3. Identifying Risks in RE

This is part of a Series in eight parts. Here are the other posts.

Risk management is probably the most important job of a RE investor. The downside is much more threatening than the upside. Not being able finishing a project is worse than finishing a crappy project. Costs can explode quickly, not only in construction phase. Today I will take a look at some of the most common risks. I will base my post on a similar post from Ian Formigle (here is the original article). He identifies 10 micro risks (he leaves out the macro events, on which an investor sowieso has no influence).

1. Sponsor Risk

Sponsor is the RE developer, the person/company in charge of the project from start to finish. How able are they to keep the project in line, and can they finish it? It is testing the capacity of Developers. Here are two subrisks: Asset management risk and Property management risk.

2. Debt risk

How much debt does a project have? If there is too much debt, the project can risk foreclosure. If the debt is wrongly structured or matures at the wrong time, can endanger the project. There are some subtypes:

Over leverage: If a property loses too many tenants, its net operating income will fall and its ability to pay the loans will be endangered. Cautious leverage on a property should be in between 0-80%, depending on the asset strategy. If an asset has more than 80% leverage, then it should have a compelling justification for the use of that much leverage.

Debt maturity risk: If a property’s debt matures in a down market, then the project may be unable to obtain a new loan in the same amount of the outstanding debt. If investors are unable to infuse the additional capital necessary to refinance the project, then the asset is now in risk of mortgage default. Debt maturity was one of the major culprits of why projects were lost during the financial crisis.

3. Cap rate risk

Cap Rate refers more to asset valuation. It has a dramatic effect on an asset’s exit value. Cap rate is the rate of return, i.e. project profit. Cap rates fluctuate, they are strongly influenced from supply and demand. A small change in Cap value has a substantial effect on the residual value of a project. When analyzing an investment opportunity, be careful on the entry and exit cap rates and ask yourself 1) is the entry cap rate attractive for this asset when compared to its competitive set and 2) is the assumed exit cap rate is defensible over the prescribed holding period?

4. Tenant risk

There are two primary subsets of tenant risk:

Rent roll quality: it is basically the credit worthiness, stability, and number of tenants. What is their staying power, can they go out of business, file bankruptcy or default on its lease? Another element of tenant risk is single tenant vs. multi-tenant scenarios. Single tenants can be great during a lease term since your property, by definition is 100% leased, but if they default or vacate at expiration, your property is now 100% vacant. In contrast, multi-tenant buildings are rarely 100% leased or 100% vacant. By creating a diverse tenant mix, where no single tenant occupies more than 20% of the total leasable area of a building and staggering lease expirations, you can mitigate occupancy risk and help to ensure your building remains mostly occupied at all times regardless of what happens with any single tenant.

Rollover risk: the duration of leases. Longer term is in general better, but that aspect of leases is often priced into assets, so it’s not as easy as simply looking for longest term leases you can find. As part of an acquisition, a reputable sponsor will interview tenants in an effort to handicap the likelihood that each tenant will perform on its existing lease and renew upon expiration.

5. Leasing risk

If your property has vacant apartments/shops, there is risk that the lease up may not occur or may occur at a slower rate than the sponsor anticipates. Good sponsors mitigate lease up risk by budgeting appropriate amounts of time and resources (monetary and human) in when contemplating lease up scenarios.

6. Physical asset risk

This is the risk of unexpected costs on a property. Defects on constructions, wrong equipment, bad construction. Aging buildings tend to decay and need repair (costly roof replacements, equipment failure, etc.). These risks can be mitigated, and they should be, before the costs explode.

7. Entitlement risks

This is the process of obtaining building permits. It can take time and can take unexpected turns.

8. Construction risks

Construction can go badly wrong, especially in terms of overruns, delays, unexpected costs. When looking to invest in a project with significant construction, it’s critical that the sponsor have experience in managing construction projects.

9. Market risk

Real estate as a whole is a very cyclical market. Good markets are characterized by strong occupancies and steady rent growth while downturns often result in lower occupancies and flat or even discounted rents. There are myriad market risk factors that can trigger an imbalance in the supply and demand for space, such as a surge in new development or a dip in demand from a slowing economy.

10. Geographic risk

Properties are heavily influenced by their location, based on the regional, state, city or even a specific neighborhood. Job growth, population and demographics are some of the key ingredients to that equation, and they can change. Even change rapidly. Primary markets (big cities) are usually safe investments. Secondary markets are viewed as riskier and tertiary markets as riskier still, because they are more susceptible to dips in the economy and have shallower pools of buyers.