Like many asset classes, there is inherent risk in a commercial real estate investment. Property values could decline, rental rates could fall, interest rates could rise, or general macroeconomic conditions could make for a challenging investment environment. Since risk can’t be avoided, the next best option is to actively manage it.
In this article, we will discuss downside protection in commercial real estate. Specifically, we will define what it is, how it fits into an investment strategy, and how to put it in place for a commercial property.
At First National Realty Partners, we invest a significant amount of time and resources underwriting deals before presenting them to our investors. As part of this process, we test our assumptions against dozens of economic scenarios to ensure that we have done everything we can to mitigate downside risk. To learn more about our current investment opportunities, click here.
What is Downside Protection?
In the simplest sense, downside protection is defined as the steps taken by real estate investors to protect their capital from a worst case scenario type event. Or, put another way, it is the steps taken to mitigate risk in an investment.
What is Downside Protection in Commercial Real Estate?
The concept of downside protection can be applied to all asset classes, but the tools and strategies used may differ. As it relates specifically to commercial real estate, there are a number of steps that CRE investors can take to protect against downside risks. They include:
- Sensitivity Analysis: When underwriting a property, commercial real estate investors often perform “sensitivity analysis” on the key assumptions in their proforma to see how future performance is impacted. For example, a proforma may assume a vacancy rate of 5% for the life of the investment. But, savvy investors will also run scenarios to see what happens at 8%, 15%, 20%, etc to see how high vacancy can rise before they run into trouble.
- Break Even Analysis: Based on their assumptions for operating expenses and debt service, real estate investors will attempt to determine a property’s breakeven occupancy level and compare the result to their macroeconomic outlook.
- Interest Rate Volatility: For properties financed with variable rate loans, real estate investors will run scenarios to see how changes in the interest rate affect annual returns. Specifically, they will look to see how high the rate can go before property cash flow turns negative.
- Sales / Liquidity Analysis: Implicit in proforma return calculations is an assumption about the property’s sale price, which is typically calculated with net operating income and a terminal cap rate. Investors will likely run several scenarios regarding the sales price to see what minimum price they need to achieve to reach their investment objectives.
- Due Diligence: Before even making a purchase, real estate investors will conduct thorough due diligence by inspecting every square inch of a property and its reports, records, and account statements to ensure there are no surprises waiting for them. For example, they may review maintenance records to ensure that there are no reported leaks that could result in a surprise bill.
Regardless of the specific strategy or test, there is a broader point to be had. In order to protect against downside risks in real estate investing, it is necessary to test proforma inputs and assumptions to understand where the risk lies and to then take active steps to mitigate it. For example, if studying interest rate volatility leaves little margin for error, a real estate investor may prefer a fixed rate loan. To make this point, a detailed example is helpful.
Example of Downside Protection
Suppose that a real estate investor is considering the purchase of an apartment building that is currently 95% occupied. As part of their downside protection strategy, they are trying to determine how far occupancy could fall before the property turns cash flow negative. The result of this analysis is summarized in the table below:
|Current||10% Vacancy||15% Vacancy||20% Vacancy||30% Vacancy|
|Potential Rental Income||$1,000,000||$1,000,000||$1,000,000||$1,000,000||$1,000,000|
|Effective Rental Income||$950,000||$900,000||$850,000||$800,000||$700,000|
|Net Operating Income||$250,000||$200,000||$150,000||$100,000||$0|
In this table, it can be seen that the property makes a nice operating profit based on its current 95% occupancy, but that operating profit turns negative around 30% vacancy (70% occupancy). Based on this information, a real estate investor could take proactive measures to lock in lease extensions for existing tenants or to compare this information against market forecasts to determine if it is truly realistic that vacancy would rise to 30%.
Downside Protection at Private Equity Firms
Steps to protect a real estate investment’s downside can happen at two different “levels.” They can happen at the asset level, which includes all of the steps described above. Or, they could happen at the “portfolio” level which is where a private equity firm comes into play.
At a high level, private equity commercial real estate firms offer two types of real estate investments, deals and funds. In an individually syndicated deal, firms offer one-off real estate investment opportunities and the downside protection strategies described above are implemented at the individual asset level. But, for those firms that are using investor funds to construct a portfolio of private real estate investments, the downside protection strategies need to happen at the asset level and the portfolio level.
Portfolio diversification is one of the most basic steps a private equity firm can take to protect their portfolio downside. The idea behind portfolio diversification is that risk can be spread over multiple properties so that underperformance in any one of them does not have a dramatic impact on the total return for the overall portfolio. For example, real estate investments could be diversified by property type (office building, multifamily, industrial, etc), real estate market, asset class (commercial real estate vs. residential real estate), and asset size.
Summary & Conclusion
Downside protection is a term that is used to refer to the steps that real estate investors take to actively manage the downside risk of their real estate investment.
Although the specific tools and methods may vary by real estate investor, they typically include some version of due diligence and sensitivity analysis. In both cases, the goal is to understand where the risk lies in a deal and to take proactive steps to protect against it. For example, an investor will perform an inspection of a property prior to purchasing it to mitigate the risk that they acquire an investment property with structural issues.
For many private equity real estate firms, downside protection is one of the concerns that is foremost in the firm’s mind at all times. When constructing a portfolio of real estate assets, one of the firm’s primary ways to manage the downside is through diversification.
At First National Realty Partners, we offer individually syndicated real estate deals that have been thoroughly vetted prior to offer. From a risk management perspective, we believe that this is a superior option because it allows individual and institutional investors to study every aspect of the property before committing capital to it. In addition, it allows them to manage their own downside through making their own portfolio construction decisions.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.