Risk-free investments are nearly impossible to find. Even supposedly low-risk investments such as certificates of deposit or government bonds have a negative return after accounting for inflation, which presents a new risk in itself.
Today, a growing number of investors are considering private equity real estate as a way to increase the returns on capital invested. As of the time of this writing, asset classes such as multifamily and industrial have outperformed in most markets and have a low correlation to the ups and downs of the stock market that prudent investors look for.
Before investing money in private equity, it is important to understand the risks as well as the rewards. In this article, we will discuss in detail the top 10 risks to consider before investing in private equity real estate.
Financial Structure Risk
The majority of large commercial real estate projects require more than one source of capital, such as different types of equity and different types of debt. In one sense, this is similar to the way many publicly held companies have multi-class stock structures, each with different levels of control and returns.
In private equity real estate, investors may reduce financial risk by analyzing the capital stack. A capital stack in investment real estate describes how capital is structured or organized and may include common equity, preferred equity, mezzanine debt, and senior debt.
This analysis should include understanding the position of their capital within the overall financing structure of the investment, the potential risks and benefits of that position, and who benefits if a deal performs better or worse than anticipated.
As a simple example, consider a $1 million private equity real estate development project with a capital stack of 50% debt and 50% equity.
At the end of five years – once the project is completed, leased up, and sold – the exit sales price is projected to be $3 million. Under this scenario, equity investors could expect to receive $2.5 million in return for their initial $500,000 investment while debt holders would receive their original capital back, plus any fees and interest received during the holding period.
Contrarily, if the project does not meet expectations, equity investors may lose part or all of their capital, while debt holders receive repayment first. For example, if the project were worth only $750,000 due to a significant change in general market risk, equity investors would lose half of their capital while debt holders would remain whole while having generated income from interest and fees.
General Market Risk
The global pandemic of 2020 is an example of general market risk.
Using the stock market again as a reference point, during four trading days of March 2020, when the pandemic struck, the Dow Jones Industrial Average (DJIA) plummeted by about 26%. In a little over one year, the DJIA has risen by almost 79% and is and is up by nearly 17% compared to its pre-pandemic plunge level.
Commercial real estate was affected by the general market risk of the pandemic as well. According to Nareit, publicly-traded real estate investment trusts (REITs) reached a low point in mid to late-March 2020, down 41.9% from their peak the previous month.
Since March of 2020, REITs overall rebounded generally in line with the stock market, although there are still some long-term concerns about the impact on some commercial real estate sectors such as retail and hospitality due to the changes in how people live, work, and travel.
Eventually, the market risk from the pandemic will run its course, but the factors that influence the performance of commercial real estate will remain the same.
On a macro level, interest rate levels, a fiscal stimulus such as the growth of public debt, and monetary stimulus such as quantitative easing are three factors real estate investors should consider. On a micro level, local business-friendly governments with common-sense policies, inbound population, and job growth are some of the many things that determine the local demand for commercial real estate investment.
Related: REITs vs. Real Estate Funds
Commercial real estate debt is serviced by the cash flow the property generates, which explains why some real estate asset classes have higher levels of credit risk than others.
In many markets across the country, office and retail tenants cannot or will not pay their monthly rent. Meanwhile, the income sources for leisure and hospitality properties have been severly reduced due to the absence of both business and leisure travel.
On the other hand, the credit risk of multifamily and industrial commercial real estate is generally lower due to rising property values driven by more reliable recurring income streams and credit tenants. As CBRE notes, the industrial sector has been one of the most resilient, with average industrial rents in the U.S. expected to grow by more than 6% this year.
To be fair, rent and eviction moratoriums were an initial concern for commercial real estate investors in the multifamily sector. But as the control of Covid improves and the economy bounces back, the multifamily sector continues to excel.
