As an investor, there are always risks. The higher the risk, the greater the reward but also the chance for significant losses. Higher risk in investing is necessary to get increased investment returns. In other words, it’s not only important to know how much risk is too risky but also how to measure that level of risk objectively.
Origin, a commercial real estate company, uses sophisticated models to account for risks involved in a new property. These models help investors assess their tolerance and find an investment that suits them.
Best Eight types of risk investors should consider when evaluating private real estate investments
1. General Market Risk
Markets have ups and downs, so investors should diversify their portfolios. All markets have high points and low points attached to the economy, financing costs, expansion, or other market patterns. Financial backers can’t take out market shocks, however, they can support their wagers against wins and fails with an expanded portfolio and system in light of general economic situations. “What you don’t know can hurt you,” the Monetary Business Administrative Power (FINRA) notes.
2. Asset-Level Risk.
Low-risk investments are ones that are also less profitable. Investment is low risk, like apartments in good and bad economies or office buildings, regardless of their location. These riskier investments, like hotels, still provide better returns than the low-risk investments that they’re classified with.
3. Idiosyncratic Risk.
Risk is usually greater with more development because you cannot collect rent during the time of construction. There are many different types of risk involved in a construction project, from political risks to budget overruns.
Risk is not always the same. If you want to invest in real estate, location plays an important role. For example, buildings behind Chicago’s Wrigley Field used for private rooftop parties went from a boom to bust investment when their views were disrupted by a new scoreboard, while properties near The 606–Chicago’s version of New York’s High Line–are randing.
4. Liquidity Hazard.
Thinking about the profundity of the market and how one will leave the speculation should considered before purchase. A financial backer can anticipate that many purchasers should appear at the offering table in a spot like Houston, paying little heed to economic situations. In any case, a property situated in Evansville, Indiana won’t have anywhere near similar number of market members, making it simple to get into the speculation, yet hard to get out.
5. Credit Risk
A property’s value is based on its rent stability, which can be hindered by the tenant’s creditworthiness. A single tenant project like Apple’s headquarters in Silicon Valley will have a higher value (and likely offer more favorable terms) than a multi-tenant building with equivalent rents.
A triple-net lease means that tenants are responsible for paying property taxes, insurance and improvements. However, landlords take on greater risk. Newer buildings may seem like a safer investment but they have not yet gained any history and cannot guarantee a tenant base.
6. The Replacement Cost risk
Rent prices are going up in older properties. It is likely that new construction will happen that might replace your investment property. If that happens, you won’t be able to change rental rates or even reach decent occupancy rates.
Consider the age of the property, location, and sub-market to evaluate whether it would be worth a new development to replace an old building. If there is competition in this industry, you need to understand what that means for you. If you can’t raise rents or maintain occupancy, it’s not worth developing.
7. Structural Risk
Equity is the last payout in the capital structure, so equity holders face the highest risk. This doesn’t have anything to do with the design of a structure; it connects with the venture’s monetary construction and the privileges it gives to individual members. A senior got credit gives a bank a primary benefit over “mezzanine” or subjected obligation since senior obligation is quick to be paid; it has top spot in case of liquidation. Value is the last payout in the capital design, so value holders face the most elevated risk.
Investors should consider the different types of compensation, as well as their relative equity in the joint venture. Investors must also be aware of the risks involved when investing in joint ventures.
If you are an investor in a deal that has an advantageous profit split with the managing investor, but the managing investor has a significantly less stake. The managing investor may be incentivized to take on more risk because he does not care about maximizing his gains.
8. The laverage Risk
The more debt on an investment, the higher the risk. Leverage is a force multiplier: It can move a project along quickly and increase returns if things are going well, but if the package of loans isn’t doing well – typically when its return on assets isn’t enough to cover interest payments – investors tend to lose quickly and a lot.
Leverage should not exceed 75% if it will include mezzanine debt. Leverage should stay around 70% and leverage should not contain mezzanine debt or preferred equity at all. Investors need to know that returns should be generated from the performance of the real estate and not generated through excessive use of leverage.
Investors need to be sure that they are receiving the appropriate return for the risk taken on projects. If not, it can lead to over-leveraged investments that could thwart financial growth.
Investors should always ask about risks before investing and get straight answers so that they are comfortable with the risks involved in an investment.