As a real estate investor, you’re very keen on working out cash flows and appreciation of a property. But what about the various risks inherent in all properties? Are you managing your exposure to different risks? Are you aware of the specific risks that come with each property?
These may be questions that you haven’t delved into with too much depth. In this article, we’ll discuss the various risks property investors take along with techniques for managing them.
Understand The Risks You Are Exposed To
The first step in managing your risk exposure is understanding the various risks that you’re exposed to. Let’s go through five areas that all property owners should have on their radar.
Market/Submarket Risk. Understanding the economic drivers of a local market is critical to analyzing and making forecasts about that market. Some key points to include in your market analysis are:
- What are the market’s main industries?
- What new businesses may be coming in or leaving?
- Are population demographics changing?
- Is the population growing or decreasing?
Within a city, there are various submarkets. For residential, this is usually neighborhoods. In addition to neighborhoods, commercial properties are separated by districts and broader areas of the city. These submarkets have their own dynamics and trends that can be different from the larger region/city. Be aware that these submarkets do exist and will influence your analysis.
Trends can begin in a submarket, eventually spreading out into the larger, surrounding area. For example, a neighborhood that is undergoing gentrification will likely see rising rents and new businesses moving in. This can affect the surrounding areas. Of course, the reverse is also true.Tenant Risk. The reliability of tenant cash flow is always a concern for landlords. This falls under the property’s rent roll quality, which extends to both commercial and residential properties alike. For commercial properties, the risk pertains to how strong the tenant’s balance sheet is, as well as the tenant’s dedication to the space. Looking at financials and credit ratings can help manage some of this risk, as well as understanding why the tenant occupies the space. For example, a tenant occupying a manufacturing facility may be more inclined to pay rent over the long-term if their distribution hub is located down the street.
Similar to commercial, residential rent roll quality comes from the financial strength of the tenant base—the only difference being that your tenant base is hundreds of people versus one or a few companies. Metrics like average household income and income to rent ratio can help you understand the financial flexibility of your tenant base. Along with this, knowing where your tenants are employed will help ensure you aren’t overly exposed to a particular industry or a nearby employer.Financing Risk. Leverage can be a great thing, but it often comes with a number of strings attached. Lenders will generally build in loan covenants. These covenants are triggered when certain conditions are met. For example, the property reaches a certain level of vacancy, or cash flow falls to a specific level. When a covenant is broken, the lender can take adverse action against the borrower. If the loan is personally secured, the borrower’s assets are at risk.
A non-recourse loan and more lenient covenants can help get around some of these issues. Additionally, not borrowing as much means a lower monthly payment. If cash flows decrease, a smaller monthly mortgage payment will be easier to deal with.Environmental Risk. Environmental risks can occur for both new construction and existing. When you buy a property, those risks basically transfer from the seller to the buyer. New construction can run into issues from disturbing the ground. Finding something that is environmentally harmful can mean a full project stop until the problem is resolved, which may involve dealing with various regulations.
For an existing structure, any modifications can expose tenants to harmful elements, depending on what might be within the structure. Environmental risks can carry severe penalties and fines. Seeking out those who can do an environmental analysis and impact study can help manage those risks.Capital Risk. In the context of this article, capital risk refers to a decrease in cash flow, leading to the inability to cover expenses. Cash flow from rent can decrease over time with a drop in occupancy or market rates. If monthly cash flow falls below monthly expenses, the landlord will experience capital risk — there isn’t enough working capital to properly maintain the property.
A similar scenario can occur if monthly expenses start increasing or unexpected capital expenses occur while cash flow remains static. These expenses will eventually overwhelm working capital. If the property falls into disarray because it isn’t properly maintained, a vicious spiral can begin as the property deteriorates further.
For direct property, an inability to cover capital expenditures from cash flow means the owner will be personally liable. For certain ownership structures, such as a Delaware Statutory Trust (DST), additional risks exist as the DST can’t make capital calls.
Steps For Managing Risks
Diversify Holdings. When it comes to real estate investing, diversification has many forms. For starters, diversification can mean more properties located in different areas. Further, this can mean gaining exposure to different property types, for example, having holdings in both multifamily and net lease assets. Property diversification shares exposure across the cash flows of different properties. If one property experiences a slump, the performance of other properties should be unaffected.
Diversification can extend to your tenant base as well. This is similar to holding just one or two stocks in a portfolio instead of a basket of them. The more tenants you have paying rent in your portfolio, the less you are dependent on the outcome of any one tenant.
Of course, this kind of diversification depends on your resources (i.e., ability to diversify). If you don’t have the resources to invest in other properties, consider recapitalizing. Pool resources together with other like-minded investors to gain exposure to more than just one property. Instead of your entire investment exposed to a single property, you’ll be diversified across other properties.
If there aren’t any potential investors that you can turn too, another option is owning fractional shares or real estate through a Delaware Statutory Trust (DST), Tenants-In-Common (TIC), or Real Estate Investment Trust (REIT). Not only does investing in fractional shares allow you to gain exposure to multiple properties, but these ownership structures can also have the added benefit of removing all property responsibilities from investors. A team of managers who operate the DST, TIC, or REIT will source deals, obtain financing, and handle all property management duties while the investment is held.
Know Your Capital Needs. Some capital expenditures are unexpected and should be covered by a reserve fund so that you don’t run into liquidity issues. Other capital expenditures are expected and need to be built into your forecast.
Capital expenditures that will eventually occur for every property are roof replacement, air conditioning replacement, parking lot resurfacing, and apartment upgrades. These capital expenditures should not just creep up on you all of a sudden. They can be planned for by monitoring the condition of each asset. Looking at a Property Condition Report is a good first step in determining potential on-going capital needs.
Consider Refinancing. If you feel as though you’re over-leveraged or the terms of your loan are working against you, it may be time to start looking at other financing options. When the market takes a turn for the worst or your cash flow begins decreasing, servicing burdensome debt will only become more difficult. Utilizing a mortgage refinance may lead to securing more attractive debt terms. If liquidity is the issue, utilizing a cash-out refinance strategy may allow you to access equity tied up in your investment property.
Try to work with your existing lender on better terms, but don’t rule out going with a completely different lender if you aren’t having any luck.
Seek Out Insurance Where Needed. Especially for those who have environmental risks, insurance can help with mitigation. Environmental risks can come in many forms, making it difficult to identify every area that you might have exposure to. Don’t rely solely on your general liability and property (GLP) policy for environmental risk coverage. Policies designed for environmental risk provide protection in the gaps left behind by GLP policies.
Real estate investment risks are just as important as determining the financial viability of a property. One bad risk exposure that wasn’t taken into consideration can sink a great investment. By understanding the various risks associated with a property and including them in your viability assessment, you’ll have a more thorough due diligence process.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
What is a 1031 Exchange
The Investor's Guidebook