Evaluating Real Estate Investments—Risk Factors

Deciding on fingerings is an advanced aspect of playing orchestra instruments.

Musicians playing wind instruments have limited fingering options because some notes can be played only one way. Pitches are created on a clarinet by opening and closing (or covering) holes in the instrument, some covered by keys and some just open holes. Some notes have only one combination of keys and holes that the clarinetist must press to sound that note--a specific finger is assigned to most keys or holes. Pianists must press a particular key to sound a pitch, but unlike clarinetists, they can use any of their ten fingers to do so.

String instruments are different. While there is only one way to play the lowest few notes on a violin, after that, there are several places a violinist can press down on the strings to sound a particular pitch. The violinist can choose which of the four fingers on their left hand (the thumb isn't used) to sound the note.

On the violin, fingerings can be utilitarian—or they can be selected to create a particular color to the sound. Violins don't have frets that mark where the fingers go, so there's some risk of missing the note with any fingering. However, some more musical fingerings require advanced techniques, such as large shifts or playing in high positions.

A violinist can be careful and select the safest fingering, making it most likely they will play each note in tune. Or they can choose a more challenging option that creates a more expressive sound. The goal is to create the most musical result—but not to be so difficult that the violinist risks missing the note altogether.

Evaluating risk in real estate investments is similar to selecting a violin fingering. All real estate investments are risky. Just as the violin lacks frets, there is no "marker" guaranteeing success. However, like violin fingerings, some options are riskier than others. But like violin fingerings, sometimes the options that pose the biggest risk carry with them the possibility of the greatest reward.

This article is one in a series on evaluating real estate investments. This article discusses “risk factors.”

Evaluating Risks

All real estate investments involve risk. Investors should understand those risks before investing. For example, if an investor is buying a property for themselves, they probably will involve third parties in helping them gather information and evaluate risk. Even the most sophisticated real estate investors likely will need third-party reports for environmental hazards and access to outside data to understand the local market. In addition, all investors should have an attorney review title and survey risks.

Investors in syndications depend on the sponsor to gather the data. The sponsor also should highlight the risks in a private placement memorandum or offering memorandum. Even then, investors are responsible for evaluating the property risks in the context of their financial situation and risk tolerance.

Real estate investment risks fall into four primary categories: real estate market risks, property-specific risks, investment risks, and tax risks. However, even for a sophisticated real estate investor or sponsor, evaluating risk frequently is more art than science.

Real Estate Market Risks

Real estate market risks include general economic risks, such as inflation, recession, COVID-19, and interest rate fluctuations. Also included in this category are risks specific to the real estate market, such as uninsured casualties, Americans with Disability Act compliance, rent control laws, mold and other environmental concerns, and real estate tax increases. And all real estate investments are illiquid, so investors can't quickly gain access to cash from their investments.

Property-Specific Risks

Property-specific risks are risks applicable to a property but not to all properties in the real estate market. For example, older properties may contain lead-based paint, aluminum electrical wiring, or asbestos-containing-materials. Or a property’s geographic location might present an increased risk of natural disasters such as hurricanes, earthquakes, sinkholes, or wildfires. As demonstrated by the Surfside condominium collapse, coastal property exposed to salt air might be vulnerable to certain structural damage. Geographic location also can lead to an increased risk of radon or wood-boring insects.

Also, in this category are known risks specific to the property. For example, a property might have underground storage tanks that pose a risk of environmental contamination. Or it might be in a flood zone, be targeted for rezoning, lack up-to-date fire suppression systems, or have open building inspection issues.

Investment Risks

Investment risks are risks specific to the investment structure. For example, investments purchased from a securities issuer in a private placement will be subject to resale limitations. And mortgage lenders usually won't allow investors to pledge or encumber their interests. Investors who own common units will be subordinated to preferred units. And the organizational documents might limit the investors’ ability to vote on major decisions or require payment of fees to a sponsor before investors receive a return of capital. Some securities offerings may be “blind” pools, where some or all of the properties haven’t yet been identified. Or investors might not be able to object to dilution of their units.

Tax Risks

Taxes are an important consideration for any real estate investment. Tax risks might relate to the property structure. For example, an ownership structure taxed as a partnership won’t provide investors with the opportunity to invest with Section 1031 exchange funds – or to do a Section 1031 exchange when leaving the investment. A tenant-in-common ownership structure accommodates Section 1031 exchanges. But it comes with unanimous voting requirements that can prevent nimble decisions in key areas, such as hiring a property manager or refinancing or selling the property.

Other tax concerns relate only to certain types of investors. For example, investors using retirement funds to buy real estate investments might have to pay taxes on unrelated business taxable income or unrelated debt-financed income. Some investors might owe alternative minimum tax or be subject to passive loss limitations or owe state taxes in a state where they don’t reside. And higher-income investors may have to pay investment tax on income from their investment.

Disclosing Risk Factors in Syndications

Syndication clients trying to cut back on legal fees sometimes say they don’t need me to prepare risk factors for their deal—that they will just copy the risk factors from another deal or leave them out “since no one reads the boilerplate.” Unfortunately, the clients haven't seen how risk factors might benefit them—so it seems like a good place to cut corners—but they are wrong.

Risk factors are like a spare tire in a car—most of the time, you don't need them, but they are critically important when you do. Just as it would be foolhardy to remove the spare tire from the trunk of their car, it’s ill-advised not to include risk factors in an offering document.

So, what about the generic risk factors? Going back to our tire example, spare tires aren’t exchangeable between different cars. The spare for my Prius won’t work on a pickup truck or SUV. Generic risk factors work no better than a "generic" spare tire. Risk factors also must be tailored to the specific real estate transaction to be effective.

Frequently, clients complain that the risk factors take up too many pages and ask me to cut back on them. I respond that I can do that. But cutting back on risk factors is like selecting an undersized “donut” spare tire instead of a full-size spare tire. The donut can be driven on for only 30 miles on dry pavement. Sometimes, that's all that's necessary.

But what if the car has a blowout on a remote road 40 miles from an exit with repair services? Or what if the blowout happens during a snowstorm? That's a once-in-a-lifetime event, perhaps. But when it does happen, someone is very happy they were prepared. And that’s why we have spare tires to begin with—to prepare for the unexpected.

A syndicator might get by for years with brief risk factors. But real estate investments are risky. Someday, a deal won’t perform as expected. Some investors become upset. And some of those investors will look for someone to blame for their misfortune. The syndicator or sponsor is an obvious target. Investors may say, "You didn't tell me [fill in the blank with what went wrong] could happen. That's when thorough risk factors can come to the rescue by demonstrating that the investors were informed of that risk.

Attorneys don’t have crystal balls. We can’t see the future. Fortunately, securities laws don’t require clairvoyance – just that the sponsor disclose reasonably foreseeable risks.

But material risks—meaning risks that might be important to investors—should be disclosed. And it requires a legal judgment to determine what is material. Plus, a securities attorney can evaluate which securities disclosure regulations must or should guide disclosure decisions.

A violinist might receive suggested fingerings in printed music or from their teacher, and their teacher might instruct them how to prevent particular errors when executing the fingering. But it's the violinist who must decide whether a fingering is too risky to attempt in a performance. Likewise, whether an investor is buying real estate securities or investing in a deal alone, it’s always up to the investor whether they are comfortable with the risks of that investment.

© 2022 by Elizabeth A. Whitman

Any references to clients and their legal situations have been modified to protect client confidentiality.

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