Real Estate as an investment class has long been popular with investors, particularly given its sense of familiarity and solidity, but as with any investment it is important to understand the risk.  With real estate there are both systemic, market risks but also unsystemic property specific risks which require proper analysis as part of your investment due diligence.  

Investors who wish to invest in the real estate sector, can follow the traditional direct ownership path, or alternatively they can choose to participate in a real estate Alternative Investment Fund (‘AIF’ or ‘fund’). Investing through a fund, can be particularly attractive for investors who wish to diversify and share the risk of the investment. When it comes to commercial real estate, funds can be particularly attractive, since investors are offered the opportunity to access premium properties such as malls and other prominent or landmark buildings that require significant capital base, and which many investors cannot, or are not willing to acquire directly.

As risk is inherent in all three phases of commercial real estate investments life cycle – from acquisition to holding and disposal – it is important to understand how the characteristics of the underlying assets, together with the investment strategy (core, core-plus, value added, opportunistic, distressed) influence the underlying unsystematic risks. Therefore, when looking at a potential investment via an AIF, it is important to understand the due diligence process as this can assist in understanding the risks as part of your investment analysis.

The Importance of Due Diligence
Prior to entering any transaction, it is recommended that a thorough due diligence is performed to ensure that all potential risks have been identified, key examples of which are analysed below:

Tenant Risk:
Tenant Risk can be explained in terms of both single tenant and multi-tenant scenarios.

Funds with commercial buildings that are wholly leased out to a single tenant, have their performance significantly linked to the performance and the financial stability of the tenant. Investors in such funds are investing in the tenants’ ability to pay the rent for the term of the lease as well as the actual physical property. Financial difficulties faced by the tenant inevitably lead to lease renegotiation or default and potentially a reduction in the funds’ cash flow or a complete cessation while a new tenant is found. As any decrease in the lease cash-flow will unavoidably decrease the market value of the property, it is necessary to assess both the credit worthiness of the tenant as well as the underlying market for releasing the property should that be necessary.

In a multi-tenant scenario, occupancy will rarely be either 100% leased or 100% vacant. The risks associated in such scenario differ. The lease terms in such cases are shorter which, during a booming market, allow the funds to generate better returns from lease rollover, but at the same time, during a market downturn, investment returns take a hit from the increasing vacancy rates and the negative rent growth.

Even though such potential hiccups may be sustainable for some time, if the reduced cashflows persist for a considerable period, in the case of a levered fund, it is possible that the fund may not be in a position to cover its loan obligations. In such cases, the fund may opt to postpone dividend payouts, or worse, be forced to sell at a discounted price.

This is precisely the reason funds spend considerable time and resources in performing scenario analysis and proper financial due diligence on both the properties and the tenants, ensuring they target well established companies/tenants with sound financial positions, and/or properties with strong tenant demand thereby limiting their exposure to such risk.

Development Risk:
In value add, opportunistic and distressed real estate strategies where significant capital expenditure is required, development related risks can have a substantial impact on the investment strategy. The implementation of such strategies often requires the acquisition of a planning or building permit, which may be significantly delayed depending on the administrative burden of each authority.

Other delays in implementing such strategies can include delays in constructions, and variations in delivery due dates which may arise due to developers’ inefficiency, but most commonly due to unforeseen events, such as the physical state of an existing asset, or the ground condition is different from what anticipated.

Finally, another common development related risk, is cost overruns arising primarily due to the failure to identify and budget for unforeseen events, that however, could be mitigated by a thorough technical due diligence and incorporating appropriate contingency allowances.

Working with credible counterparties – Fund Manager, Asset Managers, Project Managers, etc. that possess sufficient knowledge and resources – is therefore critical, to ensure that due diligence is properly performed, all technical specifications are properly determined, and budgets and timelines are adhered to.

Operational/Regulatory Risk:
By expanding its list of incentives, Cyprus has been attracting more and more international companies’ headquarters, thus securing relatively stable returns for commercial real estate investments. Potential changes in the regulations or tax revisions, could however have a potentially significant impact on the real estate market and thus investment strategies. Such changes could be considered unforeseeable and uncontrollable. Nevertheless, Fund Management companies have a solid network of professionals who can provide valuable insight and interpretation, allowing the Manager to make informed decisions about potential risks and their impacts.

Conclusions
Commercial real estate funds can be an attractive form of investment since their risk can span from low (core strategy) to high risk (opportunistic or distressed strategies), allowing investors to select strategies/assets based on their risk appetite. Risk is inherent in such strategies, and therefore cannot be completely eliminated. Nonetheless, investing through a real estate fund which is managed by professional managers with a deep knowledge of the real estate market, ensures appropriate due diligence in all stages of the investment, quality asset management and most importantly proper risk identification and mitigation.

By Anna Pavlidou, Senior Associate Resolute Investment Management (Cyprus) Ltd