Risk and real estate
By: J. David Chapman/November 7, 2019
Investment involves risk and rewards. Normally, the higher the risk, the greater potential for significant gains and losses of invested equity. Generally, one must take more risk to achieve a higher return. Most investors understand this principle, but two questions are: how much risk is appropriate and what real estate class carries the least risk?
Many investors are growing weary of low returns in conventional investment funds and turning to real estate, but contemplating in which class of real estate to invest. There are essentially five choices for investors to consider: multifamily, industrial, retail, hospitality and office. Let’s look at the fundamentals of each.
Multifamily: Multifamily properties have an increased need for management. The management tasks increase with the number of tenants and number of units; however, so does the efficiency. These buildings often have higher maintenance costs, but frankly, I’ve found them to be lower risk because of the higher ease of occupancy.
Industrial: Industrial real estate brings long leases, higher yields, and relatively steady returns. Typically, industrial leases are net leases, meaning the tenant is responsible for most expenses, taking the variability out of the costs. The downside is a significantly higher initial investment and greater risk of environmental problems.
Retail: E-commerce has been a tremendous economic disruptor in the retail real estate sector. Investors looking into retail should plan to own spaces with potential to sell things that can’t be “Amazon-ed.” Yoga, martial arts studios, hair and nail salons, restaurants, coffee shops and others offer products and services that cannot be purchased on Amazon.
Hospitality: This category appears to me to be the riskiest of all. With the shortest-term leases, as short as one-night, there is very little certainty of future incomes. Just as in retail, this category is experiencing its own disruption from sharing economy companies such as Airbnb. This disruption might bring opportunities in the hospitality sector, but will certainly increase the risk.
Office: Normally considered one of the safest categories with longer lease terms, office is highly dependent upon increased employment rolls. Leases tend to have built-in increases and tenants may be responsible for utilities, making it a decent hedge against inflation. On the other hand, it tends to be one of the first affected in an economic downturn.
J. David Chapman is an associate professor of finance and real estate at the University of Central Oklahoma (jchapman7@uco.edu).