Part 3 in the Realized Series "Risk Management and Real Estate"
Part 1: Risk In Real Estate Investments
Part 2: How to Reduce Risk in Real Estate Investing
“Quick buck artists come and go with every bull market, but the steady players make it through the bear markets.”
-Lou Mannheim to Bud Fox, Wall Street (1987 film)
Wall Street is one of my favorite films. Oliver Stone's 1987 cautionary tale of greed is an entertaining look at the fast-paced world of high finance, filled with many memorable quotes from Gordon Gekko (Michael Douglas). While Gekko is easily the film’s most quotable character, I’ve always thought that the most practical real-world words of wisdom came from Lou Mannheim (Hal Holbrook), the film's voice of reason in an era of excess. There is a scene at the beginning of the film where Bud Fox (Charlie Sheen) is pitching a get-rich quick “investment tip”, in which Lou responds with the quote above. Lou had obviously been through a few market cycles in his career, and his experience is evident in this scene; everyone looks like a genius in a hot market, but it’s how you fare during the downtimes that may determine your overall investment success. It’s easy to get excited by the prospect of high returns in real estate investing, but, like all investments, there are risks. Fortunately, there are steps investors can take to mitigate many of these risks.
Every real estate investment has a unique set of variables that determine its risks. As we covered in Part 2 of our Risk Management in Real Estate series, simply identifying these risks can be a challenge. But assuming you’ve made it this far, you now need to choose the right tool for a given risk exposure. So, let’s “open the toolbox” and discuss the choices. In this installment of the series we cover eight (8) risk management techniques for real estate investing: 1) improve forecasts, 2) scale / combine risks / diversification, 3) shift by insurance contract, 4) shift by two-party contract, 5) limit liability for losses, 6) hedge against known risks, 7) accept, and 8) avoid [1].
Technique 1: Improve Forecasts
As Warren Buffett once famously said “risk comes from not knowing what you’re doing.” So, learn what you’re doing. Conduct research and improve forecasts of critical facts. The likelihood of unpleasant surprises can be reduced by knowing more about the problem in a systematic fashion.
Common examples include hiring third-party due diligence firms to conduct an Environmental Site Assessment and quantifying current and ongoing capital expenditure needs via a Property Condition Report . This takes the guesswork out of “big ticket” items that could result in significant losses to an investor.
Firm up operating expense assumptions. Get a property insurance quote. Get quotes from service providers for things like janitorial and lawn care services. Contact the County Assessor’s office to understand how your property tax bill will be calculated.
Conduct basic market analysis. What are the neighboring properties getting for rents? What is the vacancy rate for competing properties? For commercial properties, market data is often published and readily available. For residential properties, you may have to get more resourceful, but simply driving a market along with some online research should make you much more knowledgeable. Talking to active market participants, such as sales or leasing agents, is also a great way to gain real time knowledge.
Technique 2: Scale / Combine Risks / Diversification
Another risk management technique is improving forecasting through scale of operations, combining risks by pooling resources, by or by diversifying investments. For example, a single-family rental property with a vacancy may result in negative cash flow, while 10 vacant units in a 200-unit apartment complex is a 5 percent vacancy factor, and a far more stable situation.
You wouldn’t put your entire stock investing allocation in a single stock, so why do it with real estate investing? Spread the risk by diversifying your portfolio. Real estate investments can be diversified in a variety of ways, i.e., number of properties owned, types and locations of the properties, and tenant bases.
In practice, diversification is difficult due to the prices of real estate. Most individual investors simply don’t have enough resources to invest in enough properties to gain meaningful diversification benefits. However, there are ways to achieve diversification. Consider teaming up with other investors. Would you be better off if you and three other investors formed a partnership and each owned 25% of four investments rather than 100% of a single property? Consider other investment vehicles. Real estate investment opportunities through Private Placements , REITs , DSTs , and crowdfunding portals allow opportunity to gain diversified exposures with (relatively) smaller dollar amounts. Here further diversification can be achieved in terms of sponsor , capital stack position, risk profile and target holding period .
Technique 3: Shift Risk by Insurance Contract
By shifting risks by insurance contract, an investor accepts the small certain loss of an insurance premium rather than the unpredictable loss of unknown frequency and severity of some insurable catastrophe like fire, collapse, death, or disability. However, not all risks are insurable. [2]
It seems like common sense to place casualty insurance on your investment property. But do you have the proper coverage for your situation? If you are in a hurricane-prone area, do you have additional windstorm coverage?
Consider business interruption insurance which covers the loss of income a business or property suffers resulting from a disaster. If a fire devastates your property, it’s not just the cost to rebuild that is going to hurt. It may take some time to get your property back to generating its pre-fire income.
Investors of sufficient scale may be able to combine techniques 2 and 3 through an umbrella policy. Likewise, investors may benefit from investing with larger-scale sponsors who may be able to insure multiple properties under a common policy thereby reducing coverage costs.
Technique 4: Shift Risk by Two-Party Contract
Properly drafted contracts (assuming a willing counterparty) may provide the most comprehensive protection to an investor. Contracts may be tailored to almost any situation and the risk transfer provisions customized accordingly. Contractual risk transfer typically involves assigning responsibility and financial consequences to the party best able to control or prevent the specific risk exposure. An example is a manufacturer providing a warranty on a new roof. Since the manufacturer made the product, they are the party best able to prevent it from failing.
