Beyond the IRR: Understanding Risk in CRE Investments

Do you eat raw chicken?

I’d wager a bet that you likely do not. How do I know? According to CDC, 1 in 25 packages of chicken are contaminated with salmonella, and being a reasonable person, you find those odds too high for comfort.

So what does eating raw chicken have in common with investing in commercial real estate?

Inherent risk.

Today, I’ll outline what I consider the most important factor when evaluating investment opportunities: the measure of risk I’m taking. I will discuss 5 most common areas of concern, and finish with a book recommendation.

This is a continuation of our How to Read a Real Estate Pro Forma series: check out Part 1, Part 2, Part 3, Part 4 and Part 5.

What’s Risk?

Risk is inherent in every investment activity: even Treasury bills come with a (tiny) measure of risk. In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision.

In theory, the relationship between risk and expected returns is straight-forward: as risk increases, so should expected returns. In reality, this relationship is rarely linear.

So how should you think about risk, when evaluating real estate private placement opportunities? To me, risk is the probability of investment going to 0. “What’s the most likely way this deal will lose money?” is the question I try to answer every time I evaluate an equity deal. The following five categories are the most common sources of risk, but the list is in no way exhaustive.

And before we dive in, let me remind you that this information is for education purposes only, and is not investment nor legal advice - do your own due diligence.

1. General Partner’s Experience

I firmly believe that experience of the general partner (GP or sponsor) is the best mitigator of risk. Does it help avoid all issues? No, but it helps minimize them.

Trust me on this one: few things are more painful than watching a GP learn lessons with your dollars. Choose GPs who have learned many lessons before you came bumbling along.

There is no line in the sand with what constitutes sufficient experience, but more is generally better. Of special note are experienced GPs who take on new (to them) asset classes. There are great GPs who manage to generate solid returns by investing across various asset classes. They are rare. Far more often, I run into excellent GPs who specialize in one thing only.

How can you assess sponsor’s experience? Learn how to separate skill from luck on the track record:

Skill vs. Luck

What to look for:Ask for detailed track records, and pay special attention to sponsor’s experience in a particular geographic market and size of prior deals.Track record must include cap rate and NOI at purchase and sale, as well as stabilized yield on cost.Ask about deals gone bad in the past and what the sponsor learned from those mistakes.

2. Leverage

Today, risk associated with leverage is top of mind for most investors, at least in the CRE equity space (not the case with private credit, but that’s a subject for another post). This is in stark contrast to 2020 and 2021, when most investors - LPs and GPs - ignored the risk of floating rate short term bridge debt.

Leverage is a beautiful thing to juice returns. Unfortunately, the inverse is also true: leverage can magnify losses. Many a deal has gone south (and wiped out LP equity) because of the wrong (or too much) leverage:

For a detailed dive on leverage in CRE, read this (the article comes with a downloadable sheet of common CRE debt terms):

Three areas to pay attention to:

1. Loan-to-value (LTV): the higher the LTV, the higher the risk.
2. Loan maturity forces the GP to refinance the loan, and depending on credit markets, overall economy, etc. timing might not be the most optimal. Amortization, while lowering cash flow in the near term, helps reduce loan maturity risk by reducing loan balance at refinance.
3. Interest rate risk. Most CRE investors learned about this risk when the Fed started hiking interest rates in 2022. Even loans obtained with fixed rate debt are subject to interest rate risk, if they are held to maturity (i.e. need to be refinanced).

What to look for:Understand terms of the loan: maturity, LTV (and LTC), covenants, rate, interest-only period, etc, pay special attention if the deal is underwritten with a refinance mid-hold. Ask about assumptions at refinance, and ask the GP to stress test for higher rates at refinance. See this Deal or No Deal example.

3. Capital Stack

Capital stack introduces its own risk. Generally, debt holders (lenders) have priority in repayment. Equity investors are paid after the loan, but there can also be a preferred equity sleeve (at origination, or inserted during a capital call, as in the visual below), as well as mezzanine (2nd position) debt, and/or a ground lease.

The higher your position in the capital stack, the higher the risk. For more on capital stacks:

What to look for:Understand where you are in the capital stack. Is there preferred equity ahead? How many loans? Run the math on disaster scenarios. How wide is the margin of safety for your position?Contrary to common belief: one can lose money by being in debt or preferred equity position. Evaluate the last dollar of detachment and pay extra attention to valuations used to calculate LTV/LTC. Pay special attention to capital call provisions and manager loans in the PPM. Seek legal advice, if necessary.

4. Aggressive Assumptions

What’s aggressive? This is very subjective, and this changes with time, depending on the macro environment, investor sentiment, etc.

Look at AS MANY offering memos as possible. There is no other way to get familiar with what’s aggressive and what’s conservative in any given market for any given asset class. With enough deal exposure, you will get a feel for where on the spectrum any given deal lands.

Top 4 suspects (in no way a comprehensive list):

1. Exit cap rate - the easiest metric to manipulate to show any IRR your heart desires. No one knows what the cap rate on exit will be, so ask for a sensitivity table and stress 200-300 basis points up from what’s in the pro forma.
2. Organic rent growth assumptions: tiny number, big impact (esp. on multi-family, MHP and student housing properties with over 200 units). Historically, housing rent growth does not exceed the overall rate of economic growth (when analyzed over long durations of time). For primary markets, it’s something in the 3-3.5% range, in secondary and tertiary markets, anything over 2.5% calls for a close examination. For retail, industrial, medical, etc - a lot more nuance, but you will likely have long-term tenants in place, with pre-determined rent increases.
3. Expense growth: doesn’t matter much for NNN deals, but pay close attention to expenses on all other asset types.
4. Occupancy assumptions, especially for single-tenant NNN deals. This can make or break a deal (and cause the GP to lose the property, if vacancy ends up being longer than anticipated with insufficient reserves).

Most importantly, remember: pro formas are nothing other than GP’s best estimate of what might happen in the future. Certain inputs (see above) have an outsized impact on returns.

5. Waterfall and Fees

This is the absolute last thing I focus on - most deals don’t make it to this stage, if I’m being perfectly honest. That said, don’t overlook this area:

“Show me the incentive and I will show you the outcome” — Charlie Munger

Sponsors have to make money on deals: after all, they do the work, and their risk exposure is a lot higher compared to LPs (especially with meaningful co-invest).

Compensation structures incentivize certain behaviors - YOUR JOB is to understand what is being incentivized (for example, AUM growth, or generating outsized returns). There is no right answer, find operators whose interests are as closely aligned with yours as possible.

Kris Rymer, CPA 's excellent article on waterfalls will help you understand how the mechanics work behind the scenes:

The tangent issue with fees and waterfalls has to do with risk transfer: having one preferred hurdle effectively helps protect LPs’ downside - while having multiple layers of hurdles on the top effectively limits investors’ upside.

Let’s take a hypothetical example: a deal with no preferred return, 80/20 split and 2% acquisition fee effectively incentivizes the sponsor to buy deals, regardless of what their return potential is (GP makes 2% day 1, and gets paid pro-rata even if the deal underperforms).

It is my sincere hope that next time you see a deal with limited upside and unlimited downside, you think of raw chicken.

If you made it this far, I would like to share a book recommendation. This is one of my all-time favorite investing books, although it is not, in fact, about investing at all. Annie Duke provides a framework that will improve your decision making when evaluating uncertain outcomes - such as those we face when evaluating private placement deals. I hope you enjoy the book as much as I did!

-Leyla Kunimoto