Evaluate Risk when Investing in Private Equity Real Estate
Investors seeking completely risk-free investments have a very short list of options limited to government backed bonds or certificates of deposit. The reality is that risk is an inherent part of nearly all investment choices. That’s why it is important to go into any investment, private real estate included, with eyes wide open as to the possible risks that could impact return or even return of the original principal.
How much risk is too much? That is a common question for investors. Yet there is no simple answer. Everyone has a different comfort level or tolerance for investment risk. The first step is fully understanding the risks that exist in a deal. From there an investor can determine whether they are comfortable with the level of risk, as well as whether or not the projected return is acceptable given the risk they are assuming.
Understanding risk means knowing where to look and what questions to ask to identify potential red flags. Some of the common areas of risk specific to private real estate investment include:
Sponsor Risk: The sponsor in a commercial real estate investment is the individual or company in charge of finding, acquiring, and managing the real estate investment on behalf of the investment partners. Verify the experience and track record of the sponsor. In addition, commercial real estate is very specialized and nuanced. It is especially important to review the experience in the specific property type or situation as the current opportunity. For example, building Class A office buildings is very different from developing a mall or hotel.
Business Plan Risk: Private equity real estate investments can span a wide spectrum from very low risk to very high risk. Details of the business plan provide a good barometer on the risk level. The more complicated the business plan, the more steps or phases a plan has, and the longer period of time to execute the business plan, the more chances there are for something to go wrong.
A classic example of business plan risk is a new construction project. There are many steps that need to happen even before the first shovel goes in the ground. For example, a developer may need to conduct an environmental assessment of the building site, secure city approvals and building permits and install necessary infrastructure. Once construction starts, large projects can take 18-24 months or even longer to complete. During that time, other unknowns or variables can come into play. Construction costs could rise, the economy could slow, or a competing property could be built down the street.
Property Level Risk: There are any number of risks that could impact a property’s performance, net operating income or even property value or exit price. Due diligence and underwriting typically addresses all of these major points up front. However, it is important for investors to understand that circumstances may change over time that could create future risk in these areas.
- Rent Roll: This refers to the current roster of tenants within buildings. The rent roll provides key information on building tenants, who they are, credit quality, current rent levels and remaining term left on leases.
- Leasing Risk: This relates to the current and future vacancies within a building. A business plan typically is built around a sponsor’s assumptions of their ability to fill vacancies, how long that will take, at what rent level and what additional leasing costs or expenses might be required.
- Building Condition: This is an overall assessment of the building structure and equipment. Standard due diligence typically evaluates the overall condition of the building and notes any needed repairs, improvements or major capital expenditures to avoid any costly surprises, such as a roof replacement or purchase of new HVAC equipment.
Market Risk: These risks relate to the particular type of asset, such as a hotel or office building, as well as geographic risks specific to that region, city or neighborhood. What is the competitive landscape in terms of existing supply and demand? Are there any factors on the horizon that could shift that demand, such a new development that might increase competition? Investors also need to consider macro and micro economic factors that will drive demand in that city or region. Some locations may be heavily reliant on a major employer or a particular industry, such as energy or tech, that could impact tenant demand for a particular property.
Climate Risk: Extreme weather events have the potential to directly impact the physical structure, as well as disrupt business at a facility. Climate risk is not necessarily a deterrent for investing in a particular area, such as those regions subject to flooding or hurricanes. However, climate risk is an increasingly important consideration for investors who are looking to diversifying real estate investments geographically in order to mitigate climate risk.
Liquidity Risk: By nature, private real estate investments are an illiquid asset and an exit date for an investment is by no means set in stone. A business plan with a target hold period of 3-5 years may stretch to 5-7 years depending on market conditions. It may be beneficial to hold an asset longer in order to generate a more favorable return. Investors need to consider that there is a risk that their capital could be tied up longer than anticipated, and an early exit of their principal may come with a financial loss.
Risks can and do vary widely with each private equity real estate investment opportunity. Some investors are willing to take on risks if it means generating a higher return. Other investors may be wary of taking on too much risk. So, it is important to understand those risks in relation to an individual’s own risk tolerance. It also is important to look at the risk of each investment in the context of the risk level across a broader investment portfolio. As with any investment, it is wise to work with a trusted financial advisor. To learn more, contact CanAm Capital Partners at firstname.lastname@example.org or call 212-668-0694.