9 Risks to consider when investing in unlisted real estate
Overview - Specific risks aspects to consider when investing in unlisted real estate
On this page we list and briefly discuss in broad strokes specific risks inherent to real estate investing. The aim is not to provide you with a definitive list of risk to tick off, rather to provide a framework around the risks we see in real estate investing.
These aspects are worth considering when you are investing into an unlisted real estate fund or setting up a partnership with friends to build your own real estate portfolio. The core principals remain the same and are useful even to an individual looking to purchase a single investment property not all of them would apply. For example, if you are purchasing an apartment to rent out, you would not need to consider construction risk.
Table of Contents
- Business Risk
- Financial Risk
- Liquidity Risk
- Inflation Risk
- Management Risk
- Legal Risk
- Valuation Risk
- Real Estate Development
- Country Risk
Keypoints of on the topic summed up in video format
Financial risk are all the risks that you would associate with financing of real estate portfolio. In real estate the financial risk is, to an extent, positively correlated to the amount of leverage used. At the same time too little debt results in subpar returns There is a theoretical optimal cost of capital and would be a combination of debt and equity finance. The normal range is between 40%- 60% debt to equity. This would be appropriate for normal economic cycle. In our lifetime we already had 2 outlying events, the Credit Crisis and the COVID pandemic, which has affected portfolios at the higher end of the debt levels negatively.
Another factor is the cost and structure of the debt used; what portion is fixed rate debt versus variable rate debt. Variable rate has more risk associated with it, especially in crisis environments. Rule of thumb, you do not want to use short term debt to finance long-term projects. You risk being unable to refinance your short-term debt component.
Business risk relates to potential losses because of the fluctuations in economic conditions (cycles). It would appear that the real estate market follow cycles distinct to the overall economic and business cycles. These cycles and other fluctuations affect the income produced by real estate assets. It links this to the cost of capital, the ability to increase leases and vacancy rates. The impact is not the same on all real estate assets, property portfolio with a diversified tenant pool or property with well-designed leases might have less business risk than the market average.
The quality of the assets specifically location can also be a determining factor. Economic factors that seem to have a significant impact one should consider are:
- Growth rate in consumption
- Real interest rates
- Term structure of interest rates
- Unexpected inflation
In terms of real estate liquidity risk is defined as the risk that arises when selling a property timely at a fair price. This risk balloons in times of weak real estate demand. These transactions take months to complete in a normal environment.
If it is a high-quality portfolio, the risk is less, especially if the leverage is low. Having low leverage provides the option of synthetic liquidity, by increasing the debt levels to generate cash. You can then use this cash as a bridge finance while they sell the property. This naturally brings other forms of risk.
Properties need to be managed to maintain occupancy rates, maintain the value of the portfolio, and importantly, control expenses. The risk here is how competent is the management team, to innovate, react to competition, and operates efficiently.
Certain niche properties in the portfolio might require very specialised management teams. Unfortunately, you have the classical principal-agent problem manifesting in property often, ethics of the management team should be the determining factor.
Unanticipated inflation can negatively affect the value of property and the rental income. In theory, real estate should be a hedge against inflation in periods of high demand and low vacancy rates. Similar the replacement cost should also increase in line with inflation.
Pricing power shift between landlords and tenants over different cycles, naturally one might invest in the time that favours tenants. Environments with high vacancy rates, you cannot renew lease agreements at an inflation adjusted scale. You might also struggle to pass on all cost increases to the tenants.
There are multiple methods to value property such as the income approach, valuation based on comparable sale prices, the profit approach, replacement cost etc. You need to understand the nuance of the different valuation methods and the assumptions they are based on. This is a critical area that can have dire consequences with a ripple effect on the investment strategy of the investor. Especially where debt is used and lenders have strict covenants, valuation change can cause a breach of these covenants.
You need to clearly articulate the country's risk, even within your own country. There is the political and social environment to consider, especially around sentiment on rule of law and property rights. Country risk is one of the primary drivers of funding costs, spikes in country risk directly affects the viability of many property projects over the long run.
Many funds invest across borders and have multinationals as tenants and investors from across the globe, this brings legal jurisdiction risk. From country to country one would face different nuances, such as verifying title deeds, what rights are attached to the ownership, what control does the investors have, is this outright purchase or 99-year lease, what protection against legal risk of owning property. Within this what is the tax implications for the investors.
Real Estate Development Risk
Real estate development is extremely complex that sets it apart from normal real estate investing primarily because of two factors. Firstly, a new asset is being created, secondly during the lifetime of the development one must deal with high levels of uncertainty around the revenue potential and the ultimate cost of the development.
This process entails broadly these phases, each with its own unique risks:
- The acquisition of land
- Estimation of the marketing potential and profitability
- Development of building program and design
- Procuring public approvals and permits
- Raising finance
- Constructing the project
- Leasing, managing and final sale of the property.