Understanding Investment Risk + 4 Ways to Assess It

The issue with understanding investment risk in private equity real estate is three-fold. First, in general, investment offerings often do not clearly address it; they tend to shy away from mentioning that investments, especially those exposed to debt, inherently involve risk.  Second, during due diligence, some operators and sponsors do not know how to uncover or underwrite the project risks.  Lastly, passive investors often do not know how to interpret the information they are presented with, from financial models to financing terms.  These issues can lead to overly optimistic projections that go undetected.  

Many get caught up in the projections, preemptively counting the money they are going to make.  This leads many passive investors to simply skip what they don’t know or don’t understand and look for the easy button.  The variability of outcomes and potential risk take a back seat.  And the largest, most commonly missed risk is default risk related to debt.   

Passive investors should be thoroughly reviewing financial model assumptions—and not just taking the sponsor’s word for it.  And bear in mind that reality usually does not play out the way it is portrayed in the investment models.  

It is time to lift the veil and talk about what often seems taboo in this space: debt or default risk.  We are going to review a few specific areas you should dig into so that you can confidently evaluate investment opportunities.  Then, we are going to discuss four ways to potentially measure said risk. 

Identifying Risk

How do you identify risk?  There is no stock market for private equity real estate where you can measure beta (standard deviation).  It just doesn’t exist.  Well, there are some limited data sets, but they are not generally available to retail investors.  As such, these are of little help.  So how can anyone measure or even talk about risk-adjusted returns?  

The best options are to identify risk factors at their source and evaluate how much variability they create in an investment projection’s outcome.  Many sponsors will provide a range of expected returns, which is a good place to start.  Are you comfortable with the lowest end of the spectrum?  If not, you might want to pass.  But if you are, you still need to go a few steps further in your review, specifically focusing on downside risk due to financial leverage.

(For our article on leverage, click here.)

What Drives Risk?

Risk in real estate is mostly driven by an investment’s exposure to debt, and therefore, leverage.  In this case, we’re talking about negative leverage.  If things go wrong—things that might be completely out of your team’s control— they can go very wrong quickly due to financial leverage working against you.

Investors should look closely at the debt that will be used, not only the loan terms and covenants but also the underwriting and assumptions surrounding debt repayment.  Those assumptions may include (but are not limited to) rental rate increases, expense ratios, and selling cap rates.

But to measure risk specifically related to debt, you can use several metrics to help you gauge the risk: 

Revenue Stress Test

As told by a percentage, this test determines how much the revenue of the property can decrease before the property turns cash flow negative.

Take the total free cash available for distribution (total revenue minus expenses, debt service, and capital expenditure) and divide that by total revenue.  If the result is 5%, then you know revenue can only decline by 5% before the property hits breakeven on cash flow.  

You can also vary the expenses, debt payments, and other assumptions the sponsor makes to see how they change the outcome.  Higher numbers are better for this metric.

Revenue stress test = [free cash available for distribution / total revenue] x 100

Remember, when a property does not have enough cash to pay lenders, and if there are no reserves or recapitalization from investors, the property is on a path that can lead to a 100% loss as the bank seizes the asset.  Real estate requires enough cash flow and capital to stay afloat long enough to ride out any waves.

Loan-to-Value (LTV) Ratio

This is one of the most common measures, and it is also one that is overly complex.  LTV is a percentage that measures the loan amount divided by the property value. The waters of a seemingly simple ratio get muddied by how those two amounts are determined—or manipulated to make an investment look less leveraged. 

LTV = loan amount / property value

The loan amount could be the balance at the time of purchase or after additional draws to complete value-add work.  The property value may be determined in several ways:  from the purchase price, by an appraiser, or after renovations are completed.  All are acceptable, but all lead to different results.  

It is important to understand how the sponsor calculates LTV and what that means as it pertains to leverage and risk.  Typically, LTV ranges from 50% to 80%, with stabilized properties on the lower end and value-add projects on the higher end.

Debt Service Coverage Ratio (DSCR)

This is often used by banks to determine how much cushion an investment has in terms of cash flow.  It is calculated by dividing net operating income (revenues minus expenses) by the loan payment amount.  When a property generates significantly more cash, hence a higher coverage ratio, than needed to pay the loan, investors and the bank can feel more secure that the property will not fall into distress.

DSCR = net operating income / loan payment amount

Always determine whether the loan has fixed or floating rate debt.  If floating, know how much the rate can rise before the property becomes distressed.  DSCR’s typically range from 1.0-1.25 on value-add projects and from 1.25-1.5+ for stabilized projects.

 Debt Yield

Also used by lenders, debt yield is a similar concept to DSCR.  It helps financial institutions determine the maximum they are willing to lend based on the property’s income.  It is measured by dividing net operating income by the loan amount, yielding a percentage.  Lower debt yields indicate a riskier investment.  Typical debt yields range from 8% on the low end for highly stabilized properties to at least 10% for more value-add properties.

Debt yield = net operating income / total loan amount

Investors should look at both the DSCR and debt yield and adjust the sponsor’s assumptions to understand how they impact these ratios.  They should also keep in mind what happens at the end of the loan term when it must be refinanced.  In addition, when the investment is ready to sell, how will these ratios inform the next buyer’s purchase price as they seek to place new debt on the property?

Final Thoughts

For one reason or another, the 2021 market will eventually shift.  It will likely revert to the average (cap rates will increase, interest rates will increase, prices may fall).  No one knows exactly when and how that will happen, but as an investor—be sure that you will get at least your initial investment back.  

Understanding the likelihood that a property or operator will be able to withstand changing conditions is crucial for successful real estate investing.  Before making any moves, investors should keenly evaluate the debt and leverage risk of each investment.

At Cira Capital Group, we help busy professionals diversify their traditional investment portfolios by creating funds, pooling investors’ capital with our own, and investing in commercial real estate with world-class operators.

Interested in learning more about our investments?