7 Types of Risks You Should Know About as a Real Estate Investor

Investing comes with a balance of risks and rewards, where heightened risk often corresponds to the potential for significant gains or losses in invested equity. While it's commonly understood that taking on more investment risk can lead to higher returns, determining the appropriate level of risk and quantifying it, especially in real estate, is important.

In the realm of private equity real estate markets, the acquisition of physical rental properties provides a sense of reassurance for many investors. However, it's crucial to recognize the various risks associated with commercial real estate investing and factor them in alongside the anticipated value of the investment. Establishing frames of reference that allow investors to quantify these risks becomes essential, ensuring that the real estate investment aligns with their specific needs, goals, and risk tolerance.

At Westworth Capital, we use sophisticated risk models and the extensive expertise of our team across various markets. This approach enables us to account for the many variables involved in assessing the potential returns of a new property, providing a comprehensive evaluation for informed investment decisions.

Types of Risks

Below are 7 risk factors that investors should take into account when assessing any real estate investment:

1. Market Risk

Real estate market risk refers to the possibility of changes in the real estate market that can affect the value of properties. Various factors, such as economic conditions, interest rates, and overall market trends, contribute to this risk. For example, during economic downturns, property values may decrease, impacting the potential returns for investors. On the flip side, during periods of economic growth, property values may rise. Investors face the challenge of navigating these fluctuations, and while they can't eliminate market risks entirely, they can reduce them by diversifying their investments and adopting strategies that align with the current state of the real estate market. Understanding and managing these risks are essential for making informed and successful real estate investment decisions. As The Financial Industry Regulatory Authority (FINRA) notes, "What you don't know can hurt you".

Mitigating Market Risk

The key to managing real estate market risk is diversification.  As investors are building their commercial real estate investment portfolio, it should include properties in multiple markets to limit the impact of declines in any one of them.  For example, For example, there has been a long term trend that has shifted manufacturing jobs from expensive markets in the United States to less expensive markets in countries like Mexico and China. As a result, markets that had a strong manufacturing base, like Ohio and Michigan – and their associated real estate assets – have been disproportionately impacted whereas states like Florida and Texas haven’t felt nearly as much pain. An investor with holdings in Ohio and Texas would be able to use the gains from strong markets in Texas to offset any potential losses in Ohio.

2. Asset Risk

Certain economic risks tend to impact all assets in the same class.  For example, high levels of unemployment may have a relatively minor impact on multifamily assets because housing is a primary need and renters will continue to make their payments.  However, it could have a disproportionate impact on retail assets as consumers tend to decrease spending in times of economic distress.

Mitigating Asset Risk

The key to managing asset risk is diversification and it can come in two forms.  First, a real estate investor may choose to spread asset risk over multiple property classes in their portfolio. Or, if an investor specializes in one specific type of real estate, they can manage risk by diversifying their portfolio through investment in multiple markets.

3. Property-Specific Risk

Every property is different and they all have risks that are unique to their condition, location, and age. For example, a high rise multifamily property with incredible views could face a significant drop in demand if the construction of a newer, taller building obstructs those views.  To stimulate demand, the owner may have to reduce rents, which is a net negative for the asset. For example, buildings behind Chicago’s Wrigley Field used for private rooftop parties went from a boom to bust investments when a new scoreboard completely obliterated their views, while property values near The 606, Chicago’s version of the High Line in New York, are rising. Property-specific risks are defined as risks that are specific to the asset and the asset’s business plan.

Mitigating Property-Specific Risk

An investor can manage property-specific risk through careful and thorough due diligence, not just on the property itself but on plans for the surrounding area, neighborhood, and market that may potentially affect value and/or demand.

 4. Liquidity Risk

Liquidity is defined as the ease with which an asset can be converted to cash.  For example, a share of Apple stock is incredibly liquid because it is relatively inexpensive and there is a large market of willing buyers for it.  On the other hand, commercial properties are prohibitively expensive for many which can make them less liquid.  As such, a property’s liquidity must be carefully considered prior to making a purchase.  In many cases, liquidity is tied to demand in a given market.  For example, demand for a commercial property in a high growth market like Charlotte, North Carolina, or Dallas, Texas is likely to provide more liquidity than one in a low growth market like West Monroe, Louisiana.

Mitigating Liquidity Risk

Managing liquidity risk requires detailed analysis of the supply/demand characteristics of the market in which the property is located.  It is important to begin with the end in mind by knowing what the exit strategy is before the property is purchased and to plan for the amount of time that it will take to sell.

5. Credit Risk

Any commercial property that leases space to a tenant has credit risk, which is the risk that a tenant can’t or won’t pay their rent.  Credit risk in the context of multifamily properties pertains to the potential of tenants failing to fulfill their financial obligations, such as rent payments. The creditworthiness of tenants plays a crucial role in determining the stability of rental income for property owners and investors. Factors like job stability, income levels, and overall financial health of tenants influence their ability to meet rental obligations consistently. High credit risk may lead to delayed or missed payments, impacting the property's cash flow and, subsequently, the return on investment. 

Mitigating Credit Risk

Credit risk can be managed through careful analysis of a tenant’s financial condition prior to purchase and through the creation of a “lease abstract” for each tenant that summarizes the length of the lease, required payments, payment escalations, and prohibited activities.

6. Debt Risk

The more debt on an investment, the more risky 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.

Mitigating Debt Risk

As a rule, leverage should not exceed 75%, including mezzanine and preferred equity, because both of these types of debt sit ahead of common equity in payment order. At Westworth, our portfolios never exceed 72% leverage. Returns should be generated primarily from the performance of the real estate – not through excessive use of leverage – and it’s critical that investors understand this point.

Often, property investors don’t realize how important it is to study capital costs and quantify leverage, so they end up in over-leveraged investments. Investors should ask about how much leverage is used to capitalize an asset and ensure they are receiving a return commensurate with the risk.

7. Structure Risk

This has nothing to do with the structure of a building; it relates to the investment’s financial structure and the rights it provides to individual participants. Regarding financing costs, 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.

Structure 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 limited liability corporation (LLC), which is either a majority or minority holding. This will dictate the compensation they will have to pay the manager of the LLC 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 paid to the manager and how much of the deal’s profits they will receive if the deal is successful. It’s also important to know how much of the equity is being invested by the limited partners versus the manager. Are they aligned? Do they have similar “skin in the game?”

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.

Mitigating Financial Structure Risk

When evaluating a potential investment, it is critical for an investor to understand exactly what the property’s Capital Stack looks like and how the loan and operating agreements are structured to ensure they don’t incentivize bad behavior. For example, a Capital Stack with just one senior debt holder is generally considered to be less risky than one with senior debt, mezzanine debt, and preferred equity holders all in front of the common equity holders.

A thorough and diligent investor – or investment firm – will consider all of the risks above before deploying capital into a project. For larger firms, there may even be a risk committee whose sole responsibility is to review each deal to ensure it meets the threshold for an acceptable level of risk in a transaction.  Once the risks are identified, plans should be developed to manage each one of them for the duration of the investment period.

The Bottom Line

No matter the type of real estate asset, investors should inquire about these risks and receive straight answers to be more confident in their investing decisions. Be aware of any investment opportunities that don’t make all risks involved crystal clear.

About Westworth Capital

Westworth Capital Partners is a leading private equity real estate investment firm. With an intentional focus on finding world-class, multi-family assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in. To accomplish this goal, we devote a significant amount of time and resources to proactive risk management practices.

If you are seeking a passive real estate investment option, we are here to help. To learn more about our investment opportunities, click here.