For today’s episode, we will be discussing risk, how we define it.
We will go over the 2 types of risk, debt terms, and how to quantify or identify the risk in a syndication opportunity.
What can we potentially lose with risk?
We will talk about these things…and more in another episode of Multifamily Investing Made Simple in under 10 minutes.
Tweetable Quotes:
“You have operational risk and you have a kind of macro market risk.” – Anthony Vicino
“Everything in business at the end of it can come down to just supply-demand. If you’re on the right side of that curve, you’re going to do well” – Anthony Vicino
“And there’s got to be some risk because that’s what you’re getting paid for when you’re investing. You’re getting X return for taking on X risk.” – Dan Krueger
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2 Types of Risk Explained In Under 10 Minutes
Anthony Vicino: [00:00:15] Hello and welcome to Multifamily Investing Made Simple. This is the podcast where we take the complexity out of real estate investing so that you can take action today. Today, we’re going to be talking about actually one of the most complex topics in all of investing.
Anthony Vicino: [00:00:29] So to do it in under 10 minutes, we’ve really got our work cut out for us. Dan, let’s talk about risk. What is risk? How do we define it?
Dan Kreuger: [00:00:37] Oh, Jesus is getting deep really fast already right at the deep end. So I’d say risk is what’s the potential downside in anything you’re looking at? How much could you potentially lose on an investment or an endeavor? That’s what I would say, at least for this discussion, is a risk. And there’s got to be some risk because that’s what you’re getting paid for when you’re investing. You’re getting X return for taking on X risk. So there’s got to be some kind of risk there in order for you to make some money, because that’s what you’re getting paid for. So the question is, how do you quantify or identify the risk in a syndication opportunity that you’re looking at? And how do you bump that up against what your investing parameters are and what your risk tolerance is? It’s very subjective questions, different for everybody. But I think with this little under 10-minute episode, if we can help you look in the right places to identify the risk, then I think we’ve done our job.
Anthony Vicino: [00:01:40] Yeah. And the risk is such a hard topic because you could ask 10 different investors what’s a risk to them, and they’re going to find it slightly differently and they’re going to have different metrics for measuring it. And the problem is that there’s not one standard way. So let’s just for our purposes here, like Dan said, lock into like what’s the potential downside? And the way that I look at risk really comes down to there are two types of risk. You have operational risk and you have a kind of macro market risk. So the operational risk is if I’m investing a hundred million dollars and I give it all to my 12-year-old nephew, well, there’s probably some big operational risk there that he probably doesn’t know what he’s doing. Right. He’s probably going to lose all my money. Maybe it’s I don’t know. He might be you might be really good. I know he’s been listening to our podcast, so maybe it’d be really great. But the point there is like who you invest with and like, what’s the business plan they’re planning on executing? Do they have the capacity to actually execute it? And you would think that this wouldn’t be that big of a question to try and answer. But it’s actually, I would say the primary risk you’re going to encounter in the deal because everybody can put together a proforma and underwrite with rejections, and acquiring properties is actually not all that difficult. It’s when you start executing daily and, you know, that’s where the money is actually made. And so if you’re in bed with an operator who sounded great at the beginning to really good marketers, they were really great at getting the deal locked down. Now the property is being operated, but it’s not hitting the projections. Well, that’s because you took on some operational risk there.
Dan Kreuger: [00:03:11] So I guess one of the key ways to identify an operational risk and seeing if that’s something that you’re exposed to is to look at what the business model of the business plan is for this investment, this theoretical investment that you’re looking at and saying, OK, is what has this operator done before? Is this a business model or a business plan that this person or this group has implemented before? If so, how many times have they done it? And is there a historical track record that I could look at? Or is this their first time doing this thing? Am I investing with a guy who’s been doing multifamily for ten years and now he’s bringing a self-storage or a mobile home park or something else to the table like that, even if it’s a really great opportunity? You’ve got some operational risk there because you’ve got an operator doing something for the first time, as opposed to getting into a deal with somebody who’s doing something that they’ve been doing for the last ten years over and over and over again. And they’ve got this track record of success with this very specific thing that they’re doing.
Anthony Vicino: [00:04:10] Another aspect to think about here is they might have a ton of experience executing this exact business model. That might not be the operational risk, but might be is maybe they’ve acquired maybe they’ve grown like 10x in the last quarter and they’ve taken on like five new properties, a thousand new units. And so they’re growing very, very quickly. So there’s an operational risk there, which is as you grow really quickly, you start to feel the growing pains. And is this asset going to feel those pangs? Are they going to be able to fold it in with the rest of the portfolio seamlessly? Or is it going to be bumpy because their focus is so split and the resources are so diminished because of all the growth?
Dan Kreuger: [00:04:53] And these are things they’re going to cover just by asking a lot of questions. It’s not going to be entirely clear if you’re looking at an offering memorandum or a deal package from an operator, whether or not they’ve grown exponentially and they might be struggling to get things done. But this most recent acquisition, but through your questions, you can ask them, OK, what is your track record been for the last five, ten years? And you can start to look at it. At the acquisitions and say, OK, is there an exponential increase here, have you guys taken on, you know, 10 times more properties this year than you did the prior year? And if so, like, how do you guys how do you plan to manage all this new inventory? And if they don’t have a good answer, then you might have some risk there.
