New Rules for Managing Risk
Managing risk in real estate is now more important than ever. However, the rules for risk management have never been more unclear for most people. The "new" risk management can be summed up in two parts:
- Do not lose money
- Make money
Yes, those are listed in order of importance. While conventional wisdom has always been focused on getting the highest return on investment possible, the more realistic approach to risk management in real estate investing is to avoid losing the initial investment and, only then, to make money. That does not have to feel like a pessimistic or defeatist mindset. Keep reading to learn how to manage risk correctly in any phase of the real estate cycle and particularly during a downturn.
The First Step in Managing Real Estate Risk: Impeccable Underwriting
In real estate investing, nothing helps an investor sleep better at night than good underwriting. In addition to being a necessity, underwriting is an incredible checkpoint that ensures that an investor or investment team is not just drinking the juice when it comes to a big idea. A third-party underwriter without a financial stake in the project is capable of providing a clear and objective underwriting process.
Watch as company founder, Ari Rastegar, discusses his number one priority; to protect investor capital.
What Good Underwriting Looks Like
First, it is necessary to get over the misconception that having lots of deals in the pipeline is an indicator of growth and success. In truth, an efficient and profitable investor is typically doing less than 1% of the deals they are looking at in any given year. This requires three things to consider:
- An understanding that there is a need to pace decisions.
- Rejection of the scarcity mindset that says a deal is as good as it is going to get.
- The ability to remove emotion and ego-driven opinions from the decision-making process that stem from being personally attached to the success of a project.
The reason why a third-party underwriter is vital is because this provides an objective avenue for assessing a property. Brokers have a habit of "hyping up" the potential of properties. How many times has a broker guaranteed an investor that a property is going to make "a gazillion" dollars? However, the numbers start to look a lot different once you're able to shift through the deal to break down the specifics.
This is where having your own process for vetting properties internally becomes important. However, what's even better than having a single internal process is having a third-party underwriter looking at the deal through their no-fluff, objective perspective.
The reason why a third-party underwriter is vital is because this
provides an objective avenue for assessing a property. Brokers have a habit of "hyping up" the potential of properties. How many times has a broker guaranteed an investor that a property is going to make "a gazillion" dollars? However, the numbers start to look a lot different once you're able to shift through the deal to break down the specifics.
This is where having your own process for vetting properties internally becomes important. However, what's even better than having a single internal process is having a third-party underwriter looking at the deal through their no-fluff, objective perspective.
Who needs to run through a deal before any kind of judgement can be made? An internal process should pass through at least three different gatekeepers before it ever gets in front of the decision team. First, technology can provide a good "first scan" to see if a project passes the basic requirements for an investment company's standards. Next, the property needs to reach the fund manager for a deeper analysis. At this point, the deal is scrutinized by a team of internal analysts without any vested interest in the outcome of whether or not this deal will pass through.
The Stress Test
Does it hold up? That is exactly what a stress test performed at the underwriting level reveals using conditions that a standard analysis might not take into account. If a deal passes the initial analysis, it is then moved on to a stress test that runs a property's profitability and resilience up against a number of different scenarios. This is a situation where data is going to be more important than emotion or perception. When done properly, only business plans that pass the stress test with a high degree of certainty are allowed to proceed.
Learn more about Rastegar Capital's approach to due diligence and underwriting in this short video with founder, Ari Rastegar.
The Underrated Analysis Point: Exit Opportunities
While inventors are often quick to project profit potential based on a business plan playing out in a straight line, very few draw emergency exits on the blueprint when moving forward with an investment. Remember how this article opened with the idea that not losing money is essentially more important than making money when setting goals for risk management in the current market? Varying exit opportunities are vital to this mindset.
Focusing on varying exit opportunities means looking at strategic points that allow an investor to bow out without taking a hit on their initial investment amount. An example would be an investor looking at a multifamily project. In the past, that investor may have solely focused on viewing the success of the project through the cap rate or the IRR. That would be either being satisfied or dissatisfied by the yield after dividing the property's net operating income by its asset value. Under this mindset, the investor is looking internally to find ways to increase profitability by investing deeply in the property. This could mean bringing the value up with a full renovation in order to increase rents.
The updated view of risk management looks at things slightly differently. Spending $30,000 per unit to be able to boost the IRR does not feel like such a sure thing. An investor operating under the new risk management view is looking beneath the floor to see the full potential of the property. This means looking at the land that the property belongs to from a redevelopment standpoint.
Raising rents has its appeal. In some cases, it will 100% be the way to foster a property's profitability. However, good risk management understands that raising rents may not always be the only option. When exit strategies are in place, stagnant rental rates do not have to put the brakes on an investment’s viability. In some neighborhoods where demand for real estate is evolving at a speed that is much faster than a simple multifamily unit can keep up with, the decision to tear down a property that no longer fits the needs of the investor or community can be the best one.
This is where the stress test comes back into the picture. In this situation, the investor should have an idea of the viability of successfully applying for rezoning in the specific place where the property is located. Of course, the "tear down and rezone" strategy is just one strategy that should be considered.
