Every investment carries risk. Stocks have counter-party risk: the company you are invested in could do poorly or even fail. An experienced thief can steal gold coins hidden in a safe. Governments can default on their bonds or debase the currency to delude the value of the bonds to lighten the debt burden.
Risk is not to be feared, but to be managed.
Hoarding cash in glass jars buried in the backyard may be the least risky way to save, but the value will be eroded by inflation, or you may get Alzheimer’s and forget the location of the jars. This may be one type of risk management, but it is also an exchange of one kind of risk for another.
To be successful, the goal is to find a good ratio of risk-to-return so that one can protect and grow his or her capital. Passively investing in commercial real estate equity is probably best for most folks of moderate-to-substantial means. How else could one hope to grow their wealth at 15% per year in a hard asset? For a deeper dive into the concept of risk-adjusted return, please see our blog post on The Top 3 Safest Investments.
As a passive investor, one can only indirectly manage the risks of such an investment since that responsibility belongs to the sponsors. The most effective way for passive investors to manage risk is to choose the right sponsor. We put together a mini-guide on the blog to help you do just that, and you can find it here.
That said, it can also help you choose the right sponsors to invest with by understanding some of the top risks. Here is our summary of the top dangers of commercial real estate investment and how we manage these risks as sponsors.
1. Property Management Risks
Whether a sponsor has an in-house management company or chooses to hire third-party management, the highest degree of risk is associated with the day-to-day management of the property.
An incompetent management company may fail to vet tenants properly, defer maintenance and repair requests, and treat tenants without kindness, firmness, and respect, leading to higher eviction and lower occupancy rates. They may fail to evict problem tenants promptly and efficiently.
This poor customer service will degrade the property’s reputation, making it impossible to raise below-market rents to a competitive level, and ultimately decrease the net operating income (NOI) and value of the property thereby.
Worst of all, dishonest property manager may even steal money or materials to pad their income.
Management can make or break the entire deal. For this reason, the sponsor must vet prospective property management companies with the utmost care.
When seeking management for our syndications, we gather referrals from trusted professionals within the real estate business in our target markets. Then, we carefully conduct interviews with the management companies that receive consistently good referrals. Lastly, we visit several properties currently managed by the finalists to assess operational competence and customer service quality.
2. Liquidity Risks
Another risk that can bite a commercial real estate syndicator is a need for more liquidity. This happens when the sponsor fails to raise enough capital to cover reserves for capital expenditures and unexpected shortfalls in income from the property.
This can lead to a scenario where the sponsor is forced to do a second capital raise (a “capital call”) during the investment period. Not only is it embarrassing for the sponsor to ask the investors for more money, but it could also delude the equity and decrease the returns for all of the partners, depending on how the deal is structured.
How do we mitigate this risk? It’s simple: we raise plenty of reserves for both capital expenditures and debt service in our initial capital raise. If the numbers don’t work with a conservative capital raise, then we don’t do the deal.
3. Legal Risks
Even when the customer service is best-in-class, and the management carefully screens the tenants, there can be lawsuits.
Imagine if a tenant’s 9-year-old son slipped on the ice in the parking lot and broke his leg. Dad decides to sue the owner of the property for $1.5 million. This could be a costly issue without a well-protected LLC and an umbrella insurance policy in place.
This is one reason why carrying adequate insurance and having an excellent legal council is essential.
4. Policy Risks
Few words send chills down the spine of a multifamily investment property owner than these two: rent control. The arguments against rent control are beyond the scope of this article, so we shall save them for another time. Other policies that are sure to cause consternation lead to the process of evicting problem tenants to be unnecessarily onerous.
In self-storage, one of the primary policy risks is owning a facility in a market where the local laws are overly permissive for developing additional facilities within a five-mile radius. More supply can cause downward pressure on rental rates if there is insufficient demand to meet it.
