In real estate, there are essentially three phases of development:

  • ground up construction
  • value-add (rehab)
  • stabilized

These phases represent the natural lifecycle of a real estate deal. Each sequential phase has its own set of work and therefore risk associated with it. In other words, the more phases a project must go through, the greater the risk but also the greater the potential for growth.

Risk vs. Reward by Development Phase

This graph illustrates the increasing risks by development phase. The risk vs. return curve is the essence of understanding the real estate investment market.

The more risk one takes, the greater the return should be to offset that risk.

These are some of the top risks associated with each development phase and an estimated annual return the market might currently expect for the equity investor.

While the graph helps to highlight general risk categories, it is important to remember that every deal is unique and so are the risks involved.

Loan maturity, for example, is only a risk for properties that have debt in place (the majority of real estate investment properties do to increase leverage).

Loan Maturity Risk: The “GGP” Case Study

Below we outline how one factor like loan maturity can affect an entire portfolio investment.

During the good times, loan maturity does not seem to be a material risk. Today, most stabilized properties with low leverage and strong sponsorship (i.e. ownership) can get financing. In 2008 and 2009, however, this was not the case and many property owners could not refinance their loans when they came due resulting in major shortfalls.

One of those owners was General Growth Properties (GGP), the second largest retail real estate company in the country, which was forced into bankruptcy as a result of loan maturity. Helpless, the company and its shareholders watched its stock fall to 1/30th of its original value in less than six months.

With assets of nearly $30 billion, the company had two loans for $900 million (only 3% of total assets) mature during the financial crisis. Unable to refinance, the company ended up defaulting on the loans, resulting in a shockwave across hundreds of properties that had been cross-collateralized. In retrospect, even though the real estate held billions of dollars in equity value, it was wiped out by the timing of a simple loan maturity.

Did we miss anything? What are other important risks should be considered when evaluating a real estate investment? Visit our brand new education section to learn more or add your insight.