It’s a given that every commercial real estate transaction involves some level of risk. In addition, there is a direct correlation between the level of risk involved and the variance in potential returns. A low risk investment—such as a credit tenant triple net leased property—typically provides low but stable returns, whereas a higher risk investment—such as a multifamily, ground-up development—presents a classic boom/bust scenario.
The best CRE investors are able to identify where the risk lies in each real estate investment, and they take proactive steps to mitigate or reduce it over the duration of the holding period. Fortunately, the general risks tend to be fairly consistent across transaction and property types. These are the subject of this article.
By definition, a commercial real estate asset is one that is purchased with the intent to lease the space for income. Property owners count on this income to make the loan payments so any interruption can have negative consequences. Thus, credit risk is defined as the risk that a tenant cannot or will not make their required lease payment(s).
To mitigate this risk, it is necessary to perform a significant amount of financial due diligence for every tenant. This includes looking at the income statement, balance sheet, cash flow statement, and credit report for each. In addition, it can be helpful to inquire about each tenant’s track record of paying past rent on time. Finally, it also makes sense to review the tenant’s business and to make an assessment about how vulnerable it would be to an economic downturn.
Prior to making a property purchase, it is necessary to make a pro forma financial projection to model future cash flows. When making the pro forma, an investor must make assumptions about the rental rates that can be achieved when tenant leases come up for renewal. But these assumptions must be made several years into the future, so it can be difficult to get them just right. This highlights the concept of Market Risk.
Market Risk is the risk that rental rates and cap rates are materially different than those that are modeled in the pro forma. For example, consider a pro forma that assumes a rental rate of $20 PSF upon lease renewal, but there is a market downturn resulting in market rates that are only $16 PSF. This change can have a material impact on Net Operating Income (NOI) and property values.
By definition, market conditions can be unpredictable. As a recent example of this, the COVID pandemic is considered by many to be a once-in-a-century event that was not accounted for in most financial models. As such, the best way to mitigate market risk is to make conservative assumptions in the pro forma, and to perform a “sensitivity” analysis to get a feel for how much rental rates can change before the property’s cash flow turns negative.
A commercial property purchase is typically financed with some amount of debt, which is great. But, it can also present two types of risk for investors: interest rate risk and leverage risk.
In a loan with a variable rate, interest rate risk is the risk that an increase in interest rates will raise the borrowing costs and make the property less profitable. The easiest way to mitigate this is to take on fixed rate debt for the entirety of the investment holding period. However, doing so presents its own kind of risk. Suppose that an investor works with a lender to obtain a fixed rate loan at 5%—then, at some point in the investment holding period, market interest rates fall to 3.5%, the investor is now stuck paying above market interest. They could refinance, but this would be costly and time-consuming.
Leverage risk is simply the risk that a real estate investor takes on more debt than the property’s cash flows can support. This is partially mitigated by the lender(s), who will limit the loan amount to protect themselves. But, it is also incumbent upon an investor to understand what amount of debt the property can support, and not take on more than that. As a general rule of thumb, a debt should account for no more than 80% of the property’s value.
This risk category is particularly relevant for ground-up development projects or those that involve a significant amount of renovations. These types of projects require a number of legal and regulatory approvals from municipal agencies that are not always easy to come by.
Entitlement Risk is the risk that these approvals don’t happen at all, take longer than expected, or mandate expensive changes before approval can proceed. Any of these situations can result in some loss of investment or significant delays, neither of which are desirable outcomes.
To mitigate entitlement risk, it is necessary to work with experienced investors and contractors who have the relationships and knowledge necessary to create a business plan that has the best chance for regulatory approval.
Physical Asset Risk
Commercial investment properties are physical structures and things break, usually at a very inopportune time. The HVAC system can break down, the plumbing can back up, or an electrical issue can make occupancy unsafe for a short period of time.
Physical risk is the risk that an unexpected issue can result in a significant repair bill that was not planned for in the property’s operating budget. Such an issue can result in negative cash flow for a given year, or a capital call from investors that may not be greeted with enthusiasm.
Mitigating physical asset risk is fairly simple, and these types of issues should be anticipated. As a best practice, investors should set aside a certain amount of funds from a property’s operating cash flow in reserve for big ticket repairs and unexpected issues. These reserve accounts should be well-funded, and transaction sponsors should make this line item clear on their pro formas. Failing to do so raises the risk profile of the deal.
Summary and Conclusion
All commercial real estate investment opportunities contain some level of risk. It is up to investors and transaction sponsors to identify where the risk lies in each transaction and to proactively mitigate it. Failing to do so can negatively impact property valuations, resale pricing, and the liquidity needed to operate the asset.
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First National Realty Partners is one of the real estate industry’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities in which we invest.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.