The challenges, risks and rewards of real estate

I know that I know nothing – classical ancient Greek (Athenian) philosopher Socrates

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BY KOSTA KIOLEOGLOU

People tend to believe that real estate investments operate under a safety net and have extremely low to zero risk. This is not quite right. In reality, this is a very bad belief that can lead to bad decisions and big losses. Investors have made it in real estate investments and many others have lost everything.

Real estate investments are an easy way to add diversity to your portfolio with a risk profile that best suits your needs. High, medium or low-risk property investments all have their pros and cons. Understanding the benefits and challenges of real estate investments is critical. One of the most common mistakes people make is to proceed with an investment without doing proper research to understand the investment opportunity and the risks associated with it. Most do not consider the market and project risks but more crucial is the need to be able to realize that maybe they do not have the knowledge to make this kind of investment on their own necessitating professional advice and support.

Advantages of Investing in Real Estate

Cash flow plus upside: Real estate can provide current cash flow (if it is leased to third parties) as well as an opportunity for appreciation if the value of the underlying property increases during your period of ownership. As a consequence, it is possible to achieve substantial short-term and long-term returns on your investment.

Low volatility: While capital improvements can potentially make a significant and immediate impact on property values and/or rental rates, real estate values do not fluctuate as often or as dramatically in the short-term as many other popular types of investments, such as securities. Investing in real estate, therefore, can add diversity to your portfolio without exposing you to significant market volatility.

Leverage options: Real estate investors can use a loan to acquire real estate with a smaller outlay of initial capital, as well as to improve cash flow. The loan will create a mortgage secured by the property. If net income generated from operating the property (meaning proceeds available after all property expenses are paid) exceeds the cost of the loan, you can receive cash flow generated from money you borrow in addition to income from the equity you personally invest. In the meantime, the loan allows you to put your capital toward other uses. The cost of money is critical in order to make a decision to use leverage options.

Active management or passive investment: While many people invest in real estate by purchasing a property directly, you can also invest passively in a real estate project managed by others. These options include investments in real estate syndications (private placements) and purchasing shares in real estate investment trusts (REITS). These types of investments are typically managed professionally by individuals and firms with expertise in the applicable market and asset class. Opportunities may include a single property or a fund with multiple assets. While investors must conduct their own due diligence on the manager or sponsor of the investment and familiarize themselves with the underlying real estate and/or investment strategy, the day-to-day operations, as well as matters relating to acquisition, disposition, leasing and financing (including property-level due diligence) are handled by the professionals.

Broad range of risk profiles: Investing in real estate involves some degree of risk. Real estate offers a broad spectrum of risk profiles to suit your particular tolerance. It is important to understand that a successful real estate investment can line your pockets generously, while a failed one can set you back. A ground-up development, for example, will have a greater degree of risk than the same property will have once it is fully constructed and leased. A “value add” opportunity, where an existing property is upgraded or repositioned in some way, should have a risk profile somewhere in between. There are many factors that can affect the risk of an investment, so it is important to understand the particulars before you commit your funds to a project.

Disadvantages of investing in real estate

No hedge against downside: Unlike savings or money market accounts, where your original principal is certain to remain intact, it is possible to lose your entire investment if a real estate project is unsuccessful. There is no insurance program that covers funds invested in real estate projects or protects you from the failure or malfeasance of a sponsor of a real estate investment. You may find yourself unable to sell a property for as much as you originally paid for it when you are ready to exit the investment. Or, you may be unable to find ways to generate sufficient income to cover your taxes, insurance and operating expenses.

Illiquidity: Market liquidity refers to the extent to which a market, such as a country›s stock market or a city›s real estate market, allows assets to be bought and sold at stable prices. Although most illiquid assets share a degree of similarity in being hard, tangible assets, this is not the main contributing reason as to why they are considered illiquid. Illiquidity stems from the depth of supply and demand within an asset’s market, as well as the nature of the asset, such as ease of valuation and ability to transact. Although this may hint at a market with a healthy level of supply and demand, you must look to the nature of the market and the asset to understand why real estate is considered illiquid.

