Like other asset classes, commercial real estate risks and returns are closely correlated. The higher the risk, the higher the potential return and vice versa. For example, a single-occupant property leased to a national tenant is considered to be a relatively safe investment with low, but stable returns. On the other end of the spectrum, a ground up development project is high risk, but offers the possibility of a high return.
In commercial real estate investing, risk is unavoidable. The trick to maximizing the chance for a positive return isn’t to avoid risk, but to identify it prior to making a purchase and proactively implementing strategies to manage or minimize them.
Common Types of Commercial Real Estate Investment Risk
Whether investing in a commercial property directly or indirectly, through a private equity firm like ours, there are eight types of risk that an investor should consider before committing their capital to a deal.
Commercial real estate prices are influenced by a variety of economic factors such as inflation, interest rates, and unemployment, however the effects are not felt equally in all markets. As such, it is important for investors to consider how broad economic trends could impact the market in which the investment is located. For example, there has been a long term trend that has shifted manufacturing jobs from expensive markets in the United States to less expensive markets in countries like Mexico and China. As a result, markets that had a strong manufacturing base, like Ohio and Michigan – and their associated real estate assets – have been disproportionately impacted whereas states like Florida and Texas haven’t felt nearly as much pain.
The key to managing market risk is diversification. As investors are building their commercial real estate investment portfolio, it should include properties in multiple markets to limit the impact of declines in any one of them. Using the example above, an investor with holdings in Ohio and Texas would be able to use the gains from strong markets in Texas to offset any potential losses in Ohio.
Certain economic risks tend to impact all assets in the same class. For example, high levels of unemployment may have a relatively minor impact on multifamily assets because housing is a primary need and renters will continue to make their payments. However, it could have a disproportionate impact on retail assets as consumers tend to decrease spending in times of economic distress.
Again, the key to managing asset risk is diversification and it can come in two forms. First, an investor may choose to spread asset risk over multiple asset classes in their portfolio. Or, if an investor specializes in one specific asset class, they can diversify their portfolio by investing in multiple markets.
Liquidity is defined as the ease with which an asset can be converted to cash. For example, a share of Apple stock is incredibly liquid because it is relatively inexpensive and there is a large market of willing buyers for it. On the other hand, commercial properties are prohibitively expensive for many which can make them less liquid. As such, a property’s liquidity must be carefully considered prior to making a purchase. In many cases, liquidity is tied to demand in a given market. For example, demand for a property in a high growth market like Charlotte, North Carolina is likely to provide more liquidity than one in a low growth market like West Monroe, Louisiana.
Managing liquidity risk requires detailed analysis of the supply/demand characteristics of the market in which the property is located. It is important to begin with the end in mind by knowing what the exit strategy is before the asset is purchased and to plan for the amount of time that it will take to sell.
Any commercial property that leases space to a tenant has credit risk, which is the risk that a tenant can’t or won’t pay their rent. Because a property’s value is tied to the length of the in place leases and the certainty with which the tenants will pay their rent, it is critically important that investors understand the credit risk associated with a given property. For example, a fully occupied property with national tenants on long term leases represents less risk than a fully occupied property with local tenants on short term leases. As such, it is likely to command a premium in the marketplace.
Credit risk can be managed through careful analysis of a tenant’s financial condition prior to purchase and through the creation of a “lease abstract” for each tenant that summarizes the length of the lease, required payments, payment escalations, and prohibited activities.
In addition, a tenant’s business should be considered within the context of broader market trends. For example, grocery stores and service oriented businesses likely have a brighter future than product oriented businesses like clothing or stationary.
A real estate investment’s risk profile is directly proportional to its leverage, or debt. The more debt, the more risk because there is less room for income declines before a property’s income isn’t sufficient to make the required loan payments. For example, a 10% decline in rental rates could cause a highly leveraged property to turn cash flow negative, whereas it could be a relative non-issue for a property that is conservatively leveraged.
Debt risk can be particularly tricky to manage because high amounts of leverage can also boost returns. So, it is incumbent upon investors to find the right mix of debt and equity when financing a transaction. In many cases, this decision is driven by the lender who will dictate the maximum amount of debt that can be placed on the property, usually ~75%.
Property Specific Risk
Every property is different and they all have risks that are unique to their condition, location, and age. For example, a high rise multifamily property with incredible views could face a significant drop in demand if the construction of a newer, taller building obstructs those views. To stimulate demand, the owner may have to reduce rents, which is a net negative for the asset.
Property specific risk is managed by careful and thorough due diligence, not just on the property itself but on plans for the surrounding area, neighborhood, and market that may potentially affect value and/or demand.
Risk of Physical Obsolescence
Real estate is a physical asset, which means its condition degrades over time. This risk is particularly relevant in high growth, high demand markets where there is always going to be a newer, more technologically advanced building that rents for similar prices. If a property is or becomes physically obsolete, costly renovations could be required to maintain occupancy and retain property value.
Managing the risk of physical obsolescence requires careful thought about a property’s condition relative to the market. If it lags the market, renovation and/or replacement cost must be calculated to determine if it’s economically feasible to update the property to market standards.
Financial Structure Risk
Financial structure risk is the risk that an individual’s position in the “Capital Stack” could wipe out their investment. For example, senior debt holders are always in first position to receive a property’s income and profits whereas equity holders are last to be paid so their position is considered to be riskier.
When evaluating a potential investment, it is critical for an investor to understand exactly what the property’s Capital Stack looks like and how the loan and operating agreements are structured to ensure they don’t incentivize bad behavior. For example, a Capital Stack with just one senior debt holder is generally considered to be less risky than one with senior debt, mezzanine debt, and preferred equity holders all in front of the common equity holders.
A thorough and diligent investor – or investment firm – will consider all of the risks above before deploying capital into a project. For larger firms, there may even be a risk committee whose sole responsibility is to review each deal to ensure it meets the threshold for an acceptable level of risk in a transaction. Once the risks are identified, plans should be developed to manage each one of them for the duration of the investment period.
About First National Realty Partners
First National Realty Partners is one of the nation’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. To accomplish this goal, we devote a significant amount of time and resources to proactive risk management practices.
If you are seeking a passive real estate investment option and have a long term time horizon, we are here to help. To learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.
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