According to the National Multifamily Housing Council NMHC Rent Payment Tracker, 95.9% of apartment households paid their rent in March. In fact, beginning in November of last year, the percentage of rent payments made in 2020 and 2021 were within a few percentage points of rent payments made pre-Covid, with more tenants paying their rent in April 2021 compared to April 2020.
Each commercial real estate class – office, retail, multifamily, industrial, and lodging/hospitality – has different performance characteristics and risk levels.
For example, the performance of retail properties is driven in large part by brick-and-mortar retail spending, the shift in consumer buying habits to e-commerce, and the overall economy.
The hybrid work from home model, which allows some employees to work remotely while others go into a physical office, impacts the office sector tremendously.
On the flip side, both the multifamily and industrial real estate asset classes have outperformed other property types as a growing number of people work and shop from home. The 2021 U.S. Real Estate Market Outlook report from CBRE predicts that multifamily investment volume will reach about $148 billion this year, while industrial sales volume is forecast to reach $110 billion by the end of the year.
Private equity real estate offers investors the opportunity to
mitigate risk while potentially increasing returns
by diversifying investments geographically and by asset class.
Private equity real estate offers investors the opportunity to mitigate risk while potentially increasing returns by diversifying investments geographically and by asset class. People will always need a place to live, and as the urban to suburban shift continues, suburban multifamily assets in the Midwest and Southeast regions should provide some of the best opportunities for investment performance in the coming years.
Property Specific Risk
There are three types of property-specific risk investors should consider before investing in private equity real estate: Property condition, rent roll, and leasing risk.
Property condition refers to the building itself. Older buildings have the risk of unforeseen problems that may need to be addressed sooner rather than later, such as a new mechanical system, roof replacement, or an obsolete floorplan that cannot be reconfigured to the original construction of the building.
Rent roll refers to the current tenants in the property. By analyzing the rent roll, private equity investors can learn important details about the current roster of tenants, such as payment history, current rent compared to fair market rent, the remaining term left on the lease, and credit quality.
Leasing risk refers to current and future vacancies and the developer’s business plan to lease up available space in a new commercial real estate project. Investors should consider the assumptions made regarding rent levels, leasing costs such as tenant improvements, and the length of time needed for the property to produce positive cash flow from rental income.
Taken together, these three property-specific risks affect the net operating income, property value, and exit strategy and price.
Due diligence and underwriting at the time of the investment will address these factors upfront. However, investors should also understand that initial projections could change based on future market conditions, increasing the potential risk or additional reward of the investment.
Unlike systemic risk that affects the entire market, idiosyncratic risk refers to the risk of investing in an individual property or asset class due to its unique characteristics. In “Navigating the idiosyncratic risk of real estate” from the global commercial real estate company JLL, the firm observes that idiosyncratic risk can be divided into fixed and variable risks.
Fixed idiosyncratic risk references the risk at the time the property is acquired. Potential risks include floorplate size and configuration, the floor-to-ceiling height, which is especially important with industrial real estate, the property’s geographic location in the local submarket, and environmental issues such as chemical contamination or noise pollution.
Variable idiosyncratic risk refers to the fact that tenant profiles, market rents for similar property in the immediate submarket, and capital expenditure requirements can all change over time.
Of course, commercial real estate is not the only asset that carries idiosyncratic risk. The truth is that all assets do. By understanding the various risks involved in a specific private equity investment, investors are better able to select a property to match the unique goals of their investment portfolios.
Liquidity describes how easily an asset can be turned into cash. Trading stocks online is possible 24/7 from any location globally, but selling commercial real estate may take several months, a year, or even more to complete the transaction.
That is why commercial real estate is considered to be an illiquid investment, and private equity commercial real estate is arguably even more so. In part, that is because the target holding period and exit strategy for a private equity real estate investment can change over time depending on market conditions.
For example, a private equity investment with an original holding period of five years may be extended to seven years in order to generate a better return for investors rather than exiting prematurely and generating a potential loss.