Lack of public markets: Contrary to most securities, most real estate transactions are done in private markets. Whereas public markets offer daily pricing and extensive consumer knowledge, private markets are priced on “as-needed” basis and lack transparency. Private markets are harder to access as well, as many private markets require a degree of credibility or status to enter into.

Difficulty of transacting: Real estate closings require several interested parties, and a lot of paperwork. Between structuring an offering, arranging financing, and gathering necessary due diligence items, the process could take weeks, only contributing to lack of ability to turn real estate into cash quickly.

Access to capital: There is no question that real estate can be expensive. When transactions require significant pooling of capital, in the form of both equity and debt, transactions move slower. During the operational phase, while equity owners may have difficulty finding a buyer for their respective interest, lenders may put covenants on how the property is managed financially. Although these factors highlight why real estate is considered illiquid, they do not tell the whole story. Transaction costs, demand pressure and inventory risk, and inability to find buyers and sellers all add to the illiquid nature of real estate.

The inability of real estate markets to quickly adjust and react in market shocks is increasing its sensitivity to market risks and exogenous factors, which may unexpectedly change the forecasted market dynamics and market trends. 

Financing risk: The primary risk of using leverage for investing in real estate is that debt service on the loan must be paid before owners receive distributions of net cash flow (after payment of expenses). And, the outstanding loan balance must be satisfied before the owner can receive sale proceeds. These concerns are heightened if the loan has personal recourse to the borrower. Additionally, most loan agreements have covenants to allow the lender to sweep or impound cash flow if things go wrong, even if the problem is caused entirely by tenants or other third parties. Failure to comply with the terms of a loan agreement can result in penalties or fees, loss of control over property operations and perhaps even foreclosure. Understanding how financing and gearing operate is very important in order to decide the LTV (loan to value) ratio and the interest parcentage that you are ready to accept and accept to undertake the relevant risk that comes with it.

Understanding the possibility of a bad scenario: The risk that a real estate investment will not perform as projected is heightened if you have personally guaranteed a mortgage loan for the property or if you have committed your family’s savings or money that you need for your day-to-day living. Most investment opportunities have minimum net worth requirements: While stocks, bonds and mutual funds are generally available to anyone with sufficient cash to cover the purchase price, investing in real estate requires a degree of financial wherewithal and large financial commitment. If you are not able to fully perform your loan obligations (regardless of who or what caused the problem), the lender may be able to foreclose and/or recover any deficiency from your personal assets unrelated to the real estate. This risk can be mitigated by (a) purchasing property on an all-cash basis; (b) obtaining a non-recourse loan if possible; (c) using a lower amount of leverage in comparison to the cost of the property (which lowers your risk of non-payment due to lack of cash flow and may permit you to have more lenient loan covenants); or (d) paying down your principal loan balance as quickly as possible, assuming prepayment is permitted;(e) if you invest capital which is not needed for any other reason and you can afford to lose it if something goes wrong. The psychological pressure that investors face when a project is not performing as expected can lead to irrational decisions, which can be destructive for the investor.

Reliance on tenants and market dynamics: Buy to rent schemes are very popular in the real estate industry. If you lease your property for rental income, your success is dependent upon the existence and performance of your tenants. You must keep your property occupied at a profitable rental rate and minimize downtime between tenancies. Your success is depending on the market dynamics, supply and demand. In the long term, forecasting market dynamics and trends is a very risky process, which includes many dangers.

Investing in Real Estate Comes With Certain Risk Factors

There are several factors that can affect the level of risk included in a real estate investment project. Geographic location can help or harm a prospective investment. Factors such as high population density, local job growth, access to highways, parking and public transit can help boost occupancy and reduce risk. Negative demographic trends, lack of support from local government or a poor local economy may adversely affect an investment.

