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Risks of investing in real estate development

risks of investing in real estate development

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Risks of investing in real estate development concept of public sector

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The more risk, the more return. Construction, for example, will add risk to a project because it limits the capacity for collecting rents during this time. And when developing a parcel from the ground up, investors take on more types of risk than just the construction risk. Location is another idiosyncratic risk factor. Liquidity Risk. Taking into consideration the depth of the market and how one will exit the investment needs to be considered before buying. An investor can expect dozens of buyers to show up at the bidding table in a place like Houston, regardless of market conditions.

However, a property located in Evansville, Indiana will not have nearly the same number of market participants, making it easy to get into the investment, but difficult to get out. Credit Risk. A property leased to Apple for 30 years will command a much higher price than a multi-tenant office building with similar rents. However, keep in mind that even the most creditworthy tenants can go bankrupt, as history has shown us time and time again.

Penney anchor their malls? The huge market in so-called triple-net leases, which are often said to be as safe as U. Treasury bonds and require tenants to pay taxes, insurance and improvements, can fool property investors. However, the triple-net lease landlord is taking a risk that the tenant will stay in business for the length of the lease, and that there will be a waiting buyer.

New construction may seem like a better bargain than a year-old structure customized by a prior tenant. Replacement cost risk. It may not be possible for an investor to raise rents, or even attain decent occupancy rates. This helps investors know if rent can rise high enough to make new construction viable. For instance, if a year-old apartment building is able to lease apartments at a rate that would justify new construction, competition may very well come along in the form of newly built offerings.

It may not be possible to raise rents or maintain occupancy in the older building. Structural Risk. Equity is the last payout in the capital structure, so equity holders face the highest risk. Structural risk also exists in joint ventures. In these types of deals, the investor has to be aware of their rights relative to their position in the LLC, which is either a majority or minority holding. This will dictate the compensation they will have to pay the manager of the LLC when a property is sold.

Are they aligned? A lack of alignment can create a divergence of incentives between the manager and the investor. People will always need a place to live, and as the urban to suburban shift continues, suburban multifamily assets in the Midwest and Southeast regions should provide some of the best opportunities for investment performance in the coming years. There are three types of property-specific risk investors should consider before investing in private equity real estate: Property condition, rent roll, and leasing risk.

Property condition refers to the building itself. Older buildings have the risk of unforeseen problems that may need to be addressed sooner rather than later, such as a new mechanical system, roof replacement, or an obsolete floorplan that cannot be reconfigured to the original construction of the building.

Rent roll refers to the current tenants in the property. By analyzing the rent roll, private equity investors can learn important details about the current roster of tenants, such as payment history, current rent compared to fair market rent, the remaining term left on the lease, and credit quality. Investors should consider the assumptions made regarding rent levels, leasing costs such as tenant improvements, and the length of time needed for the property to produce positive cash flow from rental income.

Taken together, these three property-specific risks affect the net operating income, property value, and exit strategy and price. Due diligence and underwriting at the time of the investment will address these factors upfront. However, investors should also understand that initial projections could change based on future market conditions, increasing the potential risk or additional reward of the investment.

Unlike systemic risk that affects the entire market, idiosyncratic risk refers to the risk of investing in an individual property or asset class due to its unique characteristics. Fixed idiosyncratic risk references the risk at the time the property is acquired. Variable idiosyncratic risk refers to the fact that tenant profiles, market rents for similar property in the immediate submarket, and capital expenditure requirements can all change over time.

Of course, commercial real estate is not the only asset that carries idiosyncratic risk. The truth is that all assets do. By understanding the various risks involved in a specific private equity investment, investors are better able to select a property to match the unique goals of their investment portfolios.

Liquidity refers to how quickly an asset can be converted into cash. Buying and selling stocks online can be done around the clock from anywhere in the world while selling commercial real estate can easily take several months, one year, or even longer to trade. That is why commercial real estate is considered to be an illiquid investment, and private equity commercial real estate is arguably even more so. In part, that is because the target holding period and exit strategy for a private equity real estate investment can change over time depending on market conditions.

For example, a private equity investment with an original holding period of five years may be extended to seven years in order to generate a better return for investors rather than exiting prematurely and generating a potential loss.

Liquidity risk can also vary by asset class and geographic location. Multifamily and industrial real estate located in the Midwest and Southeast may change hands faster and for a better price than in larger urban areas such as San Francisco and New York City that are suffering from an exodus of businesses and residents. Investors should also note that while lack of liquidity presents some risk, there are also certain advantages to illiquidity as well. Passive cash flow, diversification within a well-balanced investment portfolio, and less asset price volatility due to the longer holding period are three ways liquidity risk is minimized with private equity real estate.

Related: What Are Illiquid Investments? Two axioms in commercial real estate are that the real estate market is cyclical and that property desirability changes over time. Both of these factors have an impact on the choices that tenants and real estate investors make. Leasing rates go up in markets where the demand for commercial real estate is strong, but only to a certain point. Eventually, asking rents reach the limit where it makes better business sense to build new, more desirable properties than continue leasing older space.

As the demand for older property begins to fade, old buildings eventually become obsolete. Before investing in a private equity real estate opportunity, investors should analyze the market in detail to learn if the demand for space is strong enough to attract new development to the market. If so, owners of older property run the very real risk of having to make significant capital improvements to remain competitive. While replacement costs vary by asset class and market, newer construction can offer tenants and investors better features at the same level of rent, with lower investment risk and potentially better returns.

When used wisely, leverage can increase the potential returns on commercial real estate investments. This occurs when the cost of financing is lower than the unleveraged returns for the same investment property. All leverage comes with certain inherent risks, such as variable interest rate clauses or prepayment penalties.

