Understanding the risks of alternative investments

September 15, 20164 min read
Understanding the risks of alternative investments
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Risk is one of the key components of investing. Each opportunity comes with its own risk or combination of risks. To fully assess an investment opportunity, it is necessary for investors to understand how associated risks could affect the safety of their investment and any potential gains. Below are some common types of risk that can be associated with alternative investments.

LTV

The loan-to-value ratio is the ratio of a loan to the value of the financed asset. (e.g., a $5M loan taken out on an asset valued at $20M will have a 5/20, or 25% LTV) When a loan for an amount is at or near the appraised value of an asset, the loan-to-value ratio is deemed high. If a creditor ever has to sell the asset to recoup the investment, as in the case of default or foreclosure, high LTV ratios carry an increased likelihood that the sale amount may not be enough to cover the outstanding principal loan balance.

Default risk

Default risk is the risk that the borrower will not be able to repay the associated interest and principal on a particular loan. Essentially all lending carries some default risk, but there are a few ways to try and mitigate default risk. A traditional way is to look at the recovery rate, or the amount an investor can expect to get back if a default happens. YieldStreet works with originators who have a proven track record of success and recovery rates in case of downturns to try to mitigate any default risks.

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Concentration risk vs. diversification risk

The easiest way to explain concentration risk/diversification risk is the old saying, “Don’t put all your eggs in one basket.” There are many ways to be exposed to concentration risk. Investing all resources in the same industry, geographical region, or type of investment instrument (eg. only investing in coastline construction) could carry concentration risk. The best way to counteract this type of risk is to aim for a diversified investment strategy by putting investments in different “baskets”. Most individual YieldStreet investments are packaged into portfolios that are diversified geographically (in the case of real estate), across case types (in litigation funding), and in other ways. You can also diversify across different types of asset classes by investing in different opportunities through YieldStreet.

Liquidity risk

Market (asset) liquidity risk is the chance of being unable to sell your investment when you desire, at a fair market price. The liquidity of assets depends on the climate and structure of the market in which the asset will be sold. Treasury bonds are usually deemed to be highly liquid investments because it is not difficult to find buyers willing to pay a fair market price for that investment. Real estate liquidity can be affected by several factors, including the number of foreclosures in the area or the willingness of banks to offer new mortgages.

Uncertainty in timing

Investments are often made on a “floating” timeline. This means the payout date is a target date, or an expected date, but not a guaranteed date. With event-based payments, like with litigation finance, there is always a chance the case may settle before or after the expected payout date. A default on real estate investing opportunity can increase uncertainty around a payout date. This is more an “inconvenience risk” rather than an actual risk. Many investors prefer this type of risk may be leveraged to increase the yield of an investment without the lender taking on any risk of principal loss.

Principal risk

Principal risk is the possibility that a lender won’t get back some or all of the principal balance, the amount that they had originally invested. YieldStreet takes a conservative strategy with investments; however, a loss is always possible. For example, if a real estate property isn’t sold for the expected amount, there is a chance of principal loss for investors in that property.

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Frequency of payments

Payment frequency on a debt can be annual, semi-annual, quarterly, or monthly. The frequency of a payment can affect the price or yield (return) of an investment. For alternative investments that are closely tied to assets, unexpected increases (for example, early repayment) in the frequency of payments can reduce the return to the lender on the investment.

Higher expected returns are used to reward investors who are willing to take on more risk. Returns on invested capital are, however, never guaranteed. It is crucial to carefully weigh all the different risks that come with an investment and to understand your appetite for risk before making any sort of investment.

This communication and the information contained in this article are provided for general informational purposes only and should neither be construed nor intended to be a recommendation to purchase, sell or hold any security or otherwise to be investment, tax, financial, accounting, legal, regulatory or compliance advice. Any link to a third-party website (or article contained therein) is not an endorsement, authorization or representation of our affiliation with that third party (or article). We do not exercise control over third-party websites, and we are not responsible or liable for the accuracy, legality, appropriateness or any other aspect of such website (or article contained therein).