calculate what the projected investment returns will be under different exit cap rates.
Cap rates are influenced by investor risk appetites and the interest rate environment. Declining risk appetite for real estate will lead to an expansion in cap rates while a rising risk appetite for real estate investment will lead to a compression in the cap rate.
Cap rates are also affected by interest rates. A rise in interest rates stemming from a rise in policy rates by central banks to quell inflation will lead to a rise in cap rates. A fall in interest rates as a result of monetary loosening by central banks to stimulate economic growth in a weak economic environment will lead to a fall in the cap rates.
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 debt and the potential foreclosure that may arise as a result of overleveraging, or inability to refinance when the debt matures 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 net income generated by the property.
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 there is a credit crunch in financial markets. 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.
Rising interest rates also make it more difficult for a property investor with a mortgage to service the loan. It is therefore important to carry out an interest rate sensitivity analysis (stress testing) to determine if the property’s net income is sufficient to service in times of higher interest rates.
8) Sponsor risk
The expertise and skill of the operator or developer, 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 hold on to 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.
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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.