Ranking the real estate asset classes in terms of risk
Dear all,
Im having trouble to find arguments when ranking real estate asset classes in terms of risk.
Im mainly looking at:
-Multifamily
-Retail
-Office
-Student living
-Light industrials/Logistics
-Hotels
-Co-working spaces
I know that there are several factors playing into this, but assuming as much is equal is possible what would be a plausible ranking? What are the key factors and questions I have to ask myself when analysing riskiness? Is this also a linear function of cap rates?
Kind regards
THE answer is so obvious when you look at the delinquency and special servicing rate of each asset as well as the recovery % after default
Not always though. Hospitality is known for being highly volatile but the CMBS delinquency rates are actually the lowest of any asset class except for multifamily. However, in past cycles we see hospitality shoot up and down for delinquency rates as it as much an operating business as it is a real estate business. The ups and downs heavily correlate to consumer spending.
Where do you find that information?
like everywhere, Trepp, CMAlert, rating agencies Fitch S&P Kroll etc.
Is this a homework question?
Interview prep
Coworking is an asset class now? When was this voted on?
If anything, Data Centers should be on this list instead of coworking.
Try to think about the types of risk a real estate asset has.
You have risk associated with the durability of income, which could be associated with the credit quality of the tenants, the average lease term, the long term demand growth for the space.
You have risk associated with costs, how high are regular maintenance costs, how high and frequent are capital improvements. Also keep in mind the cost inflation varies across industries.
You have risk associated with prices. Liquidity can be important when trying to exit, how sticky are cap rates in that sector relative to interest rates.
If you think through the specific risks of each property types, you can make this ranking yourself, but also be able to discuss specific reasons why, which will be impressive for your interview.
As a more general question, assuming we are talking about a somewhat central urban location, I would say office is the riskiest. Office is subject to chunky, staggered blocks of tenant rollover which may occur all at once or in a short period of time. This makes the cash flows significantly more variable and harder to predict, esp. when you consider you technically have no idea how much downtime there will be, how much you will need to spend on TIs and free rent, etc. You also have the issue of juggling tenant credit, which can affect financing proceeds and sale valuations. If a tenant goes bankrupt two years into a deal you spent $100 in TI, a year of free rent and 6% commissions, that's not good. Finally, it's just a more capital intensive business (TIs, commissions, higher capex == $$), which amplifies the downside.
In terms of development, office financing almost always requires 25%+ pre-lease commitment. But, developers often get stuck in a catch-22 where tenants aren't looking for space 3 years in advance, so it's hard to get a lease commitment and financing that allows you to get a deal out of the ground when a building can easily take 3 years to complete.
With multifamily and to a large extent hotels, the lease exposure is chopped up into much smaller pieces. Leases are subject to some seasonality, but having rolling tenant expirations largely insulates an owner from these risks. There are more manageable turnover costs, and credit risk is not as big of an issue (just evict them and get someone else).
Im surprised! I always thought central urban office would be the least risk after residential...And I also thought long WALTs are a good thing as they ensure cashflow visibility which in turn makes Co-working/Hotels more risky?
If hotels are one of the least risky assets why do they have the highest caprates?
Hotel is normally considered one of the riskiest assets, but it's cap rate is also high because it has the highest cap ex requirements, so cap rates are higher because that is priced in.
He has some points about office development, but take it with a grain of salt. Whoever said "it depends" is correct. Ask most hotel owners today what's more risky, and they'd rather have a performing office.
As for office, it depends on market, location, and many other factors. For instance, some office buildings in good locations, like older Class B, have numerous small tenants and don't have the same type of leasing risk as he described.
No way does having longer, larger leases make your cash flow more volatile. The cash flow of a leased up office building is the most predictable. Your rent roll should be managed so only a percentage of your leases are expiring at any given time.
Hotels are considered the most risky, because you are completely at the mercy of day to day demand fluctuations.
All of this applies to retail as well except for development timing which is typically 6 months-1 year (depending on tenant size). Although, in some cases this process can get dragged out by the tenant's real estate committee extending the timeline for a significantly longer period of time.
Love this perspective! Before reading your comment, I viewed risk solely based on tenant turnover rate and confused busy with risk/ downside. Retail is more labor intensive given the high turnover esp. in today's world, but it is easier to backfill therefore downside is smaller in this view.
"It depends"
Assuming a higher cap rate = more risky, than:
From riskiest to less risky:
Hotel Suburban Office Class A/B Retail Neighbourhood Downtown Office Industrial Class A/B Multifamily
Many thanks!
One more question: Why do luxury hotels have lower cap rates compared to cheaper "limited service" alternatives? Seems more risky and counterintuitive to me? (e.g. market downturn, first thing people would abandon is luxury)
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