An equity investor’s risk in a real estate deal increases with exposure to changes that may negatively affect the outcome of an investment project.
In many ways, risk and exposure are the same thing.
The impact of time on risk
Time has a dramatic effect on this concept of exposure and risk: The more time added to a project, the greater the exposure and the greater the risk.
Risk factors that can wreak havoc on real estate development projects include:
- Business risk (fluctuations in economic activity over time)
- Liquidity risk (non-cash flow assets tend to be non-liquid)
- Legislative risk (such as unexpected zoning changes)
- Interest rate risk (dramatic rise in rates during development)
These risk factors are exacerbated by prolonging the time it takes for equity investors to earn cash flows and see a return on investment (ROI).
Essentially, the longer the time between initial equity investments and incoming cash flows, the greater the chance of negative impacts on investments due to unknown risk factors.
Raw land developments involve a great deal of time — months or years — before assets can be stabilized and cash flows become consistent.
Are the risks worth it?
Whether these increased risks are offset by adequate returns is highly dependent upon the equity investor, the development itself and the current risk environment.
While Realtors hate when I answer their questions about returns with, “It depends,” the fact remains that ROI is dependent upon a great many things:
- Does the equity investor have an aggressive outlook?
- Is the equity investor willing to take on moderate risk for moderate return?
- Does the development itself have a value proposition superior to that of its competition?
- Is the current risk environment acceptable to the investor?
- Is the potential gain worth the moderate risk?
Depending on your answers, the return may justify the increased risk.
Thinking like an investor
I always try to put myself in the investor’s shoes by thinking about what he or she would be most concerned about. I determine which risk factors are controllable and which are uncontrollable, and I gather valuable information for risk mitigation planning.
A thorough market study, a clear comprehension of the local legislative environment and a complete understanding of the economy — including interest rates, inflation and environmental shifts — can help decrease exposure felt by the investor.
How to decrease risk
We know that an increase in time between the investment of equity and the return of cash flows will increase risk for the investor.
As a development partner, you should seek to reduce that time and risk as much as possible by doing the following:
- Forecasting the local market’s impact on your project
- Predicting the moves of your competition
- Leverage relationships with legislative decision makers or those in the know
- Providing loan guaranties
- Taking responsibility for construction cost overruns
- Making effective product choices and placements
- Implementing thorough, smart marketing campaigns
- Participating in aggressive pre-leasing or pre-sales
While these tips are sure to work, keep in mind that effective project management can organically push a development project ahead of schedule, which is another great way to reduce risk.