When you understand how to evaluate risk, you can form, test, and reform your investment thesis.
The past few years have thrown a few curveballs to commercials real estate investors, to say the least.
If you’ve kept your eye on the ball, however, you likely have seized the opportunity to buy cash-flowing assets at a decent price and been able to benefit from inflationary rents and historically low interest rates. On the other hand, you may have been caught in the crosshairs of NIMBYISM and government control, hindering your ability to effectively run your property. Or, you may have not taken any action, and now you’re trying to figure out what to do and when.
Let’s address the most important factor: risk.
What is risk? Risk can be defined as a situation involving exposure to danger.
Sam Zell, a legendary real estate investor said: “Risk is the ultimate differentiator. I have always had a deep and complex relationship with it. I am not a reckless person, but taking risks is really the only way to consistently achieve above-average returns—in life as well as in investments.”
It is our job to understand the risks for each project we are pursuing and do the best we can to quantify it, plan for it, and eliminate it. That’s what our investors expect and, frankly, what they deserve. If you are investing solo, you had better understand how to work through the risks of each market, project, and business plan implementation.
Risk is one of the most misunderstood aspects of a deal. It can be considered anything that is unknown or not a part of the plan; however, saying something is high risk is often incorrect. For example, a risk with a high likelihood of occurrence but a small impact may be completely acceptable. On the other hand, a risk with a medium likelihood of occurrence and high impact may be completely unacceptable.
Here’s a model for risk from real estate pro Victor Menasce that can be extremely helpful .
FTW’s risk management plan represents these risk types:
- Time delay
- One-time financial cost
- Recurring financial cost
How do you manage risk properly?
- Enumerate the potential risks.
- Qualify the risks (time, feasibility, cost, quality).
- Determine the likelihood.
- Quantify the impact if the risk comes true.
- Develop contingency plans for the risks with the higher impacts.
Some of the risks in the market are inflated asset values and a rapidly changing debt environment that will not support these prices. The rapid pace of inflation and interest rate increases creates macro risks that influence the debt markets, making it more difficult to mitigate debt risk on projects.
Many recent acquisitions in the marketplace over the last 12-24 months have been secured with short-term, floating-rate debt. This has been the way many value-add sponsors have secured capital that aligns with their strategy and the prices they have been paying for these assets. However, the volatility in short-term rates creates an extreme, exponential risk profile for using unhedged, floating rate debt in the current environment.
Additionally, the cost of buying a “cap” on interest rates for these loans has become extremely expensive, and the interest rate caps one can secure still leave you exposed because these caps are even much higher than we would deem desirable.
Sam Zell notes: “Opportunity is very often embedded in the imbalance between supply and demand. It could be rising demand against flat or diminishing supply or flat demand against shrinking supply. At some point, those two lines are going to intersect, and when they do, people will make money.”
What Is Your Investment Thesis?
FTW implements a multidisciplinary approach using a latticework of nonbusiness mental models to assess risk internally at the specific investment level and externally from a macroeconomic approach. We then measure said risk against perceived benefits and value creation to make investment decisions. Typically, we are looking for assets that are well below replacement cost, creating a margin of safety for investors.
We are still bullish on multifamily, affordable housing, and residential projects when they are priced correctly, and we are buying with a margin of safety (hard to find). We are still bullish on the property type due to a supply/demand imbalance with users and physical spaces (i.e., there is not enough housing to satisfy the number of housing units demanded).
Rising demand against a supply that is growing less quickly and not nearly at a rate to absorb that demand should push rental rates higher. However, the capital demand for these properties is also at a historical all-time high, pushing asset prices through the roof. Although many justify overpaying for these assets because of the physical supply/demand imbalance, the rate at which the capital markets have pursued these assets has pushed values too high to take advantage of the physical supply/demand imbalance.
At the prices investors are willing to pay for multifamily, the financial risk involved outweighs the opportunity to exploit the physical supply/demand imbalance. In other words, at these prices, the risks often outweigh the returns.
We are tracking the Green Street Property Price Index, and although prices seem to have flattened and even declined slightly, they are still at levels that are much higher than the pre-pandemic levels we were accustomed to.
While we will continue to evaluate on-market and off-market multifamily properties for acquisition, the opportunity to buy these properties at the right price are fewer and farther between than any time in recent years. We have the most success identifying distressed properties we are well-equipped to manage. These properties can generate the high risk-adjusted returns we require.
With that said, we have continued our efforts to analyze data and trends, as well as pair that with anecdotal and qualitative data we receive on a regular basis to create investment opportunities we feel will generate exceptional risk-adjusted returns.
As we evaluate the real estate market as a whole, and especially other property types and sectors, we notice other supply/demand imbalances that are riper for the picking than multifamily is today. The areas where we are especially interested today are in neighborhood retail, neighborhood office, well-located Class A office, and flex industrial properties.
Why are each of these compelling to us at this time? We have data and anecdotal evidence to support that on the physical supply/demand side, we have stronger physical demand than is largely believed to exist standing against a flat or flattening supply. On the capital markets side, these properties are trading at spreads above their historical cap rates.
What this means is these properties are performing better physically than the market believes; yet the capital markets, due to some foundational misunderstanding about these properties, are not highly demanding these properties, bringing asset prices to historical lows. If you believe capital demand for these assets will come back once these assets have a longer time to prove their resilience and necessity in the physical marketplace, as we do, then now is the time to acquire these properties at a discounted price and be in a position to sell back into a higher capital demand (thus, higher priced) market.
Although the majority of our strategy focuses on value-add and core plus assets, we have also identified opportunities for ground-up development where there are unique and profound supply demand imbalances. These can be found in particular markets and submarkets today in multifamily, build-to-rent (BTR), and industrial where new Class A properties are often selling for well above completion costs. We will pursue opportunities in these strategies with the right partners at the right time as they become available; however, we do principally believe the majority of ours and our investors’ portfolios are better off in the value-add and core-plus strategies.
When you can start with evaluating risk, your investment thesis can be formed, tested, and reformed. It seems these days, you need to be testing more often than not.
Logan Freeman brings over five years of real estate experience to the team. He started his real estate career with a single-family rental portfolio where he executed over $50 million in acquisitions. From there, he moved to Clemons Real Estate where he was the leading salesperson year over year as he created, lead, and executed a unique strategy for representing buyers in 1031 transactions.
Freeman oversees the Investor Relations and Marketing Divisions at FTW Investments and contributes heavily to its project sourcing and capital raising efforts. He leads XchangeCRE, an affiliate of the firm that assists 1031 exchange investors in identifying replacement properties and other tax-advantaged reinvestment strategies, including TIC investments with FTW Investments. He leverages his people skills and transaction background to drive new acquisitions, capital raising, and investor relations. Freeman is a voting member of the firm’s investment committee.