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How intelligent investors evaluate risks before investing in real estate?

How intelligent investors evaluate risks before investing in real estate?

Real estate remains one of the preferred asset class for investment during crisis as well. Investor’s choice of asset class may have changed in few markets but demand for good rental yield assets and land is still high. The real estate market is known for its ups and downs with the ever-changing economic conditions. Crisis period teaches us to be more cautious evaluating all risks associated with investments.

For this reason, when investing in the real estate assets, investors should always be aware of its dynamic nature, understand and stay up-to-date with the market economy and how it functions, and prepare ahead of time to be able to forecast any real estate market downturns. This will help investors determine whether buying an investment property at a certain time is a good investment decision.

Investing involves risks and rewards – and usually the higher the risk, the greater the potential for significant gains and losses of invested equity. Intuitively, we understand that it is necessary to take more investment risk to achieve higher returns. But how much? And how can one quantify investment risk to understand if it is a choice one wants to take?

Here are eight risk factors investors should consider when evaluating any real estate investment:

1. Market Risk

In real estate investing, the economy plays a major role in the value of an investment property.

Supply and demand, macro-economic conditions, demographics, interest rates, government policies, and unforeseen events all play a role in real estate trends, including prices and rental rates. One needs to monitor investments and adjust entry and exit strategies as needed.

Investors cannot eliminate market shocks, but they can hedge their bets against booms and busts with a diversified portfolio and strategy based on general market conditions.

Investors can lower the risk of getting caught on the wrong side of a trend through careful research, due diligence, and monitoring of their real estate holdings.

2. Asset Risk

Some risks are shared by every investment in an asset class. In real estate investing, there is always demand for apartments in good and bad economies, so multifamily real estate is considered low-risk and therefore often yields lower returns. Office buildings are less sensitive to consumer demand than shopping malls, while hotels, with their short, seasonal stays and reliance on business and tourism travel, pose far more risk than either apartments or office.

3. Property Risk

Property risks are defined as risks that are specific to the asset and the asset’s business plan. It includes:

  • Legal and Regulation risks: The title risk is always associated with every real estate investment. There’s also regulation risk – the chance that government agencies with jurisdiction over a project won’t issue the required approvals to allow the project to proceed;
  • Environmental risk that range from soil contamination to pollution; budget overruns and more, such as political and workforce risks.
  • Development risk: Construction, for example, will add risk to a project because it limits the capacity for collecting rents during this time. And when developing a parcel from the ground up, investors take on more types of risk than just the construction risk.
  • Location is another property risk factor.
  • Vacancy and Tenant risks
  • Physical condition/ Hidden Structural Problems of the property

4. Liquidity Risk

Liquidity is the ability to access the money you have within an investment. One risk of real estate investing is that investment properties are illiquid, meaning you cannot easily convert them into cash. Selling a property is neither a quick nor a simple process and selling quickly or under pressure will most likely result in taking a loss on your investment.

This lack of liquidity forces real estate investors to hold their investments for longer than other types of investments, which is risky for those who might need access to cash quickly if necessary.

An investor can expect dozens of buyers to show up at the bidding table in a Tier 1 Cities like Mumbai, Bangalore, and Delhi NCR regardless of market conditions. However, a property located in Tier 2 and especially Tier 3 cities like Bhopal, Coimbatore, Nagpur will not have nearly the same number of market participants, making it easy to get into the investment, but difficult to get out.

5. Negative Cash Flow Risk

In real estate investing, the cash flow of investment properties is the amount of profit that the property investor earns after paying off all expenses, taxes, and mortgage payments. The next risk associated with real estate investing is the possibility of generating a negative cash flow instead of a positive one. This means that expenses, taxes, and mortgage payments are all higher than the property income, which results in losing money.

The top reasons for negative cash flow include:

  • High vacancy
  • Too much maintenance
  • High financing costs
  • Not charging enough rent
  • Not using the best rental strategy

The best way to reduce the risk of negative cash flow is to do your homework before buying. Take the time to accurately (and realistically) calculate your anticipated income and expenses—and do your due diligence to make sure the property is in a good location.

