Pick One Risk
“Investing involves risk. Returns are not guaranteed. See important disclosures.” The fine print that most people skip over in their excitement to get their money invested is full of reminders that there are no free lunches, and that earning a return on your capital means taking on some measure of risk.
For professional investors, taking calculated risks and navigating them successfully is the core of their job description. The trick is identifying which risks are worth taking, and which ones are best left for someone else.
Within real estate, there are plenty of ways to take risk in the pursuit of return. It might be rezoning, construction, and leaseup in the context of a new development, or betting on an up-and-coming location with an adaptive reuse strategy. It could be buying a vacant office property to lease and sell, or renovating apartments with the intent to raise rents. It could be backing a first-time sponsor or buying into a complicated ownership structure. The list goes on and on.
Where people often get into trouble is when they layer multiple risks on top of one another. Those risks often don’t scale linearly but can quickly compound, particularly when leverage is added to the mix. Taking a risk on a complicated redevelopment is one thing. Doing so in an unproven location is another. And layering expensive leverage in a complex structure on top of it takes the range of possible outcomes much wider.
Pick One Risk
Having spent my career managing real estate portfolios for family offices and institutions, picking the right risks is at the heart of what I do. And with more conservative strategies that often boils down to taking one main risk per investment.
This approach works especially well in the context of a larger portfolio, where it allows for simplicity and scalability. The timing and impact of potential negative outcomes can be monitored and managed to ensure they can be weathered. And the investor can rest easier knowing that, for each investment in the portfolio, the primary risk factor is understood and has been accounted for.
What might this look like in practice?
Buying an older, imperfect industrial asset because tenants prioritize its location or lower rental rate over its newer competition and the associated bells and whistles.
Buying a neighborhood retail center with a large near-term lease expiration because you are confident that the existing rent is well below market, and it can be backfilled minimal downtime if renewal negotiations are unsuccessful.
Paying what feels like an exorbitant price for a trophy asset and location if it is intended to be a generational hold and you are confident the income will grow steadily over time.
What we want to avoid is combining too many risk factors in one investment.
A highly specialized lab building might make sense in an established life science hub, but not in a tertiary market without a deep roster of potential users.
Buying a property leased to a tenant with weak financials without a significant security deposit may be worthwhile if the space is functional and easily backfilled if they run into trouble, but not if it would be difficult and costly to replace them.
Taking construction and development risk in a market with high barriers to entry provides more room for error than a market with lots of competing buildings going up at once.
Permanent vs Temporary Risk
One way to get comfortable taking risks is to think about permanent versus temporary conditions. All else equal, we should prefer taking risks that can be removed. A shaky tenant can be replaced. A complicated structure can be simplified. Vacancy can eventually be filled.
But a property can’t be moved from a bad location. Challenging site topography can’t be changed. Environmental contamination can make a property unusable.
Eliminating temporary risks from properties is a path to great returns. Taking on permanent risks is tempting fate.
What About Leverage?
Leverage is the one risk that is nearly ubiquitous in the real estate world. Most bad outcomes involve an unsuccessful business plan combined with too much leverage or a loan expiration that doesn’t allow room for error. It is the ultimate amplifier of returns, for better or worse.
And leverage is unique in that it is a risk that is completely under the investor’s control. Factors like location, property age, tenant profile, or functionality all must be accepted by the buyer in order to come into play. Don’t like the risks involved in a particular property? Let it go and move on to the next.
Leverage, on the other hand, is actively sought out. The investor has control over the amount and terms they are willing to accept. During down cycles, when lenders are extra conservative, it is hard to take on too much debt (because it won’t be offered). In upcycles, on the other hand, lenders get more aggressive, loan amounts creep up, spreads tighten, covenants loosen, and deals that shouldn’t get done have multiple loan options available. If the supposedly conservative loan officer can get comfortable with the risks at the asset level, why wouldn’t the borrower take them up on it?
Savvy investors recognize that there are times when it is safer to push leverage and times where it should be applied sparingly. The most aggressive leverage should be reserved for the assets with the most consistent cash flows (core apartments, for example), while assets with more income variability (traditional office, for example) should be carefully financed. The more complex the execution, the more conservative the leverage profile should be – and this goes double for loans requiring a personal guarantee.
With a thoughtful approach, conservative investors who are unwilling to push risk at the asset level can enhance returns at the portfolio level by dialing the leverage up when it is accretive and down when it isn’t.
The Ultimate Risk Mitigant
At the end of the day, the ultimate risk mitigant is the price paid for the asset. Given a low enough purchase price and a large enough margin of safety, buyers may find themselves able to get comfortable with a property that is slightly outside of their traditional strike zone. After all, taking calculated risks and successfully navigating them over time is how wealth is built.
By picking one risk, preferably one that is temporary, and leveraging it smartly, even conservative investors can enhance their returns – and still sleep soundly at night.