However, there are two potential leverage risks investors should be aware of when analyzing a private equity investment. The most obvious risk is using so much leverage that debt service and normal operating expenses leave a minimal amount of income left over should market conditions change. Over-leveraged investments could see negative cash flow if market rents decline, vacancies take longer to fill, or unanticipated cost of capital improvements.

The second leverage risk relates to the part of the capital stack invested in. While investing in equity may be more attractive due to anticipated higher returns, those advantages may disappear when debt investors are paid off first if an over-leveraged property does not perform as expected. Of course, investing in the debt end of the capital stack can also have leverage risk as well.

Debt investors may see interest payments deferred when an over-leveraged property does not generate enough income after operating expenses are paid. The sponsor is the party responsible for locating, acquiring, developing, managing, and eventually selling the property on behalf of the other investors.

With so many moving parts, it is safe to say that some sponsors are more qualified than others. Fortunately, sponsor risk is the most controllable risk when investing in private equity real estate. If a potential investor does not like what he learns about a sponsor, he can simply move on to the next opportunity.

Does the sponsor have past, proven success in the local real estate market and the asset class? If a sponsor is new to the market or developing a project for the very first time, a prudent investor may choose to in a private equity opportunity sponsored by a company with insight into the local marketplace.

What is the reputation of the sponsor? Investing in private equity real estate could require leaving capital in the hands of the sponsor for up to five years or more.

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Idiosyncratic risk is specific to a particular property. The more risk, the more return. Construction, for example, will add risk to a project because it limits the capacity for collecting rents during this time. And when developing a parcel from the ground up, investors take on more types of risk than just the construction risk.

Location is another idiosyncratic risk factor. Liquidity Risk. Taking into consideration the depth of the market and how one will exit the investment needs to be considered before buying. An investor can expect dozens of buyers to show up at the bidding table in a place like Houston, regardless of market conditions.

However, a property located in Evansville, Indiana will not have nearly the same number of market participants, making it easy to get into the investment, but difficult to get out. Credit Risk. A property leased to Apple for 30 years will command a much higher price than a multi-tenant office building with similar rents. However, keep in mind that even the most creditworthy tenants can go bankrupt, as history has shown us time and time again.

Penney anchor their malls? The huge market in so-called triple-net leases, which are often said to be as safe as U. Treasury bonds and require tenants to pay taxes, insurance and improvements, can fool property investors. However, the triple-net lease landlord is taking a risk that the tenant will stay in business for the length of the lease, and that there will be a waiting buyer.

New construction may seem like a better bargain than a year-old structure customized by a prior tenant. Replacement cost risk. It may not be possible for an investor to raise rents, or even attain decent occupancy rates. This helps investors know if rent can rise high enough to make new construction viable.

For instance, if a year-old apartment building is able to lease apartments at a rate that would justify new construction, competition may very well come along in the form of newly built offerings. It may not be possible to raise rents or maintain occupancy in the older building. Structural Risk. Equity is the last payout in the capital structure, so equity holders face the highest risk. Structural risk also exists in joint ventures. In these types of deals, the investor has to be aware of their rights relative to their position in the LLC, which is either a majority or minority holding.

This will dictate the compensation they will have to pay the manager of the LLC when a property is sold. Are they aligned? There are several ways to keep your property costs down over the long run, including paying attention to regular maintenance and upkeep. Relatively small expenses today can save you from large costs down the road.

Finally, choose a good location that will be less likely to either witness crime or have low occupancy rates. A landlord is allowed to increase the rent depending on local and state laws, and pursuant to language that exists in the lease. In places without rent controls, there may be no legal limit to how high the rent can be increased.

Real estate has traditionally been considered a sound investment, and savvy investors can enjoy a passive income, excellent returns, tax advantages, diversification, and the opportunity to build wealth. Just as with other types of investments, however, real estate investing can be risky. You can limit your risks by doing your due diligence and conducting a thorough real estate market and rental property analysis.

Also, be sure to hire pros to inspect the property, screen potential tenants, and learn everything you can about the real estate market. Keep in mind that there are plenty of ways to invest in real estate without owning, financing, and operating physical properties. Options include REITs, real estate stocks, real estate crowdfunding , and real estate partnerships. You also might consider investing in yourself by learning a new skill or getting a new license.

Many real estate investors, for example, become licensed real estate agents or brokers —not necessarily to work as one, but to take advantage of the benefits, such as multiple listing service MLS access, networking, and the commissions earned on sales and rentals. Mortgage lending discrimination is illegal. PwC PricewaterhouseCoopers.

Financial Crisis Inquiry Commission, via govinfo U. Government Publishing Office. Real Estate Investing. Home Equity. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. Table of Contents. Choosing a Bad Location. Negative Cash Flows. High Vacancy Rates. Problem Tenants. Hidden Structural Problems.

Lack of Liquidity. What are some ways to diversify real estate investing? How can one minimize the risks of being a landlord? How high can a landlord raise rent? The Bottom Line. Alternative Investments Real Estate Investing. Part of. Real Estate Investing Guide. Part Of. Real Estate Investing Basics. Investing in Rental Property. Alternative Real Estate Investments. Investing Strategies.

Tax Implications. Key Takeaways Owning real estate consistently ranks in the top place among Americans as the best investment opportunity. Key risks include bad locations, negative cash flows, high vacancies, and problem tenants. Other risks to consider are the lack of liquidity, hidden structural problems, and the unpredictable nature of the real estate market. Here, we detail seven such risks. Article Sources.

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