6. Leverage/ Financial Risk

Financial risk primarily reflects uncertainty about the residual equity return when debt financing is used. Debt increases the variability of the investment return to the property owner; increased leverage can mean increased returns, but since debt service must always be paid before the equity holder, it might also mean lessened or even negative returns.

The more debt on an investment, the riskier it is, and the more investors should demand in return. Leverage is a force multiplier: It can move a project along quickly and increase returns if things are going well, but if a project’s loans are under stress – typically when its return on assets isn’t enough to cover interest payments – investors tend to lose quickly and a lot.

Returns should be generated primarily from the performance of the real estate – not through excessive use of leverage – and it is critical that investors understand this point.

Financial risk also includes interest rate risk; larger-than-expected increases in interest rates with a variable-rate or short-term loan will increase a property’s debt service and thus decrease the rate of return to equity investors. Increased interest rates may also lower the price that subsequent buyers are willing to pay. Yield rates that investors require for real estate tend to move with interest rates generally.

It is important to thoroughly assess a project’s anticipated net operating income because it is this amount that will be required to cover the debt service. The risk of a shortfall is increased when there is more debt on a property.

7. Financial Structural Risk

It relates to the investment’s financial structure and the rights it provides to individual participants. A senior secured loan gives a lender a structural advantage over “mezzanine” or subordinated debt because senior debt is the first to be paid; it has top place in the event of liquidation. Equity is the last payout in the capital structure, so equity holders face the highest risk.

Structural risk also exists in joint ventures. In these types of deals, the investor must be aware of their rights relative to their position in the company (SPV/LLP), which is either a majority or minority holding. This will dictate the compensation they will have to pay the manager of the company when a property is sold. If an investor is a limited partner, they must understand that the gross profits will be diluted by the compensation that is paid to the manager and should understand how much of the deal’s profits they will receive if the deal is successful. It is also important to know how much of the equity is being invested by the limited partners verses the manager.

A lack of alignment can create a divergence of incentives between the manager and the investor. For example, if you are a limited partner in a deal that has an advantageous profit split with a manager, and that manager has significantly less money invested in the deal, the manager is incentivized to take risk.

8. Platform Risk

If you decide to invest in real estate via a real estate crowdfunding platform, there is a chance the platform could shut down for whatever operating reason. If the platform shuts down, your investments should be protected because investors of the platform do not have a lien on your investments in your respective real estate deals. You are an investor in real estate deals, not the real estate crowdfunding company itself.

However, there may be some disruption as individual investments get transferred to a fund administrator, and coverage teams responsible for following up with sponsors get whittled down.

Risk and Return in Real Estate Investing

Risk and return are positively correlated because people are risk averse. Increased risks require that an investor demand increased returns in compensation. The return needs to be sufficiently above the current risk-free rate of return (10-year bond yield) for someone to risk their capital.

In general, it is good to require at least a 2X or 3X premium on the risk-free rate of return. In other words, if the risk-free rate is at 6%, you would require a return (ROI) of at least 12% – 18%.

Investors must always be aware of the various risks involved with an investment, both those related to the economy and real estate markets themselves and those that relate to a specific project.

Undergoing appropriate due diligence on a project, including on the project’s sponsor or (for loans) on the proposed loan-to-value ratio, is key to understanding whether the expected rates of return for a certain investment are commensurate with the project’s overall level of risk.

Conclusion

Owning investment properties is a relatively safe investment. Nevertheless, real estate investors can never 100% guarantee a profitable investment. The above-mentioned challenges are the most common risks associated with real estate investing which should always be taken into consideration before investing in real estate assets.

Smart and successful real estate investors conduct a thorough real estate market analysis in addition to a rental property analysis to avoid these risks. This includes studying the market economy, property inspection, computing expected expenses, and so forth. This gives them the ability to know when, where, and for how much to buy and sell, which ultimately helps them hedge against major losses.

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Gorakh Jhunjhunwala

Gorakh Jhunjhunwala
Managing Director

Gorakh spearheads Meraqi's overall operations, direction, strategy and growth. He is an expert with multidisciplinary experience across advisory, valuations, capital markets and investment management. He has advised over 50 clients on numerous consulting assignments and executed investment transactions valued at USD 100 million.Gorakh holds a B. Arch from RVCE, Bangalore and M. Tech from IIT Delhi.