Downside Protection — Practices & Protocols in Real Estate Investing
This learning series on Modern Commercial Real Estate Investing first appeared on the EquityMultiple blog. Please check in there for updates and additions to this series.
Investors often refer to “downside protection” as the degree to which the probability and magnitude of a worst-case scenario has been mitigated.
At EquityMultiple, we seek to mitigate risk at the asset level — with each real estate investment we consider. Like all investments, EquityMultiple investments carry risk, including the potential for loss. As such, we avoid using the term “downside protection” explicitly in describing our investments. However, we do seek investment risk mitigation on behalf of our investors in the following ways:
- By conductive exhaustive diligence on every investment we consider, ultimately selecting fewer than 10%
- By seeking to work with only experienced real estate firms
- By stress testing our underwriting assumptions
- By considering the “last dollar basis” of the investment
- By negotiating and structuring investor protections whenever possible
Let’s look at a few of these methods of achieving investment risk mitigation in depth:
The EquityMultiple team brings a wealth of experience in real estate law and investment structuring. As such, we are often able to build substantial investment risk mitigation into individual investments.
Particularly at this late stage of the cycle, EquityMultiple’s investment team prioritizes senior debt, junior debt, and preferred equity investments that hold significant payment priority.
Similarly, holds of between 9 and 24 months can help to mitigate liquidity risk, particularly at a time when some experts expect some form of economic correction in the near future.
EquityMultiple’s primary goal is the preservation of investor principal. Our investment team structures protections and remedies into our investment level documents. While these protections are critical, we don’t want to bore you to death by going into too much detail here. More on the topic can be found in this article.
Last Dollar Basis
Our Real Estate team also seeks to provide investment risk mitigation by considering the worst case scenario. In real estate investment underwriting, this analysis is referred to as “last dollar basis” — we use the term last dollar basis to represent the price at which we would need to sell the asset in order to cover our investors’ principal.
This term is usually used in the context of debt and preferred equity — higher positions in the capital stack. However, the same concept applies for an equity investment, though the term ‘cost basis’ may be used instead.
Let’s use a recent debt investment — the Downtown Brooklyn Residential Loan offering — as an example.
- The total cost of the project is $97.97M and the total net residential square footage was 68,707 SF. So our cost basis is $1,426 per SF. Note: While the project included a 12,667 SF retail component, we ignored the retail portion in order to be conservative.
- The total senior loan and mezzanine loan (our position) was a combined $79.95M. Taking $79.95 divided by 68,707 SF gets us to a last dollar basis of $1,164 per SF.
- This means that upon completion, we would have to sell this project for a price that is at least $1,164 per SF in order to return our investment amount.
- How does $1,164 per SF compare to the market? We provided a breakdown of recent sale comparables in our offering. The average of these listings was $1,461 per SF.
- Hence, the Brooklyn entry-level condo market would have to drop by approximately 20% in order for the investment to lose principal.
In other words, this particular investment contained several forms of investment risk mitigation: priority of payment, recourse in case of borrower default, and a conservative last dollar basis.
Performing Stress Testing
Sometimes referred to as “scenario analysis”, stress testing in real estate underwriting is the practice of examining what exit pricing and return potential would look like in different scenarios.
In the underwriting of an equity position, we typically look at three scenarios: upside, base, and downside. If the underwriting of a debt or preferred equity investment (where there is limited or no upside) we look at several downside scenarios.
In either case, our Real Estate team will look at several variables concurrently to model expected returns in one or several downside scenarios. Some examples of these variables:
- Exit capitalization rates — We re-run our return modeling based on increases in cap rates due to rising interest rates, changes in the expectation of future NOI growth, exogenous demand and supply shocks, or other variables that would adversely impact our base case scenario.
- Rental rates — While our base case modeling will consider trends in prevailing rents in the market and for the property type, our stress testing will examine what would happen should market dynamics adversely impact rent growth
- Lease-up rates — While our base case modeling will consider qualitative input from the sponsor and leasing data specific to the property type and market, our stress testing considers what would happen should the sponsor’s leasing progress slower than expected.
- Structural vacancy rates — Similarly, our base case modeling will bring to bear various data regarding prevailing vacancy (and net absorption) rates. Our stress testing will consider the impact of higher-than-expected vacancy.
Priority of payment can potentially contribute to investment risk mitigation.
Stress testing is a method of predicting future cash flow (and subsequently return metrics) based on potential scenarios. This entails quality data and expert use of data in modeling for different scenarios. However, our Investment Committee also discusses at length the likelihood of the downside scenario happening and what built-in downside protection we can negotiate to protect our position if a downside scenario were to occur.
The Bottom Line
While downside protection is the holy grail of investment management, no investment is risk-free, and all real estate investments are subject to some degree of risk based on macro and microeconomic factors. EquityMultiple’s dedicated Real Estate team seeks to mitigate risk on behalf of investors in many ways throughout the underwriting process.
That said, please do review the Risk Factors documentation that accompanies all investment offerings on the EquityMultiple platform, and carefully consider whether the attendant risk of a potential investment is suitable for your portfolio. As we’ve discussed previously, investors can potentially reduce exposure to risk at the portfolio level through intelligent asset allocation, diversification, allocating to private-markets assets, and limiting the degree of correlation between assets.
All investments involve risk to investment capital. Investment risk can come from many sources including the investment itself and outside market forces that can affect the investment’s overall performance. It is not possible to eliminate risk however we believe it is possible to mitigate such risk by utilizing research, due diligence and prudent investment methods.