Private real estate investing can be lucrative, but these investments are not without risk. There is a reason the accredited investor status exists. You are required to prove you’re in a financial position to absorb a loss before investing in many syndicated and crowdfunded real estate deals.
Risk, however, can be managed. Michael Episcope of Origin Investments understands these risks well, and he elaborates in this guest post on three different types of uncertainties that exist with private real estate and what one can do to mitigate risk amidst uncertainty.
One component of risk management in all types of investments is diversification. One way I diversify is by investing in a variety of asset classes, with real estate comprising about 20% of our invested assets.
Let’s see how Michael Episcope defines and deals with risk and uncertainty in private real estate.
Risk Management in Private Real Estate: 3 Types of Uncertainty
When interest rates drop and market volatility rises, investors often turn to private real estate. And for good reason, since it offers them great benefits such as portfolio diversification, passive income from rents, tax benefits and appreciation. But like every investment, real estate investing can have significant risk—especially for those who are new to the process.
Investors are always weighing risk, and understand that the higher the risk, the greater the potential reward. But understanding their risk tolerance in the real estate asset class is very different than understanding their risk tolerance for the stock market, which is liquid and doesn’t require the same type of due diligence and oversight. Physicians’ training may help them better understand the nature of uncertainty, but in private equity real estate it takes investment expertise to take a truly disciplined approach to risk and reward.
Weighing Risk Factors in Private Real Estate Investing
When real estate asset managers perform risk management evaluations, they’re weighing market indicators to take appropriate actions. Observations help them develop an investment theory—a pricing model that factors in the degree of risk.
In that respect, we’re like the physician who reviews a range of patient symptoms before delivering a prognosis. Just as lab or imaging results test a medical hypothesis to substantiate a diagnosis, good asset managers have systems in place to approximate physicians’ scientific method.
At Origin Investments, my partner and I evaluate real estate on behalf of our investors and for ourselves. We gather market data that can be tested quantitatively, and in the past few years we’ve developed a highly effective objective risk model to vet our choices. We’ve found a few risk factors have an outsize influence on the efficacy of a real estate investment.
Economic factors are beyond our control. If interest rates rise by five percentage points or the country slides into recession, there’s not much we can do to reverse the course of the economy. Yet economic stress has predictable effects on real estate returns.
Recessions slow leisure travel, which affects hotel revenue. This asset-level risk is well understood. Multifamily real estate is historically safer than retail or office investments. People have to live somewhere, in good or bad economies.
Other risk factors are not as well-known but are just as important in maximizing the rewards of private equity real estate.
Three of the most important are idiosyncratic risk, replacement cost, and leverage.
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Idiosyncratic Risk: It’s Complicated—and Can Kill Returns
Idiosyncratic risks are unique to a project or its underlying real estate. The degree of risk varies from property to property—and while it’s uncertain, it’s not unpredictable.
Construction, for example, is rife with inherent risks due to delays, site conditions, material and labor costs and more. Developing real estate from the ground up increases risk still further; investors must rely on municipal approvals to proceed, and can’t collect rent on a unit a project is completed.
A light value add project, with limited construction involved, carries less idiosyncratic risk. Most tenants will be able to stay in place, with common areas getting a facelift rather than a reconfiguration.
A core real estate investment—one that’s nearly fully occupied, needs no improvement and is managed well—has the least risk. Investors are essentially buying a cash-flow stream. However, this steady income leaves less room to maneuver on price. With few ways to improve cash flow, it will be hard to compensate for a miscalculation.
Location also contributes to idiosyncratic risk. Municipal government limits housing supply in some locations through restrictive zoning, and boosts demand elsewhere by making public improvements.
For example, Chicago raised property values exponentially along an abandoned railroad spur by building a landscaped trail dubbed the 606. The quality of schools, transportation, parks and other public assets all affect surrounding property values.
Our acquisitions team evaluates idiosyncratic risk the same way lenders underwrite a loan. Their research identifies buildings that are under-leased or have below market rents. They track market conditions that might affect capitalization rates.
Analyzing these factors validates the deal’s price, as well as projections of capital to raise and revenue to expect. A quantitative model also tests the business case for the acquisition. The process is no different than for evaluating any startup business.
Asset managers then must execute their business plan. Hiring a best-in-class manager is a reliable way to assure that returns will meet expectations. A track record of creating physical spaces and providing quality service can compensate for idiosyncratic operational risk.
Replacement Cost Risk: Newer Is Nicer
As demand for space drives lease rates higher, it’s inevitable that new construction will become more viable. Prospective tenants will find a new building with comparable rents more attractive. As new construction comes online, investors in older buildings will have less ability to raise rents or retain tenants. To understand this risk, investors need to identify a property’s replacement cost.
Consider the price of a comparable new building. A new garden apartment should be a good indication of the replacement cost for a similar existing building. Compare that price to the acquisition price of the target property, plus the capital required for renovation. If these combined values are greater than replacement cost, a competitor could develop new product at a lower cost basis.
A 10-year-old building constructed with exceptional materials might be more competitive than an older building. Even so, rentals depreciate quickly, so finish details may not contribute much to the building’s current value. A building with a functional configuration and desirable amenities will be more competitive. But by and large, tenants would rather rent new, even if quality renovations are available.
A property’s asset class, location and submarket all have a bearing on this potential for new supply competition to emerge. A great management team prices this risk into their pricing model, and an average one does not.
Leverage Risk: When Risk Overtakes Return
Return on equity increases exponentially with the amount of debt that’s put on a deal—or it should, because any risk needs to have a comparable reward. The common mistake that investors make is to think that a deal with 60% leverage—meaning 60% is the bank loan or a loan of any kind—makes just as much sense at 70% leverage. In fact, taking on that extra risk means that investors should expect returns to increase by much more than 10%.
A low-risk asset, like a multifamily building in a nice neighborhood, suddenly becomes less secure at 80% leverage. That’s fine if the investor is compensated for the added risk. At 50% or 60% leverage, the price might pencil out at a 7% internal rate of return. But at 80% leverage, the deal may demand a 14% return. Even investment managers fail to account for the potential for bigger losses should the market decline.
Great Management Is a Trump Card
For all three types of risk, management is the one variable that can most reliably mitigate risk. An investor who wants to control risk needs top-level execution of a business plan that can compete with new construction and pay the investor a fair profit for the risk involved.
A direct investor who doesn’t have that expertise can hire real estate services to assist or leave the work to a fund manager. In either case, it’s important to size up who does what. Management requires special expertise just as in any other business.
Who at the firm is doing construction, analysis, asset management, risk management? If the answer is the same one or two people, that’s a red flag. And the investor who tries to go it alone is taking on more risk in the bargain.
What do you do to mitigate risk in your real estate and other investments?