How to Invest in Private Real Estate with Less Risk: A Primer

Just like stocks and bonds, commercial and multifamily real estate investments come in all varieties. Literally, in all shapes and sizes, all conditions, with all manner of backstories.

Different real estate investments, like different stocks and bonds, carry varying degrees of risk and reward.

The most conservative real estate investments — in other words, those considered the least risky — are the most annuity-like, offering relative stability and predictability. Think a fully leased neighborhood shopping center with tenants paying current market rents, few if any delinquencies, no upcoming lease expirations, and maintenance and improvements up to date. Or a relatively new warehouse leased to Amazon at market rates for 15 years. Those assets, generally speaking, should generate consistent returns with dividend-like cash flow, with their overall value rising or falling incrementally with the surrounding market based on macroeconomic growth and the supply of competitive product serving the same user needs.

At the other end of the spectrum — in other words, among the most risky real estate investments — is new development built speculatively. Think of an office tower with no tenants signed before the first shovel hits the dirt. That asset, which may not be completed for a couple years, will attract tenants at an unknown pace, also based on macroeconomic factors, various local market forces, and the supply of competitive product.

The investor returns on a speculative development like that one could fall within a very wide range. Maybe while the building is under construction the developer entices a major corporation to move its headquarters to the building, absorbing 75% of the space on Day 1 of its occupancy. Or maybe the developer isn’t so lucky, and only a fraction of the space gets leased before the building opens for business. You get the idea.

Between these examples of the lowest-risk and the highest-risk real estate investments are a range of opportunities representing safer bets, for sure, than the speculative office building described above, but also with the opportunity to generate higher returns (more reward) than the shopping center example.

Maximizing Reward While Minimizing Risk

Midloch operates in this range, typically deploying a value-add strategy with the potential to generate higher returns than the most conservative investments, but potentially lower returns than the true gambles like the speculative office tower that has the potential to be a big winner or a big loser. In threading the needle on returns, our goal is to maximize reward while minimizing risk. In other words, take very calculated risks.

Here are two examples that fit our risk-return profile:

First, let’s stick with the neighborhood shopping center. But in this case the center is only 70% leased and some of the tenants are less desirable, plus the property is facing some deferred maintenance and maybe it’s poorly marketed in the trade area. This shopping center generally will sell at a discount relative to the example above, and for good reason: the property needs some love, including some new tenants.

To us, the opportunity is there to add value to the center by improving it – curing the deferred maintenance, carefully pursuing selected tenants to fill vacancies and turning over some existing tenants, and working with tenants to better market the center overall. Capital improvements, tenant curation, and improved operations are just three ways that value can be added to an asset to increase its cash flow and the likelihood of more versus less appreciation at the time of sale.

Second, let’s look at a relatively new industrial-flex property that’s fully tenanted with positive cash flow, but with its story not fully written either. Maybe the rents are somewhat below market, or the property is over-levered (thus with high financing costs), and there is available land on the site that could be built out or sold off altogether. This is a pretty conservative investment but with incrementally more risk and higher return potential than a development that is fully baked with no remaining opportunities for value creation.

Individual investors have their own risk-return profiles they apply to their investment portfolios the same way a firm like Midloch approaches its own. Said another way, we’re describing an investing philosophy or, in our case, a lens through which we underwrite and model the performance of different investments. (More on how we do that in a minute.)

Of course a funny thing about risk is that even when we’re prepared to take it on a calculated basis, we take numerous steps to mitigate it. For example, before we invest, we air out the opportunities and challenges associated with every asset to all but ensure no surprises. Then we underwrite and model the performance of potential investments to further assess risk. In other words, we never stop thinking about it.

How Midloch Works to Minimize Risk

How do we do that? How do we identify and manage investments in a way that minimizes risk?

To start with, we don’t often chase assets in markets that are prone to hyper-growth or even major boom/bust cycles. (Though we do scout discounted and distressed assets most everywhere.) Rather, we typically invest in markets that are consistently consistent — with solid, stable demographics, supply and demand generally in balance, and some nice growth tailwinds expected over the medium term (say three, five or seven years).

Often the markets we invest in have a high presence of government agencies, educational institutions, and major healthcare facilities such as teaching hospitals and medical centers that are magnets for public and private investment. These are all characteristics, generally speaking, of markets with solid underlying fundamentals that should support demand for income properties like the ones we invest in.

Notably, we also seek to make investments at a discount relative to market pricing. For example, we can save money by buying property in an off-market transaction, which generally avoids a bidding war and often results in lower commissions and other fees paid. Same with a property that’s in some level of distress, such as in advance of the current owner’s facing a balloon mortgage payment that will be a challenge for him or her to make.

Other ways we often identify to unlock value:

●       Buy property and spin off (sell off) excess land.

●       Buy property in areas with high barriers to entry or where the supply-demand balance is tight or likely to tighten in the short and medium term.

●       Buy property where rents are below current market rates.

●       Renovate property to achieve a rent increase or a renovation premium.

●       Grow other income or miscellaneous income by charging for parking or other services.

●       Lease up previously vacant space.

●       Work with local operating partners, who often bring scale to bear for the benefit of our joint investments, to improve property performance.

●       Streamline property operations to reduce expenses.

●       Invest in green-energy infrastructure to minimize a property’s carbon footprint and reduce ongoing utility costs.

●       Refinance property on more favorable terms, potentially using clean-energy financing, incentives, or rebates for energy efficiency improvements.

As you can see, before we shell out even a dime, our goal is to identify multiple ways to improve cash flow and appreciation to increase returns for investors, while de-risking investments; in other words, lowering the risks going in to maximize the return.

In the same vein, we’re also conservative in our underwriting relative to projected rent growth, expenses, income, and future values including the prices we’re projecting to realize at the time of property sales. Being conservative in our underwriting is also a form of risk reduction for investors.

Your role as a real estate investor is to determine your own risk-reward profile and financial goals in the context of a diversified investment portfolio, and then to identify investment sponsors and opportunities with similar profiles that can help you achieve your goals.