5 Biggest Risks of Investing in Private Real Estate

Investing in private real estate deals can be lucrative, but it also presents certain risks that you should consider before investing.

There's some stuff you can know and plan for - tenants, financing, maintenance -  and there's some stuff you can't - which we call the known unknowns.

Just like the weather, they're hard to predict but influence investment's success. 

This article focuses on identifying the risks that you can't plan for, so you can better adjust the sails when they do.

Let's go through the five biggest ones.

1. Rent Growth and Inflation

Many markets experienced double-digit rent growth following the global pandemic in 2020.

This was ultimately driven by supply and demand as well as underlying inflation - but it's unlikely to continue.

The Reserve Bank adopted the inflation target in the early 1990s and aims to keep consumer price inflation between 2–3%. The aggressive rat hiking across the developed world following the pandemic has brought this back closer to where they want it to be.

Low and stable inflation reduces uncertainty in the economy, helps people make saving and investment decisions, and is the basis for strong and sustainable economic growth.

Real estate with short-term leases tends to perform well in an inflationary environment.

Most properties are leased on a one-year term and therefore turn over annually (unlike office, retail, and other property types). This time frame allows owners to increase rent to accommodate rising inflation. 

2. Cap Rates

The entry and exit cap rate of any investment has a significant influence on the outcome, especially when the holding periods are shorter.

This is because the entry and exit price determine most of the returns, whereas if you're ‘buying and holding’ the investment, the cash flows over the life of the investment will have more of a say in the return targets.

You can see that simply changing an exit cap assumption from 5% to 6% can wreak havoc on the returns. This is something we’ll cover when we discuss underwriting and sensitivity analysis.

Private real estate valuations are driven by cap rates, which are influenced by many different things - but the biggest influencer of all is interest rates.

3. Regulatory Changes

Given that one of the main value drivers of property is the value of the land, which can be changed by the government, staying abreast of key regulatory changes is important.

Zoning changes not only shape the present market but also cast a long shadow into the future, influencing investment viability and strategic decision-making.

Governments also don’t want the responsibility of housing people, so they often provide incentives for private real estate development to spur property growth.

Both of these regulatory factors also invite opportunities for real estate investors who are prepared to navigate government structures and incentives (which can be a significant source of returns). 

4. Super Funds Legislation

The Australian superannuation market is a beast, with many trillions stowed away and invested for the future of millions of Australians. 

It's ~2x bigger than the entire market capitalisation of the ASX.

Approximately one-third of this wealth is self-managed, which opens investment opportunities that would be too small to be attractive when managing billions of dollars.

Changes in these markets no doubt drive capital flows in the market.

Tax is a big factor here. When the rules change, you can expect a change in how these self-managed super funds invest.

The Australian Government has proposed a tax reform targeting large super accounts, aiming to reduce tax advantages for individuals with substantial super balances. What this means is that more super funds are becoming active in tax-effective investments.

But what's the most tax-effective investment? 

Real estate.

The new tax, intended to start on July 1, 2025, isn't yet law and could undergo changes. As the situation evolves, it's crucial for investors to stay informed and consider professional advice for their superannuation strategies.

5. Construction Costs

Real estate development, and construction in particular, brings with it a range of challenges that can significantly affect investment returns. 

While Australia’s Construction Cost Pressures are easing, the rate of growth in construction costs and prices has been elevated in recent years.

Fluctuations in the prices of raw materials, shifts in the financial landscape, housing supply and demand, and changes in building codes all influence costs to deliver.

It's impossible to predict this stuff with meaningful confidence in the future, but staying ahead of these changes is crucial for planning and leading property syndicates that invest in the market.

Conclusion

While real estate can enhance your investment portfolio, it comes with risks that require careful management.

There's some stuff you can plan for and some stuff you can't. but knowing the variables and their potential influence can help you make more informed investment decisions.

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