UNDERSTANDING RISK Let’s address the most important factor: risk. What is risk? Risk can be defined as a situation involving exposure to danger. Sam Zell, a legendary real estate investor said: “Risk is the ultimate differentiator. I have always had a deep and complex relationship with it. I am not a reckless person, but taking risks is really the only way to consistently achieve above-average returns—in life as well as in investments.” It is our job to understand the risks for each project we are pursuing and do the best we can to quantify it, plan for it, and eliminate it. That’s what our investors expect and, frankly, what they deserve. If you are investing solo, you had better understand how to work through the risks of each market, project, and business plan implementation. Risk is one of the most misunderstood aspects of a deal. It can be considered anything that is unknown or not a part of the plan; however, saying something is high risk is often incorrect. For example, a risk with a high likelihood of occurrence but a small impact may be completely acceptable. On the other hand, a risk with a medium likelihood of occurrence and high impact may be completely unacceptable. Here’s a model for risk from real estate pro Victor Menasce that can be extremely helpful . FTW’s risk management plan represents these risk types:
Risk is one of the most misunderstood aspects of a deal.
How do you manage risk properly? • Enumerate the potential risks. • Qualify the risks (time, feasibility, cost, quality). • Determine the likelihood. • Quantify the impact if the risk comes true. • Develop contingency plans for the risks with the higher impacts. Some of the risks in the market are inflated asset values and a rapidly changing debt environment that will not support these prices. The rapid pace of inflation and interest rate increases creates macro risks that influence the debt markets, making it more difficult to mitigate debt risk on projects. Many recent acquisitions in the marketplace over the last 12-24 months have been secured with short-term, floating-rate debt. This has been the way many value-add sponsors have secured capital that aligns with their strategy and the prices they have been paying for these assets. However, the volatility in short-term rates creates an extreme, exponential risk profile for using unhedged, floating rate debt in the current environment.
Additionally, the cost of buying a “cap” on interest rates for these loans has become extremely expensive, and the interest rate caps one can secure still leave you exposed because these caps are even much higher than we would deem desirable. Sam Zell notes: “Opportunity is very often embedded in the imbalance between supply and demand. It could be rising demand against flat or diminishing supply or flat demand against shrinking supply. At some point, those two lines are going to intersect, and when they do, people will make money.” WHAT IS YOUR INVESTMENT THESIS? FTW implements a multi- disciplinary approach using a latticework of nonbusiness mental models to assess risk internally at the specific investment level and externally from a macroeconomic approach. We then measure said risk against perceived benefits and value creation to make investment decisions. Typically, we are looking
• Feasibility • Time delay
• One-time financial cost • Recurring financial cost • Quality
for assets that are well below replacement cost, creating a margin of safety for investors.
INVESTOR REVIEW :: 23
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