Liquidity risk can also vary by asset class and geographic location. Multifamily and industrial real estate located in the Midwest and Southeast may change hands faster and for a better price than in larger urban areas such as San Francisco and New York City that are suffering from an exodus of businesses and residents.
Investors should also note that while lack of liquidity presents some risk, there are also certain advantages to illiquidity as well. Minimizing liquidity risk in private equity real estate can be achieved through three methods: generating passive cash flow, diversifying investments within a well-balanced portfolio, and reducing asset price volatility through a longer holding period.
Related: What Are Illiquid Investments?
Replacement Cost Risk
Two axioms in commercial real estate are that the real estate market is cyclical and that property desirability changes over time. Both of these factors have an impact on the choices that tenants and real estate investors make.
Leasing rates go up in markets where the demand for commercial real estate is strong, but only to a certain point. Eventually, asking rents reach the limit where it makes better business sense to build new, more desirable properties than continue leasing older space. As the demand for older property begins to fade, old buildings eventually become obsolete.
Before investing in a private equity real estate opportunity, investors should analyze the market in detail to learn if the demand for space is strong enough to attract new development to the market. If so, owners of older property run the very real risk of having to make significant capital improvements to remain competitive.
While replacement costs vary by asset class and market, newer construction can offer tenants and investors better features at the same level of rent, with lower investment risk and potentially better returns.
When used wisely, leverage can increase the potential returns on commercial real estate investments. This occurs when the cost of financing is lower than the unleveraged returns for the same investment property.
All leverage comes with certain inherent risks, such as variable interest rate clauses or prepayment penalties. However, there are two potential leverage risks investors should be aware of when analyzing a private equity investment.
The most obvious risk is using so much leverage that debt service and normal operating expenses leave a minimal amount of income left over should market conditions change. Over-leveraged investments could see negative cash flow if market rents decline, vacancies take longer to fill, or unanticipated cost of capital improvements.
Over-leveraged investments could see negative cash flow if market rents decline, vacancies take longer to fill, or unanticipated cost of capital improvements.
The second leverage risk relates to the part of the capital stack invested in. Investing in equity may seem more appealing due to the expectation of higher returns. However, these advantages can vanish if an over-leveraged property underperforms and debt investors get paid off first. .
Of course, investing in the debt end of the capital stack can also have leverage risk as well. If an over-leveraged property does no produce enough income after paying operating expenses, debt investors may face deferred interest payments.
The sponsor is the party responsible for locating, acquiring, developing, managing, and eventually selling the property on behalf of the other investors. With so many moving parts, it is safe to say that some sponsors are more qualified than others.
Fortunately, sponsor risk is the most controllable risk when investing in private equity real estate. If a potential investor does not like what he learns about a sponsor, he can simply move on to the next opportunity.
Key questions to ask when researching the sponsor of a private equity real estate deal include:
Does the sponsor have past, proven success in the local real estate market and the asset class? If a sponsor is new to the market or developing a project for the very first time, a prudent investor may choose to in a private equity opportunity sponsored by a company with insight into the local marketplace.
What is the reputation of the sponsor? Investing in private equity real estate could require leaving capital in the hands of the sponsor for up to five years or more. Speaking with other investors and looking at the sponsor’s track record of success are two ways to find the most reputable sponsors of private equity real estate.
Does the sponsor have experience through all parts of the real estate cycle? When the market only goes up, it is easy for almost anyone to sponsor deals and make money. However, by selecting a private equity real estate sponsor with experience in both bull and bear markets, an investor can minimize sponsor risk and increase the likelihood of reward.
The best sponsors of private equity real estate investments are experts at uncovering hidden value. By renovating and installing state-of-the-art technology, a great private equity investment can generate higher rents, longer leases, and greater returns for investors in private equity real estate. When held for the long run, private equity real estate investments can build wealth for the investor and future generations
“Private equity real estate offers investors the opportunity to mitigate risk
while increasing the returns they might otherwise get in stocks or bonds.”