November 1, 2023
By: Ben Nelson, Investor Relations Regional Manager
“Progress always involves risks. You can’t steal second base and keep your foot on first.” Frederick B. Wilcox
The Crucial Role of Financial Risk Management
Working to reach a level where you are able to invest is an especially gratifying personal milestone. It can take years for some and decades for others, but it’s something many of us strive towards.
Achieving this goal takes time, patience, consistency, discipline, intuition, and occasionally, a lucky break.
The realization of this milestone is exciting, but human psychology intervenes early and often. When acquiring something that takes a great deal of time and hard work, we place an especially high value on protecting it, often avoiding financial risks and thereby superseding the opportunity for growth.
Inherently, we know that we must employ some elements of risk to our capital or risk the possibility of the erosion of that capital due to inflationary factors. If there is anything that 2023 has taught us, it’s that inflation is very real and can negatively impact our financial situation.
So, let us discuss risk, truly an ugly four-letter word.
The hard truth is that in any situation, capital is at risk.
Whether it’s highly volatile options contracts that eventually expire worthless, a savings account above FDIC limits at a troubled institution that experiences a bank run, or cash held under a mattress seized by a thief, capital must always be considered “at risk” and guarded carefully.
Also, everyone has a different perception of, and appetite for, financial risk. Some people welcome risk, even seek it out, believing they will be able to pick more winners than losers. Others avoid risk whenever possible, content with the status quo of safety, even if it means missing opportunities along the way.
Most lie somewhere in the middle, pondering the classic and ever-present conundrum: who can generate the highest returns while taking the lowest level of financial risk? Who is the best at playing both offense and defense?
Sorry to spoil the surprise.
This answer changes every day, and none of us will ever be able to keep up.
Capital has a predictable tendency to flow to where it is best treated and understanding where your financial risk lies is crucial to making wise investment decisions.
Working in investor relations, I spend much more time speaking with investors about what could go wrong versus what could go right. Not only do I agree with people who approach investing like this, but I believe it is vital to study risk as thoroughly, or even more thoroughly, than you study the potential rewards from an investment.
Today, I want to examine three risks that you should be aware of as it relates to real estate investing. There are many more than just these three, so I encourage you to perform additional diligence on this matter.
High Level: General Market Risk
Our global market is a living breathing organism. Not only does it never sleep, but each sector relies upon and is affected by others; sometimes directly and substantially, and sometimes indirectly and inconsequentially.
They are always moving and interacting with one another, similar to the functionality of the human body.
Most examples of market risk deal with factors you cannot control, only monitor and do your best to navigate around. Natural disasters, war-time conflicts, global pandemics, Federal Reserve interest rate shifts, governmental policy changes, and market imbalances/corrections are the first things that come to mind.
To attempt to avoid these financial risks entirely over your investing lifetime is not only a fools-errand with a minuscule probability of success, but it will likely limit your ability to grow. But what general market risks can deliver is opportunity.
During the financial crisis of 2008 and 2009, I worked for a financial institution with a storied history and strong balance sheet. When most Wall Street banks started failing and stock prices were taking a nosedive on a daily basis, I walked into my boss’s office trying not to appear in a state of panic.
He looked at our stock price and said, “There’s no way we’re worth that much per share but we’re being penalized with everyone else.”
In a highly bold move, I watched as he took his entire savings account and converted it into our company’s stock. “You have to believe in something,” he told me as he hit “buy.”
Over the next eight months that one transaction would make him over 400% and change his life.
Now, am I telling you to take risks like this? Absolutely not. The U.S. Government could have shut us down and he would have lost his job and everything he saved in a matter of weeks. But I am telling you that he saw an opportunity from a market risk outside of his control and seized it.
Mid-Level: Financial Risks
Financial risks are not only easier to forecast but are also easier to prepare for. A few examples are risks such as liquidity risk and leverage risk.
Not enough liquidity on your balance sheet? Too much leverage on your assets? You need to pay close attention.
These are typically not problems in a steady healthy economy and promote economic growth – banks lend, companies spend, rules relax, and progress is made.
However, in the past year, the treasury yield has inverted, meaning short-term U.S. Treasuries are paying a higher yield than long-term U.S. Treasuries. Talking about treasury yields is not very exciting, understandably, but this kind of action does sound alarm bells for what could be coming around the corner.
When treasury yields invert, banks find it much more difficult to make loans (i.e., borrow long-term and lend short-term). In fact, even the previous loans they have issued make them nervous.
For example, has your bank offered to swap you out of that 3% fixed-rate mortgage and put you into an 8% mortgage with a pile of cash from your equity? Mine surely has. Since 1978, each time the yield curve has inverted it has signaled an incoming economic recession.
The timing has been different for each, but the consistency of this “signal” has been one of the rare truths of our lifetimes. (1) A recession means rising unemployment, tightening lending standards, lower growth, and more often than not, high volatility in equities. For real estate, it can mean declining property values and a lessened ability to transact.
Low Level: Property Risks
In real estate, property risks are the easiest to control, but that doesn’t imply that they are easy. Types of property risks are vacancy risk, tenant risk, location risk, and repair risk.
As a syndicator, we always want our properties to have 95% occupancy or higher. But what if a new apartment is built across the street offering an attractive introductory deal to get people to make the switch? Or, what if a major corporation moves its headquarters to another city?
That’s vacancy risk. Failure to properly screen your tenants and having many people delinquent on rent payments is tenant risk.
If a wave of gang-related crimes enters a city where your property is located and begins making headlines and driving down demand to live there, that would indicate location risk.
If you own older Class C apartments and the units need to have all washers and dryers replaced after having major malfunctions, that would be a type of repair risk.
This list is not exhaustive by any means, but, for the most part, these are risks you can uncover through due diligence.
How Does Ashcroft View Financial Risk?
We own and manage over $2.8 billion worth of properties, but our most valuable assets are our limited partners.
Ashcroft Capital’s first and foremost goal is capital preservation. We believe after achieving that we can pay a consistent passive income and generate attractive returns that will keep our investors excited about future offerings.
We are in a period where market risks are popping up everywhere, and we continue to be pleased with how our assets are performing despite headwinds. Interest rates have risen, and while we have had no control over that, we have done everything in our power to lower expenses, raise revenues, and organically grow net operating income.
We’ve also been purchasing properties at a much lower loan-to-value ratio to reduce interest charges and improve leverage ratios and reduce financial risk. When people are worried about elevated insurance rates in Florida, we are pleased to tell them how we’ve structured our insurance coverage across our entire portfolio of assets.
We love the locations of our properties and know we eliminated so many property risks by doing our due diligence on each with a fine-tooth comb. Our overall vacancy rate remains low and our property management continues to be best in class.
What I am most pleased with is that we have stayed true to what got us to this point. 2023 has been a spectacular year for playing defense against risk, but we’ve also been playing offense and have seizing opportunities.
In what is a very slow market for multifamily transactions, we’ve still managed to find almost 1,000 doors in three high-growth markets in our current offering, the Ashcroft Value Add Fund III. In the longer term, we think we took advantage of a situation that most chose to or were forced to sit out.
If you’d like more information on our current offering, please contact investorrelations@ashcroftcapital.com to speak with one of our representatives.
Sources:
- Ermey, Ryan. “This classic recession indicator just hit its lowest level since 1981—here’s what it means for you.” CNBC. July 7, 2023. https://www.cnbc.com/2023/07/07/yield-curve-inverted-the-lowest-since-1981-what-it-means-for-yo.html