Some classes of assets are arguably riskier than others, with all other factors (like location) being equal.

For example, hotels—where operating revenues can vary based on occupancy and rates—have more volatile cash flow than a commercial property with long-term leases and tenants with strong credit.

Risks specific to office properties include trends to reduce the overall office footprint, whether due to telecommuting, “hoteling”, or eliminating paper file storage, as well as changing tenant appetites for open floor plans and collaborative space. At a minimum, office investors should ensure that they plan for sufficient reserves to address these types of tenant improvement requests as they arise.

The nature and number of tenants at the property and the duration of their lease terms will also impact investment risk. If a property has a single tenant, the success of the investment depends on the economic viability of that tenant. The terms of the tenant’s lease, and the costs of retaining or replacing that tenant when its term expires, are also important factors.

A greater number of tenants can protect you from having an all-or-nothing income stream. On the other side, you may spend more time and resources keeping the property fully leased, maintaining common areas, and ensuring that all of the tenants timely pay rent and perform their lease obligations. If rents fluctuate in the market, properties with greater tenant turnover will be impacted at their bottom line more quickly.

There are also a variety of tools available to help mitigate financial exposure in a real estate project.

Obtaining lease guarantees and maintaining operating capital and additional reserves can reduce the impact of a tenant default or unexpected property damage.

Using professional property managers or working with experienced, full-time real estate sponsors can help you avoid potential problems before they arise, and to promptly resolve issues before they escalate.

Keeping any leverage at a lower loan-to-value ratio can help reduce your risk if rental incomes decline.

So far, we have tried to give a quick holistic overview of real estate investments and their risk. In reality, the risks and the elements that can influence any real estate project are unlimited. Markets are sensitive to local and international changes and turbulence. Anything that can influence the macroeconomic environment where the project is operating has to be considered. There is no generic rule that secures the profitability of any project, in contrary; the only guaranteed condition is that project performance is subject to market dynamics, trends and changes.

In a short period of time, major markets around the world stalled and reversed their course from positive to negative due to unexpected developments although they had been booming and were expected to keep outperforming for many years. Dubai suffered the world’s steepest property slump in the global recession, with home prices dropping 50 percent from their 2008 peak, according to Deutsche Bank AG in just a few months.

Greece is another example of a market that was growing fast but from 2011 onwards went into a huge recession with properties losing over 45% in value on average. Turkey, US, Spain, Cyprus, just to mention a few are some of the countries where real estate “betrayed” the trust of investors. UK property market is also under huge pressure after the 2016 referendum, the most unexpected development in the European history for the last 50 years happened. Britons voted yes for a Brexit. This triggered a domino effect on each and every economic sector of the country increasing volatility and instability, negatively affecting the UK markets.

Market risk, combined with oversupply, lack of understanding of basic investment principals and wrong estimation of the market dynamics can be a catastrophic combination. All the above are simply called RISK. The risk you take every time you decide to put your money in a bank account, ignoring the fact that if the bank will go down you may lose the majority of your savings. This is the risk that comes with every investment offering low, medium or high returns and the risk that accompanies every project under any conditions anywhere in the world. Even those investments that sound very safe such as treasury bills and bonds are supposed to have the guarantee of a state have been proven a bad choice many times in the market’s history.

Real estate can be an important and lucrative addition to your investment portfolio. You must be certain to conduct your own due diligence in order to assess the risks of any given investment and to evaluate whether those risks are consistent with your financial objectives. It is always prudent to consult with your own financial advisors to help you determine whether a particular investment is a good fit for you. It is of great value to be able to understand how much you do not know in order to be able to control your risk exposure. Thinking that we know everything and skipping expert advise is what leads to wrong decisions and high risk.   

Kioleoglou Konstantinos
REV Valuer by Tegova
Civil Engineer Msc/DBM
Managing Partner, Avakon Ltd.