Don't let your higher potential returns override your gut instinct.
If it doesn't feel right, walk away. The only way to factor in all of the intangibles that can't be qualified.
- Who are you buying from?
- What city are you buying in?
- What market factors are at work?
- General sentiment?
- Touch/Feel of a project
Most analysis is done on a pre-tax basis. Individual taxes vary, some are tax exempt. However, the ability to shield income is one of the most important benefits of real estate. Other tax considerations are:
- Writing off interest expense
- Cost recovery (aka depreciation)
- Commercial = 39 years, apartments = 27.5 years
- Tenant improvements = useful life
- Cost segregation can advance schedule
- Shields only income, not capital gains
There are some risks to consider in real estate. Just remember, no investment is worth a sleepless night. Historically real estate seen as higher risk.
- Return hurdles higher than equities/bonds
- Recent thought that more transparency and available information decreased risk – not true
- Still less transparent and less regulated than most
- Recent “credit crisis” is partially due to inappropriate pricing of real estate risk
- Never enough potential return to account for a bad deal
- Financial Risk
- Will NOI cover debt service?
- Potential for capital calls even in good deals (i.e. TI’s)
- Inflation Risk
- Agreements lock in rates for many years – will they keep pace with inflation?
- Some LL’s use CPI rate increases to hedge
- Most have base stops for expenses or NNN structure
- Political Risk
- Changes in laws change inability to produce NOI
- Zoning, building codes, environmental law, tax law
- Examples: 1986 tax law changes, ADA compliance
- Market Risk
- Changes in economic and market conditions
- Can be micro or macro
- Projection Risk
- Use numerous assumptions when creating DCF
- Changes to assumptions has big impact on CF’s
- Importance of conservative underwriting
- Only thing you can be certain of is that you will not hit your projections exactly
- Liquidity Risk
- Real estate is a cash business. Cash is always king. Needed for tenant improvements, operations, debt service, capital repairs, etc.
- Never assume something can be sold, even at a deep discount
- Capital markets (both debt and equity) serve as “oil” of the real estate engine.
- Interest Rate Risk
- Floating rate loans typical for construction and short-term notes
- Can hedge with caps, floors, collars, swaps, etc.
While risks may be present, there are ways to manage that. Here are some risk management strategies:
- Due Diligence
- Know everything about a property you can before you buy
- Diversification
- Buy different product types in different markets
- Key advantage of fund structure vs. one-off deals
- Insurance
- Credit Enhancements
- Lease guarantees, loan guarantees, letters of credit, corporate backed lease
- Shifting Risk to Tenants
- CPI, base stop and/or NNN
- Non-Recourse Debt
Contributor:
Thanks for sharing good information. David Lindahl
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