Anthony Vicino: [00:05:33] Yeah. And at the end of the day, it all comes down to the answer. Maybe they made a key strategic partnership or alliance and now their team has tripled. So, like, there’s always there can always be a good reason is just knowing what that reason is. Now, the other type of risk besides the operational risk is macro market risk. And that is the harder risk to you can’t predict it. That’s covid level events. And like what’s going to happen in the market with rents and vacancies. We can project based on trends, but it’s very difficult to look too far into the future with any degree of certainty. So what are we looking for in particular when it comes to projections and underwriting assumptions as it pertains to the market?
Dan Kreuger: [00:06:15] There’s a lot. There’s a lot. I mean, one really easy one that any passive investor can pick out from an underwriting page on a marketing package for a deal is what are their cap rate assumptions. Right. Is the operator do they have some lofty assumptions about what the market’s going to be doing over the next five years? You know, for those who either don’t know, cap rates are inversely correlated to value. So a rising cap rate equates to a market that’s getting softer. So if you’re looking at somebody’s package and they have the cap rate compressing year after year for the next five, six years, you might want to ask, what is your thesis? How did you come to assume that the market’s going to keep it getting incrementally better here? And also, have you done sensitivity tests to see how this deal changes if maybe the cap rate stays flat or even goes up a little bit? Like is your business plan predicated on the market continuing to improve? Another one is interest rates. Look at the debt that they have on the property. Is that is that in alignment with the Fedspeak that we’re hearing from the Fed? We’ve been hearing that rates are going to be held quite low or at least the next two to three years here. How does that line with the debt terms that your operator has to have their rates fixed for one or two years or seven or 10 years? Right. So trying to get your head wrapped around what kind of interest rate risk they have and also the cap rate assumptions. Those are two of the biggest ones I can think of right there.
Anthony Vicino: [00:07:50] No, I want to tie into this, actually. When you mentioned the interest rates, another great one, market risk is the debt terms itself. You know, if it’s a three-year term, then that presumes that it’s going to be a really quick turn, like what’s going to happen in three or so. Like the term gets shorter. There’s a little bit more risk associated with that. You have to hope that the market stays somewhat similar and then a shorter horizon. So you can’t really you don’t have as much of a long runway to weather storms. So that’s something to keep in mind. Another aspect is let’s think about rent growth and expense growth and how do we model those out? Generally, in the last five, six years, we’ve been able to consistently model like five percent rent growth year over year and easily hit that. Is that such a fair assumption to make in a year coming off of covid and Vacances, maybe being a little bit higher than usual? I don’t know. Again, it’s all about the story that the operator can tell to justify why they’re making their assumptions. But generally, we like to air on the side of assuming that the future it’s going to be worse than the present. And if the deal still works, given Armageddon-type situations playing out, then you probably have a pretty good deal in your hands. But if you have a deal that really just relies on everything going well and the future world is better than it currently is, that’s honestly a lot of risks to take on.
Dan Kreuger: [00:09:12] Yeah, yeah. I think that’s it’s great to be optimistic about the future, but when it comes to investing, you’ve got to try to hedge some of that off somehow. So also say that when it comes to looking at pro forma projections that operatives put in front of you make sure that that aligns with what you know about the area that this deal is going down. And because at the bottom, at the end of the day, a lot of how the multifamily asset class performs is predicated on job growth and population growth. And so just from a really high 50000-foot macro level, it’s pretty clear for just about every metro area out there how strong their particular region is. And so what you want to be looking for is markets that have a diverse industry, because then you you can hedge off that kind of Detroit style risk where, you know, if one industry has a rough period or completely collapses, that that’s not going to drag down yours. Vestment, right, you could have a really great property in a great area with a great operator, and if the industry that in that area takes a hit, it has nothing to do with the operator or the deal or the multifamily space in general. You were just you just had too much of your you said too much exposure to one industry. So you want to find areas that have a diverse industry. You also want to see population growth and you want to see job growth because as jobs are created, more people are going to come in. And as more people come in, that’s going to cause rents to go up because of good old-fashioned supply and demand.
Anthony Vicino: [00:10:50] Everything in business at the end of it can come down to just supply-demand. If you’re on the right side of that curve, you’re going to do well, most likely regardless of your operational inefficiencies. Then this is why most operators have done so well in the last decade. It’s been a really rising tide where, you know, it’s been hard not to make money just because there has been this limited supply in high demand. And so don’t mistake that because that’s not always going to be the case. Don’t assume it’s going to play out that way in five years. So those are some of the big things to think about when it comes to risk. Honestly, you guys, we could spend another two hours easily on this topic coming out of all sorts of different angles.
Anthony Vicino: [00:11:31] But for the purposes of a 10-minute episode, just to get you noodling on the concept, I think this is going to suffice. So thank you for joining us. And we’ll catch you guys next week.
