There is no surprise that real estate investing stands as an attractive opportunity for individuals trying to grow their wealth. Real estate investments cater to diversification1, while allowing for the potential of steady risk-adjusted returns backed by real property. These potential returns that investors look for don’t exist without the onset of a degree of risk, however, making these kind of investments not all rainbows and butterflies - some investment objectives may vary. Whether it derives itself from the market, tenant, or even financing of the property, risk is assumed in a variety of ways and differs property type to property type.
This article will walk you through the potential risk factors to consider when investing in real estate, and looks to help you establish exactly where you feel comfortable taking on risk in your next investment.
Factors to Consider
Market Risk: The real estate market is cyclical, and highly correlated to the state of the economy. While downturns may result in decreased property values, upturns may provide opportunities for appreciation and rising rental rates. The uncertainty behind the future state of the economy is what drives market risk, and there is no guarantee that a property will be more valuable in the future than it is now. To provide an example, purchasing property when demand is high exposes an investment to the potential risk of a lower selling price in light of a downturn.
Tenant Risk: Revenue from investment property is driven by the obligation and ability of the tenants to make payments on rent. Particularly in retail, where a lease is typically guaranteed by an underlying business, tenants have varying degrees of financial stability, and thus ability to pay off their financial obligations. The strongest tenants are considered to be credit tenants. Whereas Walmart has a credit rating of AA from Standard & Poor’s, Burger King has a credit rating of B+ and may stand less of chance of fulfilling its rental requirements.
DST Sponsor Risk: Investing into sponsor managed properties means exposing yourself to the risks associated with the operating capabilities of that particular sponsor. How diligent is the asset manager? Is the sponsor taking care of the property? These type of things affect the marketability of the underlying real estate, and should be answered before any investment is pursued.
Financing Risk: Taking on debt can sometimes be necessary when securing quality investments, but adds risk to the property’s cash flow. Debtors always get paid before equity holders. Along with this, over-leveraging may drop the debt service ratio in the financials below 1.00, increasing the risk of default on a mortgage. Interest rate risk plays a role as well, affecting the value of the underlying property.
Property Type Matters
Property type influences how your investment will withstand the pressures of risks like the ones mentioned above. Different properties deal with risk in different ways, and strategically investing may decrease your downside. To provide an example, consider student housing. University enrollment in the US tends to grow at a faster pace during recessionary periods, than during non-recessionary periods. While it is important to note that the increase in undergraduate enrollment rate does not automatically translate to an increase in demand for student housing at the same rate, student enrollment remains one of the most important factors that drives the student housing demand.2 This is why student housing may be claimed by some to be “recession-resistant”3. Property type affects the impact of vacancy rate risk as well. When entering into a multi-family investment, vacancy still poses a risk but possibly not as much as if you owned a single-family residence. In a single family residence, you’re relying on one tenant whereas in a multifamily property you’re relying on many tenants. These are simplified examples and many other factors play a role such as location, market conditions, and management ability. One risk factor cannot be looked at in isolation from other factors.
Risk and return is a balancing act in investing, and deciding where you want to put your risk is one of the most important first steps you can take as an investor. There are several factors to be considered in the investment process, all having the capability of making or breaking your investment portfolio.
The Realized team understands the necessity of weighing risk and return, and we make it our mission to understand all facets of your investment decisions. Call us today at 877-797-1031 or logon to www.realized1031.com to find out more about how a Delaware Statutory Trust (DST) investment could potentially earn you risk-adjusted returns.
- Diversification does not guarantee returns and does not protect against loss.
- Source: NCES
- Source: National Real Estate Investor (www.nreionline.com)