Real estate private equity firms will expect you to understand the risk profiles of each major real estate sector. Fortunately, the differences between each sector are pretty intuitive. But can you explain these differences in the investor’s vernacular? This article helps you take what you likely already understand, such as hotels being the riskiest asset to own during a downturn, and explain it succinctly in an interview setting. The knowledge herein is real estate private equity for beginners, so make sure you have a firm grasp.
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Please order the major real estate sectors in order of risk and explain why.
Bullet answer: Multifamily, Office, Industrial, Retail, as evidenced by average cap rates.
Risk equals reward, so the average cap rates within each sector should reflect the inherent risks. Thus the order from lowest to highest risk, is multifamily, office, industrial, and retail. Industrial and retail have changed places in the last few years as online shopping has spooked investors as to the long-term viability of brick-and-mortar retail. Cap rates have risen to reflect this higher risk, and now retail is the riskiest major asset class.
Which asset would you rather own during an economic downturn? A hotel, an office building, or a residential building? Why?
Bullet answer: residential building first, then office building, and finally hotel. Demand elasticity is least sensitive to economic changes in multifamily; most sensitive in hotels.
First, a residential building is the smart asset to own through a downturn because people will cut back on other expenditures before they cut back on housing. Hotels would be the last preference to own, because both business and leisure travel decrease during a downtime. Office buildings would be in the middle of the three. While the longer term leases may carry you through a downturn, your tenants could also go bankrupt or otherwise move out upon expiration, leaving you with a vacant space during a very difficult economic period to release.
How does the tenancy of an office building vary from that of an apartment?
An office building will have fewer tenants in larger spaces, the leases themselves will be longer term and more customized, and in most cases the creditworthiness of the tenants will be far superior. Additionally, the capital outlay for office tenants is much higher due to tenant improvement allowances and leasing commissions to fit out the office space and pay the brokers who find your tenants.
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