How do we hedge against policy risks? We target markets with local governments that are historically more landlord-friendly in nature and avoid those that make life unduly difficult for landlords. For self-storage, we look for places with higher entry barriers for new facilities. We regularly check in with the building departments to determine when permits have been issued for new self-storage developments. If a new facility is planned to be built nearby and supply is balanced, it might be time to sell it.
5. Market Risks
What happens when your apartment complex is located in a town where the only real industry is oil refining, and the refinery is shut down? Many tenants will lose their jobs, be unable to pay rent, and may need to relocate for a new job. This can lead to vacancy issues and put downward pressure on market rents.
Or how about the scenario where the apartments turn out to be in an area where there is a sufficient amount of crime to be a deterrent to the kind of people that make good tenants? You know, the ones who like to live in neighborhoods where they don’t have to worry about being mugged if they would like to take an evening stroll. You will probably be limited to the demographics that can’t afford to live in better neighborhoods, and, therefore, unless the area is improving rapidly, there will be a low ceiling on submarket rents.
We mentioned in the section on policy risks about the issue of market oversupply. While this is generally not a problem with apartments due to a general undersupply in most markets, this is something to look out for when acquiring or building self-storage facilities. It can easily be a deal killer. Any facility with over ten square feet per person within a five-mile radius should be approached cautiously. If the competing facilities are all full with higher rates than the subject property, square feet per capital becomes less relevant.
The key to mitigating these market risks is to vet the market and submarket where an asset is located. Key indicators of a good market are a diverse employment base with solid job growth metrics, high median household income, low rates of crime, and other relevant demographic information. And with self-storage, we look for submarkets that are undersupplied above all.
6. Environmental Risks
We prefer to avoid areas with high incidences of flooding or hurricanes.
If we find a deal in such an area, purchasing the appropriate insurance to mitigate environmental risk is vital. The financing institution that provides the mortgage for the property in question will generally require sufficient insurance.
We prefer to avoid properties in a flood plain, for instance. Even if the underwriting indicates that the numbers will work with a flood insurance policy intact, the cost of the policy could change drastically, adding a degree of volatility to the deal.
7. Financing risks
It is often said, and rightly so, that debt can be a killer. Even if one’s mortgage is set at a fixed interest rate, it’s possible that capitalization rates will decompress when market interest rates shift upward.
That’s not the only situation in which cap rates could expand, but for the sake of illustration, let’s use this example:
Imagine a $5 million self-storage facility leveraged with 80% debt and 20% equity. If cap rates were to decompress from 5% to 6% and net operating income (NOI) were left unchanged, then the new market valuation would be $4.17 million. If the bank requires a minimum of 20% equity, they might force a principal pay-down to keep the 80/20 ratio since most of your equity was wiped out with the market shift. The owner could need to raise more capital if he required more reserves to satisfy the lender.
To avoid such a situation, it’s essential not to be over-leveraged. Beginning a value-add syndication with the above 80/20 debt-to-equity ratio might be okay because the equity will increase proportionately to the forced appreciation. It’s always safer to start with a 70/30 or 60/40 debt-to-equity ratio if the value-add component is insufficient to correct the ratio.
Conclusion
This article was not intended to frighten potential investors away from real estate. Instead, it’s intended to educate them so they can make wise investment decisions for themselves. Financial education is the key to financial freedom. And the risk is a part of the process to be embraced and managed.
For those considering purchasing their own real estate, something to keep in mind is that they will need to do their risk management for all of the above items. If one were to instead invest passively in real estate syndications, then they mainly need to vet sponsors. If the sponsors are competent and reputable, they will manage the above risks so that the passive investor can be just that: passive.
If investing passively in real estate interests you, we invite you to read over some of the articles on this website and book a no-pressure, 25-minute call with us to determine whether we are a good fit for each other. If not, we can point you in the right direction so that you can meet your financial goals.
Disclaimer: The opinions conveyed in this article are provided for educational purposes only and should not be interpreted as an offer to buy or sell any securities or to make or contemplate any investment.