“Risk management is a more realistic term than safety. It implies that hazards are ever-present, that they must be identified, analyzed, evaluated, and controlled or rationally accepted.” – Felix Beck
Those of you who have been following me for a while have likely heard me talk about taking calculated risk. While investing in real estate, and multifamily in particular, has many benefits, it does not come without a risk. The one guarantee I will make is that risk is always present. Just like with any investment, there is a real risk of loss of capital. This reminds me of my own experience as a former commercial lender when I had to take calculated risk when lending multi-millions to borrowers in the middle market space.
While one cannot eliminate risk, one can think through the possible risks upfront and ways to mitigate them for an optimal outcome.
In today’s quick snippet I’ll cover a few of the key risks common to multifamily investing and offer a few mitigation strategies for passive investors to be aware of, so they can be better positioned to evaluate deals and the deal sponsor’s risk management.
1. Cash Flow Risk. A lower than expected rental income or higher than expected expenses could quickly lead to thinner or potentially negative NOI. Having optimistic or aggressive assumptions not supported by current data, can quickly lead a deal from hero to zero.
This is why, as a way to risk mitigate potential variability, it is important to have realistic assumptions about projected rent growth, vacancy (physical and economic), and expenses (adjusted for tax and insurance), validated by third parties like the lender, property manager, insurance broker, boots on the ground contact. You can reference our 6-step blueprint on key assumptions on this topic.
2. Valuation Risk. If anyone knew where markets would be, that person would likely be betting or consulting hedge funds. As such, it is not only important to buy the deal right (see my recent article on how to quickly and efficiently vet a deal for success), but also to prudently think through the exit valuation. If markets rise, then there is only an upside. However, if markets contract (leading to cap rate reversion), that can have material impact on valuations.
Projecting cap rate expansion throughout the tenor of the hold period is one way to manage the risk of potential market fluctuations.
3. Market Risk. In prior snippets I discussed the importance of knowing the market and submarket and questions one should ask for preliminary diligence. In addition, understanding the demand and supply dynamics and absorption trends is key. In 2023-2024, many submarkets were impacted by new supply of multifamily entering the market in an environment where household formation was slowing down, resulting in rent decline and increased vacancy.
Making sure the property has adequate cushion as measured by low break-even occupancy and adequate operating reserves is one way to mitigate the risk upfront. In addition, having multiple exit strategies provides optionality and additional flexibility to pivot if/as needed.
4. Economic Risk. If a recession is to occur, are the employers in the area recession resistant or diversified enough? Does the property have particular tenant concentration? Is this a one-employer town? Do tenants have adequate household income? All of these factors can impact the property performance.
Selecting markets that have multiple employers, preferably export related and recession resistant, diversified employer base, and minimum median household income of $50MM helps mitigate such economic risk.
5. Interest Rate Risk. Macroeconomic, global, and geopolitical factors can impact interest rate movements. And as we saw in the 2022-2023 period, those can quickly change over a short period of time.
I am not in the game of speculating where rates would be. As such, I like to lock in fixed rate debt. Not all debt providers have that option but they would be able to offer risk mitigation tools such as swaps or caps to mitigate the interest rate fluctuation risk.
6. Operational Risk. This pertains to the operator’s/key sponsor’s ability to run the property, which includes managing the property manager, lease up, marketing, maintenance, managing the rehab (if applicable).
Understanding the operator’s performance track record, how they handled prior mistakes or challenges, their business and real estate background is key. In addition, I prefer to work with vertically-integrated operators, as that keeps them one step closer to the asset and operations. Alternatively, if a third party property manager is hired, I want to understand their track record and how long they’ve worked with that sponsor.
7. Legal/Regulatory Risk. As the name suggests, this pertains to the risk of lawsuits or other legal matters like zoning, title, building code compliance, licenses required to operate the property
There are a number of ways to mitigate this potential risk, including working with a licensed real state and SEC attorney at the onset of setting up the investment opportunity. In addition, working with a property manager and being well versed in the local and regional regulatory requirements is imperative. Last but not least, having adequate insurance that not only provides liability mitigation but also loss of risk coverage, including lost rental income in a natural disaster scenario.
8. Liquidity Risk. There is nothing worse than running out of money at the onset or in the middle of a deal. A lot of unexpected events could happen.
How one can help mitigate against such risk is having adequate operating reserves (ideally at least six months of operating expenses AND debt service) and capex reserves with contingency cushion (at least 10% or more) from the beginning.
9. Refinance And Finance Risk. Those working on live deals in mid-2022 to early 2023 likely remember many situations where the lender walked away or changed material terms to the deal in the last minute. Certainty of close is important, especially when working through so many variables during the diligence.
While one cannot control the lending landscape, working with a broker or a lender with a proven track record of closing deals usually helps. They may not be the least expensive ones but you get what you pay for.
In addition, when evaluating investment opportunities we do not bake in a refinance in the numbers. A refinance, which in most cases (2022-2023 were an exception) returns the initial principal investment in full or in part, typically inflates projected returns. I do not want to depend on a refinance to meet projected returns, especially if the rate environment happens to be unfavorable to refinance at that future point of time.
I recognize we covered a lot today but hope today’s snippet provides a streamlined blueprint on the key risks to consider. I’d like to end on a positive note form Benjamin Graham I often refer to:
“The essence of investment management is the management of risks, not the management of returns.” – Benjamin Graham
Download The Busy Professional’s Quick Guide To Investing In Multifamily here.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.