Recognizing the Risks in Real Estate
In my previous blog, I outlined the 5 main risk classes of real estate. In this follow-up blog, I want to outline some scenarios where those risks materialize.
Because Core assets are newly built assets in strong markets, these exhibit the least risk. However, when we look at where the returns are truly derived, we can find that there is risk. Core assets draw a bulk of their return from cash flow. So, the risk materializes from impacts to that cash flow.
Back in the financial crisis of 2009-2011, Core assets were hit particularly hard as companies and people started cutting expenses. In the multifamily space, there was a lot of uncertainty about employment at all levels of an organization. Because of this, the high earners that would typically live in the nicer apartments began looking for ways to cut living costs and moved into cheaper, Class B properties.
With the onset of COVID, a different scenario happened with the complete upheaval of the professional workforce moving to work from home, sometimes indefinitely. As a result, Core multifamily projects are experiencing higher vacancy rates and reduced rental rates as city center residents move to the suburbs for more affordable, larger units.
Similar to Core, Core Plus asset returns are primarily driven by cash flow. Therefore, the same examples listed above still hold true. Although, these assets present a couple unique risks as well. Core Plus can either be a newly built property in a Class B area, or a Class B property in an A or B area.
When talking about Class B areas, by way of comparison, your rents will be lower than new construction in a Class A area. Your tenant base will likely have a lower income than in Class A areas, and therefore likely have a slightly higher risk of layoffs or impacts to earnings.
Beyond the slight increase in tenant risk relative to the typical Core asset, you often have an older asset. While these assets are remodeled with most deferred maintenance addressed by the prior owner, there is additional capital expenditures relative to new construction. The maintenance costs with the Core Pluss asset are higher than Core, and there is the increased chance of large ticket repairs.
Value Add assets generate their returns from both cash flow and appreciation. The same risks that effect cash flow outlined above can occur with Value Add assets as well. Similar to Core Plus, since these assets are dated, they tend to be lower rent options and therefore may see a higher-risk tenant base.
Value Add assets tend to require a reasonably significant amount of capital to be spent to renovate the property. Therefore, construction costs become a risk. Whether this be timeline or cost, both can affect the returns of the asset. A real-world example of this is the current situation with COVID, which is causing a significant increase on construction material costs. While the Value Add operator is typically not doing major construction relative to redevelopment or new development, these cost overruns can still impact investor returns.
Often times, a significant portion of the overall return of the asset comes from appreciation, which carries its own risks. Markets can shift dramatically over an operator’s hold period, meaning the asset cannot be sold at a favorable price. Often in multifamily syndications, approximately half of the overall return to the investors comes from profit at sale. Market shifts effecting the long-term value of the asset can create significant volatility in the overall returns.
Opportunistic deals or Redevelopment deals create the most risk of any existing class. Since these assets often are cash flow negative through significant vacancy and require significant capital to bring back to leasable, the risks are immeasurable. From unexpected construction costs to longer lease up timelines, there are many moving parts and little to no revenue to offset these potential issues.
Real world examples of these risks include the current increase of all construction materials. Geopolitical issues have been known to effect steel and drywall costs dramatically in a short amount of time. Other renovation risks and cost overruns happen all the time simply by opening up walls and realizing major systems are not to code.
Real risk, also, comes with the overall timeline of an opportunistic investment, specifically as it related to changing tastes of your tenant base. While changes in taste tend to evolve over time, the COVID pandemic has proven that sometimes demand can shift quickly. The longer you have an asset with little to no income, the more pronounced the effects of those shifts can be. Examples of changing tastes range from location preferences to amenities on the property to paint colors.
The riskiest of all asset classes is development. Again, the same risks are true for Development compared to Opportunistic assets. However, there are some risks that Opportunistic assets won’t encounter; primarily, entitlements.
Entitlements, in general, are all of the sign offs and approvals you need. If you want to change the use of a plot of land, you either need it rezoned or a variance. If you want to put 200 apartment units in an area, you need approval from the sewage department to confirm the sewer system can handle the additional demand, or from the school district to determine if all the new residents will have space in classrooms. You need approval from neighborhood councils, that your design fits into the look and feel of the neighborhood.
At the end of the day, all of the approvals needed to put a new building up create significant risk, as not receiving a single approval can stop a development in its track. While seasoned developers will not acquire a property until they are reasonably confident all approvals can be obtained, if the approvals are not obtained, it can dramatically affect the value of the property, as future developers may be less inclined to even pursue the property knowing the prior developer was not able to obtain the necessary approvals.
As outlined, here and in my prior blog, all investments come with risk. Our job, as investors, is to pursue investments where we feel the risks associated are worth the reward.
About the author:
Evan is the Investor Relations Consultant for Ashcroft Capital. As such, he spends his days working with investors to better understand their investment goals and background. With over 13 years in real estate, he has seen all sides of real estate from acquisitions, to capital raising on the equity and debt side, to operations, and actively invests himself. Please feel free to connect with Evan here.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.