Top 10 Sources of Risk in Real Estate

Investment Deals
By: Ian Formigle; CrowdStreet; 5/16/16

Risk is the elephant in the room when it comes to private real estate offerings. It’s open
discussion is often skirted at the outset of a proposed investment opportunity and, in some
instances, vastly underestimated. While avoiding investment risk is ideal, unless investors
want to simply hold treasuries (which is generally referred to as the “risk free rate of
return”), the reality is that risk is a natural part of any investment and commercial real estate
is no exception. In this chapter we walk you through the ten most common source of risk
present in commercial real estate investment opportunities. After reading, you should better
understand the relative levels of risk present in the opportunities you evaluate and be able
to insure you are being adequately compensated through appropriate risk-adjusted returns.
Risk is the elephant in the room when it comes to private real estate offerings. It’s open discussion
is often skirted at the outset of a proposed investment opportunity and, in some instances, vastly
underestimated. While avoiding investment risk is ideal, unless investors want to simply hold
treasuries (which is generally referred to as the “risk free rate of return”), the reality is that risk is a
natural part of any investment and commercial real estate is no exception.

So, rather than pretend that every investment will experience the “good deal” exemption, it is wiser
to confront the issue head-on by recognizing where risks exist, estimating how big those risks are
and determining whether or not you, as an investor, are getting sufficiently compensated for
assuming that level of risk. The first step is understanding the different types of risks that can pop-
up to negatively affect a real estate investment. At a macro level, there are a number of broad
geopolitical and economic events that can derail a potential investment. Since investors have no
control over such events and they are nearly impossible to predict, this article will, instead, focus on
the top ten micro or “deal” level risks that are more easily compared and contrasted across
competing investment choices.
When evaluating a real estate investment, it is important to consider the following ten elements
of risk:

1) Sponsor risk: The experience and ability of the developer, operator or lender can have a
substantive impact on whether that sponsor can execute on a business plan and deliver targeted
results to stakeholders. Within sponsor risk, there are two primary subsets:

1a) Asset management risk: The asset manager is charged with executing the business
plan at a strategic level. The asset manager’s expertise and attentiveness to the asset is
paramount in translating a business plan into a successful outcome.

1b) Property management risk: Assets that require individual customer service as an
important part of executing a business plan (e.g. multifamily, senior housing, hospitality and
storage) are highly dependent upon property management. In these scenarios, outstanding
property management is critical as the day-to-day onsite operations of the asset will have a
direct effect on its performance.

2) Debt risks: Placing debt on a project is a common practice but placing too much debt on it or
having it mature at an inopportune time can imperil it, particularly in the event of a market
downturn (see market risk below). Debt risks can lead to foreclosure. Foreclosure isn’t as much
of a risk itself but the unfortunate outcome of the incurred risks of over leverage, debt maturity
or a combination of both.

2a) Over leverage: If a property loses too many tenants its net operating income can drop
to the point that its debt coverage service ratio can fall below 1.0, which now places the
asset into risk of defaulting on its mortgage. Prudent leverage on an asset can range
anywhere from 0% to 80% depending on the asset strategy (see: Real Estate Investment
Strategy: Four Categories of Risk & Reward). If an asset is leveraged in excess of 80% of
value then it should have a compelling justification for the use of that much leverage.
Otherwise, it may be overleveraged.

2b) Debt maturity risk: If a property’s debt matures in a down market (see market risk
below) or at point when its net operating income is compromised, as noted above, 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: Of all the financial assumptions in a pro forma, cap rate risk is the most extreme
since it has a dramatic effect on an asset’s exit value, and that is why it is included in this list. As I
illustrated in my articleour chapter, “What is a Cap Rate?”, prevailing cap rates for different asset
classes move in ranges and are subject to supply and demand for that particular asset class. A
small movement in a cap rate percentage can have a substantial effect on the residual value
of an asset and, in turn, the profitability (or loss) on a particular transaction. When analyzing
an investment opportunity, pay attention to 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 a) rent roll quality and b) rollover risk:

4a) Rent roll quality: This usually refers to credit worthiness, stability and number of
tenants. Do the tenants of a particular property have staying power, or could the tenant(s)
go out of business, file bankruptcy or default on its lease? Generally, large national tenants
such as Google or Amazon are viewed as highly desirable and less risky compared to a
mom-and-pop start-ups. 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.

4b) Rollover risk - this refers to the remaining term left on leases at a property and it
affects both single tenant and multi-tenant properties. Logically speaking, more term is
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. In addition, acquiring a property with a tenant
on a long-term lease that then defaults is the worst case scenario. You likely paid a premium
for the value of that lease, which is now diminishing the asset’s value. 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. Operators who
are adept at analyzing the quality of a tenant rent roll and assessing rollover risk can create
asset value.

5) Leasing risk: In an asset where current vacancy exists that the sponsor expects to lease up over
time, 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 a pro forma when contemplating lease up scenarios.
6) Physical asset risk: There is the potential that unexpected costs may arise due to the condition
of the property itself. Aging assets tend to have more risk for unforeseen problems to surface,
such as costly roof replacements or equipment failure. Sponsors can mitigate physical asset
risk through professional third-party reports that examine the physical aspects of an asset
and highlight abnormal costs. Good sponsors then utilize these reports to further mitigate risk
through renegotiation of price or terms with sellers.

7) Entitlement risk: (new development only): New developments must navigate a lengthy and
often complex process in order to obtain municipal approval to construct the project. This is
referred to as the entitlement process and, prior to receipt of construction permits, all new
development possess entitlement risk. Since this process is detailed and contains many unique
features, we have dedicated a chapter to its discussion, “The Real Estate Development Process:
Understanding the Risks and Milestones”.

8) Construction risk: Any time a project entails significant construction (new development or
redevelopment of an existing asset) there are risks that the construction project may incur cost
overruns, take longer than anticipated to complete (creating leasing risk as noted above) or
expose previously unknown defects in the physical asset (see physical asset risk above). 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 known for its up and down-market cycles. 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. Primary markets such as New York, San Francisco, L.A. or
Chicago have larger, more diverse economies and a bigger population base to insulate it from
market downturns. In contrast, 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. While primary markets to enjoy the greatest amount of transaction activity, it is also
imperative to remain cognizant of this factor becoming overpriced into assets. For example, after
an amazing run over the previous five years, core located assets in San Francisco are currently of
topic when it comes to the conversation of location overpricing.
Given the discussion of the risks summarized above, it becomes easier to now understand how
two real estate investments that both offer the same targeted return may have dramatically
different risk profiles. In that regard, it is important for the investor to peel back the different
layers of risk to determine the superior risk-adjusted return, which is another way of asking
which deal poses the opportunity to earn the most return for the least amount of incurred risk.
One final point is that risk is subjective. Two different investors may have entirely different views
of the risks that can translate into different perceived risk-adjusted returns. For example, in the
category of tenant risk, one investor may argue in favor of the certainty associated with a single
tenant while another investor may argue in favor of a multi-tenant property, citing the huge risk
of absolute vacancy if the single tenant vacates - they are both correct.

Investors must make their own judgement calls on risk based upon what feels acceptable in the
eye of the beholder. Once a determination of risk level is identified in an investment