Legal Risk
There can be lawsuits.
Imagine if a tenant’s 7-year-old son slipped on the ice in the parking lot and broke his leg. Dad decides to sue the owner of the property for $2.5 million.
This is one reason why it’s important to carry adequate insurance and have excellent legal council in place.
2. Property Management Risks
The highest degree of risk is associated with the day-to-day management of the property.
Poor customer service will degrade the reputation of the property and also ultimately decrease the net operating income (NOI) and make it impossible to raise below-market rents to a competitive level.
Management can make or break the entire deal. For this reason, the sponsor must vet prospective property management companies with the utmost care.
When seeking management for our syndications we gather referrals from trusted professionals within the real estate business in our target markets. Then, we carefully conduct interviews with the management companies that receive consistently good referrals.
3. Policy Risks
The arguments against rent control are beyond the scope of this article, so we shall save them for another time. Other policies that are sure to cause consternation are ones that lead to the process of evicting problem tenants to be unnecessarily onerous.
Additional supply can cause downward pressure on rental rates if there is not enough demand to meet it.
How do we hedge against policy risks? We simply target markets with local governments that are historically more landlord-friendly in nature and avoid those that make life unduly difficult for landlords.
4. Liquidity Risks
lack of liquidity can often happen when the sponsor fails to raise enough capital to cover reserves for capital expenditures and unexpected shortfalls in income from the property.
This could delude the equity and decrease the returns for all of the partners depending upon how the deal is structured.
How do we mitigate this risk? It’s simple: we raise plenty of reserves for both capital expenditures and debt service in our initial capital raise. If the numbers don’t work with a conservative capital raise then we don’t do the deal.
5. Market Risks
What happens when your apartment complex is located in a town where the only real industry is oil refining, and the refinery is shut down? Many of the tenants will lose their jobs, will be unable to pay rent, and may need to relocate for a new job. This can lead to vacancy issues and put downward pressure on market rents.
We mentioned in the section on policy risks about the issue of market oversupply. While this is generally not a problem these days with apartments due to a general undersupply in most markets, but this is definitely something to look out for when acquiring or building self-storage facilities. It can easily be a deal killer.
The key to mitigating these market risks is simply to vet the market and submarket in which an asset is located. Key indicators of a good market are a diverse employment base with strong job growth metrics, high median household income, low rates of crime, and other relevant demographic information. And with self-storage, we look for submarkets that are undersupplied above all.
6. Environmental Risks
If we do find a deal in an area of flooding or hurricanes, it’s key to purchase the appropriate insurance to mitigate environmental risk. The financing institution that provides the mortgage for the property in question will normally require a sufficient amount of insurance.
We prefer to avoid properties that are situated in a flood plain, for instance. Even if the underwriting indicates that the numbers will work with a flood insurance policy intact, the cost of the policy could change drastically, adding a degree of volatility to the deal.
7. Financing risks
Even if one’s mortgage is set at a fixed rate of interest, it’s possible that when market interest rates shift upward, capitalization rates will decompress.
That’s not the only situation in which cap rates could expand, but for the sake of illustration, let’s use this example:
Imagine a $10 million apartment complex that is leveraged with 80% debt and 20% equity. If cap rates were to decompress from 5% to 6% and net operating income (NOI) were left unchanged, then the new market valuation would be $8.33 million. If the bank requires a minimum of 20% equity, then they might force a principle pay-down to keep the 80/20 ratio since most of your equity was wiped out with the market shift. The owner could need to raise more capital if he did not have sufficient reserves to satisfy the lender.
To avoid such a situation, it’s important to not be over-leveraged. It might be okay to begin a value-add syndication with the above 80/20 debt-to-equity ratio because the equity will increase in proportion to the forced appreciation. It’s always safer to start with a 70/30 or 60/40 debt-to-equity ratio when possible if the value-add component is not strong enough to sufficiently correct the ratio.
This was not intended to frighten potential investors away from real estate. Rather, it’s intended to educate them so that they will be able to make wise investment decisions for themselves. Financial education is the key to financial freedom. And the risk is a part of the process to be embraced and managed.
For those considering purchasing their own real estate, something to keep in mind is that they will need to do their own risk management for all of the above items. If one were to instead invest passively in real estate syndications then they mainly need to vet sponsor. If the sponsor is competent and reputable, they will manage the above risks so that the passive investor can be just that: passive.
If investing passively in real estate is something that sounds interesting to you then we invite you to read over some of the articles on this website and fill out our investor questionnaire to determine whether we are a good fit for each other. If not, we can probably point you in the right direction so that you can meet your financial goals.
Disclaimer: The opinions conveyed in this article are provided for educational purposes only and should not be interpreted as an offer to buy or sell any securities or to make or contemplate any investment.