Other common examples include the triple-net (NNN) lease structure which shifts the risk of variability in operating expenses from landlord to tenant, and fixed-rate debt which shifts the risk of rising interest rates from borrower to lender.
Contractual risk transfer is not without cost. The investor pays for the transfer either financially or through lost opportunity. The roof warranty either was an additional cost or it was built into the price of the roof. With a triple-net lease, the landlord is foregoing potential cost savings if operating expenses are below budget. Fixed-rate debt typically has a higher interest rate than floating rate and the borrower additionally gives up potentially lower payments should interest rates decrease.
Contractual risk transfer does not eliminate risk, but it does provide an additional source of loss recovery. It is important to consider counterparty risk. The transfer is only as good as its collectability or enforcement.
Technique 5: Limit Liability for Losses
While still retaining the risk, an investor can limit the severity of certain risk exposures. For instance, investors may be able to limit liability for losses through the form of ownership used to invest. Investment entities that may limit an individual’s losses include corporations, Limited Partnerships (LPs), Limited Liability Companies (LLCs) , and Delaware Statutory Trusts (DSTs) . Each entity type has its strengths and limitations and it is highly recommended that investors consult experienced legal and tax advisors prior to choosing the form of ownership.
Non-Recourse Debt limits the lender’s remedies to both foreclosure on the mortgage and acquisition (or sale) of the property in the event of default by the borrower, even if property value is less than the loan amount. Barring any breaches of carve-outs, the borrower will not have personal liability for the loan.
Contractual arrangements (combination of techniques 4 and 5) may also limit liability. Damages caps in contracts may limit losses, restrict available remedies or impose time limitations to recover damages arising from a breach of contract. Indemnification agreements may hold one party responsible for liability that another party may incur. For example, a landlord may require a construction contractor to indemnify them from any damages caused to a neighboring property through fault of the contractor.
Technique 6: Hedge Against Known Risks
Hedging is a broad term which covers a variety of devices for protecting against future price fluctuations or other future contingencies. For example, a developer can hedge political risk by buying an option on a piece of land. This may take the land off the market for an agreed upon period while the developer attempts to gain zoning change approvals. If the zoning change is granted, the developer can continue the purchase. If not, the developer is out the cost of the option, but it is better than paying the full price of the land only to have an unfeasible project.
Contingencies provide “outs” for certain events or findings (or lack of events or findings). A common example is a financing contingency where an investor agrees to purchase a property at a certain price and terms if they can obtain sufficient financing. If they are unable to secure the financing, they may be able to void the agreement without penalty.
Another common hedging technique is setting up a reserve fund at the beginning of an investment. Here, investors set aside funds for future unknown issues that may arise. Establishing the reserve upfront helps ensure the funds will be there if needed as it may be harder to raise the money when times are tough.
The last two risk management techniques are self-explanatory, but worth mentioning:
Technique 7. Avoid
Avoiding an investment altogether may be considered the most intrinsic form of risk management. “Yet it is interesting to observe that many (investors) fail to consider the option of avoiding the transaction at all. As they become more involved in the project, additional time and money are expended to force the deal to make economic sense. Many (investors) become emotionally and financially attached to the project and therefore unable to ‘pull the plug’ on the transaction to avoid further financial loss.” [3] Investors should consider identifying their maximum financial exposure at the outset to know when to walk away from a deal.
Technique 8. Accept
Accepting the unknown may be considered the opposite extreme to avoiding the deal. Novice investors may be perfectly content to accept the unknown consequences of an investment, believing that the market will bail them out or ‘this project will be different”. All investments have risks. The important thing is to be aware of them and factor them into the final ‘go/no-go’ decision.
Final Thoughts
Upside in real estate investing is exciting, but downside can really hurt. Consider risk management techniques to avoid or limit the pain. Risk management techniques are not without cost. Higher expected returns generally carry higher risk. Know your personal risk profile and be realistic about the level of returns possible within your tolerance for risk and loss. An effective risk management technique may be not spending time, effort and money chasing deals that are outside your comfort zone.
Realized will prepare a 1031 Investment Plan, which among other valuable insights helps you understand your individual risk profile and the potential risks of real estate investments you may be considering*. With nearly 60 years of collective experience and $5.0 billion of real estate transactions behind us, the Realized team has the expertise and the tools to assist in understanding the risks and returns of investments. Visit our Marketplace to view a variety of tax-efficient, 1031 -qualified real estate investment opportunities. Offerings are pre-packaged, allowing accredited investors to efficiently compare multiple opportunities and create customized portfolios.
*Realized 1031 is not an Investment Adviser and does not provide investment advice . Any information contained in the 1031 Investment Plan or other materials is for illustrative purposes only. Securities offered through the Realized Marketplace are exclusively through WealthForge Securities, LLC, a registered broker/dealer and member of FINRA/SIPC (“WealthForge”). Certain members of Realized are registered representatives of WealthForge.
[1] Graaskamp, James A. “Fundamentals of Real Estate Development.” Development Component Series. Washington, D.C.: ULI – the Urban Land Institute, 1981.
[2] Graaskamp, James A. “Fundamentals of Real Estate Development.” Development Component Series. Washington, D.C.: ULI – the Urban Land Institute, 1981.
[3] Ciochetti and Malizia. “The Application of Financial Analysis and Market Research to the Real Estate Development Process.” University of North Carolina. 1997. p.139
