Do real estate investors incur credit risk? If you are on the lending side of a real estate deal, then yes, you’re likely taking on credit risk. But what about investors buying properties or investing in real estate funds?
Those investors are assuming credit risk as well. If that doesn’t make sense, stick around, and we’ll go through the details. All real estate investors should be aware of credit risk and what to look for when determining if credit risk exists.
Credit Risk Defined
Credit risk is assumed by a lender when credit is extended. A simple example of this is a bank originating a mortgage for a real estate investor. The bank is extending credit to the investor. There is a real risk that the borrower may get behind on payments or even default on the loan. All of those risks are called credit risks.
However, the lender is not the only entity within a real estate deal who is assuming credit risk.
Direct Real Estate Credit Risk
Any investor who purchases a rental property assumes credit risk. The risk is that the tenant may stop paying rent at some point. The investor is basically allowing the tenant to borrow the property in good faith that the tenant will pay each month.
The investor, hopefully, checked the tenant’s creditworthiness and determined the tenant was a fit for the property. Checking the creditworthiness of a tenant can reduce the investor’s credit risk. But it does not eliminate that risk.
Credit risk will always exist for rental property investors because a tenant can stop paying at any time. If the tenant stops paying, they may continue occupying the house. The investor can certainly try to evict them but depending on local laws, it could turn into a drawn-out process. Even with the courts involved, there’s no guarantee that the investor will be able to get the tenant out of the house.
While trying to get a non-paying tenant out of a rental property is beyond credit risk, it all starts with credit risk.
DSTs and Credit Risk
Credit risk does exist within DSTs (Delaware Statutory Trusts). Although to the investor, it may seem as though they are only depositing funds into the DST and doing nothing more. This is because a DST is a passive investment — Investors don’t get involved with tenants, loans, or any management of properties held by the DST. But look a little deeper, and we can see where credit risk lies.
A DST holds properties that seek to generate income. Just like a direct real estate investor who owns rental property, the DST is taking on credit risk through its tenants. However, there is a big difference in the creditworthiness of residential rental property tenants and commercial-grade property tenants held by a DST.
Commercial tenants generally have lower credit risk than residential tenants. This lower credit risk transfers directly to DST investors.
Banks also take on credit risk within a DST. If the bank believes certain properties are at higher than average risk, it will charge a higher interest rate on any financing and may require more capital.
Through the above risk management methods, the bank passes on the impact of high credit risk to DST investors. A higher interest rate and higher capital requirements can reduce DST returns.
As a side note, since we are talking about risk, the direct real estate investor potentially puts their assets at risk (via collateral) through the loan taken out for their properties. While DSTs also take out loans, DST investors are not borrowers. They are not connected to the loan, making the loan nonrecourse for DST investors.
Are DST Investors Compensated for High Credit Risk?
In our above bank example, it certainly seems as though the bank is being compensated for higher credit risk but are DST investors also being compensated?
It is difficult to answer that question as it really depends on the sponsor. Did the sponsor charge a higher lease rate to make up for higher interest rates and capital requirements? DST investors can go over this with the sponsor to get clarification.
Ways to Reduce Credit Risk Exposure?
Investors always try to find ways to manage their risk. But there are different types of risk, and it’s important to know what they are. That way, investors have a better idea of how to manage specific types of risk.
Some people may say that they want to improve their credit risk. What they really mean is that they want to reduce their credit risk. Less risk is usually better for an investment.
Real estate investors might incorrectly assume they don’t have credit risk because they are not lending money to anyone. However, there is a form of lending that occurs with tenants, and that is where credit risk comes in.
Those investors who do thorough credit checks on their tenants can reduce credit risk (but not eliminate it).
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