Asset Risks:

The risks associated with the asset include; value, physical condition of the property, structural and code issues, utility issues and crime in the neighbor.  The current rental income and expense also have an important role.  Even if the asset is desirable, overpaying for increases the overall risk.

Economic and local market changes:

The current economic market is uncertain.  National/ local market conditions vary as a result of Federal Reserve interest rate changes, inflation, international crisis and changes in local and global governmental policies. Economic dips can lead to higher unemployment rates and massive layoffs.  As a result, tenant housing can become un-affordable, resulting in increased vacancy.  Rent prices may need to be lowered to compensate for these factors.

Risks Associated with Real Estate:

The real estate and the stock market are cyclical. History has shown this repeatedly during expansion/contraction.  There is a potential risk of acquiring an asset at the height of the market and being forced to sell at an inopportune time.  As a result, the asset manager’s business plan may be unachievable therefore affect the targeted return. Asset managers and investors must be aware of the current market cycle they are investing in and plan according to hedge future downturns

Competition in the marketplace:

 There is competition for tenants. Competitors may own a newer product, provide a different array of amenities or be less expensive which could affect the vacancy rate.  In certain markets there is a shortage of construction labor and materials which can increase the development and renovation costs. In short, competitors can adversely affect profit margins.

Legal Action:

Legal issues can arise from a variety of reasons. Whether the accusation has merit or not, the judicial system can be a time-consuming profit burner. 

Management Risk:

Multifamily success rely’s on the operators and property managers.  A multifamily project has numerous day to day activities including; marketing, tenant screening, tenant relations, maintenance, bookkeeping and etc.  Neglect of any of the elements can slowly deteriorate the attractiveness and value of the property. Undermanaged assets tend to underperform and result in profit loss.

Proforma Projection/ Underwriting Risk: 

Operators create a proforma that projects the financial return.  The proforma is based on various factors such as projected rent growth, expenses, vacancy rate, and cap rate. Aggressive underwriting can lead to underperformance of an asset, while conservative underwriting accounts for unknown issues that may arise. Operators with conservative underwriting often budget for contingence capital which can be used later as an investor windfall. 

Overleverage Risk: 

Multifamily Residences are purchased with debt.  The ratio of debt, known as loan-to-value (LTV) is a metric used to evaluate leverage of the asset.  Typical leverage for a multifamily deal is 30-35%.  High leverage can starve the property if there is a downtown leading to the risk that the property’s cashflow may not sufficiently serve the debt.  The lender could foreclosure on the property and the common equity holders could be wiped out.

Financing Risk: 

Properties purchased with short term variable interest rate loans may be subject to risk when interest rates rise.  A higher interest loan raises the cost of the loan and will affect cash flow.  If there is insufficient cash flow to service the loan, the property could default. When short term financing matures, it needs to be paid back either through an exit sale or refinance. Terms of refinancing are unknown and the option may not even be available, as evidenced during the Great Recession.  At loan maturity, if the balloon payment cannot be made, or a refinance cannot be arranged, the investor’s continued ownership of the property could be jeopardized.   

Illiquidity of Real Estate

Real estate is a hard asset that is illiquid (incapable of quick disposition).  Multifamily projects tend to last 5-7 years.  A disposition event may be postponed due to market conditions.  Disposition in an inopportune time can affect the capacity to deliver investor return and could result in investor losses. In this case, a mitigation measure is implemented, extending the project and holding the asset longer.  Investors need to be aware that the capital invested in multifamily project could be inaccessible for years. 

Investors Distributions Risk

Asset Managers estimate investor return based on their proforma (project returns).  Distributions can vary during the lifetime of the investment based on the performance of the asset and market conditions.  Asset managers mitigate this by offering a preferred return (8Pref).  Preferred return is a threshold return that investors will receive before general partners receives their portion of the cashflow.  If the preferred return is not met the unpaid balance carry’s over.  The preferred return will accumulate until all distributions are made. If the projected lifetime preferred is not met investors will be paid out first from the available capital once the debt is paid.

Insurance Risk:

Operators of multifamily project face risks every day. To limit liability from natural disaster, resident-caused damage, personal injury or internal property damage, comprehensive insurance acquired. Scenarios can arrive were a in which the property could suffer a liability in excess of insurance coverage.

Tenant Retention:

Tenants are the fundamental life line of a multifamily project.  The ability of an Operator to strategically market the property to attract and retain tenants is crucial to the success of the project.  Understanding the competition and creating a unique product is vital.

Operating Expenses:

 It’s normal for expenditures to increase. The costs of operating real estate – taxes, insurance, utilities, and maintenance – tend to move up over time. We have limited control over some of our operating costs, and if costs increase it may reduce the amount available for distribution to investors.