In private real estate investments, the fact that you are buying physical rental properties gives many investors a level of comfort. Yet there are many risks involved in commercial real estate investing that have to be considered in conjunction with the expected return of the investment.
Below are the 8 risk factors investors should consider when evaluating any private real estate investment:
1. General Market Risk: This risk is tied to broader economic factors, such as fluctuations in interest rates, inflation, and market trends. Market shocks cannot be eliminated, but investors can reduce their impact by maintaining a diversified portfolio and adjusting their strategies in response to general market conditions. Understanding market dynamics and trends is crucial to make informed investment decisions.
2. Asset-Level Risk: Different types of real estate assets have varying degrees of risk. For instance, multifamily properties tend to be more resilient in both good and bad economies due to consistent demand for apartments. On the other hand, office buildings may be less affected by consumer demand compared to shopping malls. Hotels, with seasonal stays and reliance on business and tourism, often pose higher risks.
3. Idiosyncratic Risk: Idiosyncratic risk is specific to a particular property or project. Construction-related risks can arise, affecting rental income during construction. Entitlement risk refers to the possibility of government agencies not granting required approvals. Environmental risks encompass issues like soil contamination or pollution. Political and workforce risks may also impact the project. Additionally, location-specific factors, such as changes in the surroundings, can pose idiosyncratic risks that investors should consider.
4. Liquidity Risk: Liquidity risk is influenced by the ease of buying and selling a property. In highly liquid markets like Dallas, many buyers participate in property transactions regardless of market conditions. However, in less liquid markets like Evansville, Indiana, the number of potential buyers is limited, making it easy to enter an investment but challenging to exit.
5. Credit Risk: This risk pertains to the creditworthiness and stability of a tenant's rental income stream. Even a seemingly secure tenant can face financial difficulties. For example, during the 1990s, retailers like Sears and J.C. Penney, once considered stable tenants, faced financial challenges. It's important to evaluate the creditworthiness of tenants and be aware of the potential risks associated with long-term leases.
6. Replacement Cost Risk: As lease rates rise in response to increased demand, it becomes economically feasible to construct new properties that may compete with existing ones. Investors need to understand the replacement cost of their property to assess the risk of obsolescence. This involves considering factors such as asset class, location, and sub-market conditions. If rents can justify new construction, older properties may face challenges in maintaining occupancy and rental rates.
7. Structural Risk: Structural risk relates to the financial structure of the investment and the rights of participants. Different debt positions, such as senior secured loans and mezzanine debt, have varying levels of risk and priority in the event of liquidation. Investors in joint ventures must understand their rights and compensation agreements. A lack of alignment between investors and managers can create incentives for the manager to take excessive risks, potentially impacting the investor's returns.
8. Leverage Risk: The use of debt, or leverage, can magnify both returns and losses. While it can boost returns when things are going well, excessive leverage can lead to substantial losses if a project's income doesn't cover interest payments. Investors should be cautious about exceeding reasonable leverage levels, usually not exceeding 75% of the property's value, to prevent over-leveraging. Real estate performance should generate returns rather than relying heavily on leverage.
Considering these 8 risk factors and seeking clear information about them is essential for making informed decisions as part of your due diligence before moving forward with a private real estate investment.
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