Dual Business Plans
Having an exit strategy does not mean that exit is the only path to profitability. Let us consider an example of an office building purchased in a prime neighborhood in Austin. As the leading secondary market in the country right now, Austin is attracting a massive influx of both residential buyers and corporations seeking to own space in the city. When purchasing an Austin office building from the 1960s, investors can look at viability from the perspective of either renting out office space or executing a condo conversion strategy. The conversion strategy may be the ultimate long-term exit goal. However, it may not be what is appropriate at the outset.
In this scenario, the investor can move forward with getting occupants while also putting pieces in place to get a tear-down plan approved by the city. Under the new way of managing risk, it is vital to have a plan for if everything goes to "hell in a handbasket" while still moving forward optimistically.
Watch as company founder, Ari Rastegar, discusses how great real estate should be a response to humanity.
One Thing That Has Not Changed: Location, Location, Location
While the market may feel strange and unfamiliar to some investors at the moment, the reality is that a good location remains one of the best buffers against risk. That is because location moves a property like nothing else can. What if you need to sell suddenly because a true, fast exit strategy is the only viable exit strategy? When the location is good, it is far less likely that you are going to lose your capital in a fire sale. This is precisely why focusing investments in Austin is a good risk-averse strategy. As one of the most in-demand markets, Austin consistently attracts investors who understand the upward growth that is projected for the upcoming decades.
While all goals may not be realized when selling off an asset quickly, an investor can still be confident that they can still follow the new first rule of risk management in real estate investing that prioritizes simply not losing money. Ultimately, those who can figure out without losing investor capital can live to fight another day!
Another Piece of Risk Management: Leverage
While leverage often gets a bad name, it has its place in risk management. Most people are used to playing by the rule of not going above 65% loan-to-value ratio. However, a broader understanding of leverage should not necessarily box investors into this belief. In some cases, going up to 75%, 80%, or 85% can be smart. For instance, having 80% to 85% leverage while buying it for $0.50 on the dollar.
Of course, investors do not want to run the risk of being penalized for higher leverage when they want to pursue the types of returns they are seeking in their larger investment plans. This is where the multifamily properties referenced above can come into the picture. When buying a 1960s or 1970s vintage product, there is an opportunity to scoop up massive land sites that are currently profitable while still having a larger plan for redeveloping those properties in the future. With the equity view being lower multifamily properties, the leverage can be higher at the beginning.
Watch as company founder, Ari Rastegar, discusses The Truth About Leverage in this short video clip.
Final Thoughts on Market Risk: Patience and Timing
Investors cannot control what cannot be controlled. In the current market, "control" can only look like risk management. This is why the risk-to-reward ratio is ultimately the guiding light for making decisions. For this reason, many investors are simply sticking with secondary markets that offer the combination of lower entry points and higher demand. Unlike primary markets that always involve high risk in order to get reward, secondary markets offer scaled-down risk with rewards that can match those found in primary markets in many cases. Factors pushing up the risk-reward ratio of secondary markets include:
- Population migration growth.
- Corporate relocations.
- Available space for development.
- A receptive attitude toward expansion and zoning changes.
When it comes to risk in secondary markets, no investor is insulated from being wrong in the short term. However, it is much harder to be wrong about risk on a long-term basis in this type of market because secondary markets are primed for consistent and sustainable long-term growth in ways that other markets simply are not. While investors who scrape the bottom of the barrel for low-cost opportunities in obscure markets may strike gold once in a while, this is a very low-reward scenario that often leaves the investor taking a loss on the initial investment. With a slightly higher risk that involves a deeper investment, an inventory can be insulated from a total loss in a secondary market because they are very likely to be able to at least preserve their initial investment in a fire sale.
The final thing to talk about when assessing the new rules of managing risk in real estate is simply a lot of patience. When acquiring a new property, there may be an instant and strong desire to "fix and flip" in order to begin generating revenue now. However, this could place an investor in a situation where they are sinking money into an investment that is not meant to bloom in its current form. Based on an analysis, the property might be a much better investment when it is reimagined in a newly zoned setting. Waiting just two to three years could be a better option. Of course, this takes an understanding of how to manage expectations in a world where people are skeptical of a "wait and see" approach with anyone who is holding their money.
What should investors walk away with when trying to understand their relationship to risk under the new dynamic of the market? Good risk control is the antidote to skepticism. Good risk control can only be achieved by having third-party controls in place for assessing deals.
Not Taking on Construction Risk
Another interesting topic surrounding new ways to manage risk in real estate is construction risk. For investors, this is one of the easiest areas to cut risk because there is not necessarily a need to shoulder the burden of ground-up construction alone. Being an investor and project manager at the same time compounds risk. What is more, the construction business has much tighter margins than investment.
That is why a better option can be to bring in a general contractor who takes on the risk of completing the project. In this setup, the investor is in the role of underwriting the execution of the contractor's risk. When taking bids, real estate investors need to be diligent about vetting a contractor's track record, insurance, processes for sourcing projects, and beyond.
