It is a given that a commercial real estate (CRE) investment contains risk. Prior to committing capital to a property, it is a best practice for investors to spend a significant amount of time understanding where the risk lies in the transaction and how it can be minimized. Traditionally, much of this effort tends to focus on the CRE risk of investing in general, the market risk that rental rates will change or the credit risk that a tenant will default on their lease payments. While these are important considerations, they ignore a lesser known, but equally important risk, regulatory risk.
What is Regulatory Risk?
Whether it be a state, city, and/or county all commercial properties are located within some sort of governmental jurisdiction that is responsible for creating and enforcing laws that impact the property. As such, regulatory risk is the risk that changes in those laws will make it more cumbersome or more expensive to own or operate a commercial real estate asset.
Regulatory risk can be tricky to evaluate because a property owner is largely unable to control it. Changes in laws can happen suddenly and without any warning and can have a material impact on both the tenants and property owners. Examples of these changes include:
- Zoning: Assume that a real estate developer invested a significant amount of their resources developing a plan for a property that meets current zoning rules. But, a last minute change in the allowable use of the property renders the original plan obsolete. This change can make it very expensive and/or time consuming to reconfigure the plan to accommodate the change.
- Building Codes: To protect the safety of a property’s occupants, local regulations require specific building techniques and they can vary by location. Changes to local building codes can make it expensive to retrofit a property or they can impact a property’s valuation during a sale as the new owner would have to perform needed renovations.
- Access: Many commercial properties depend on access to public assets to survive. So, changes to the availability of that access can impact their operations. For example, a retail property could depend heavily on the vehicle traffic passing by for customers. But, changes to the traffic pattern could significantly reduce it, which could also reduce the attractiveness of the property to potential tenants.
- Taxes: Taxes are levied on a commercial property from a variety of sources and unexpected increases can materially impact the property’s cash flow.
- Rental Rates: High cost locations in New York and California have strict rules on how much rental rates can be raised each year. This is particularly relevant for commercial multifamily properties whose rental upside, vacancy rates, and corresponding market value may be limited by local housing authorities.
- The Environment: To protect local waterways and native animal populations, local regulatory authorities can make changes to building requirements or allowable property uses to minimize environmental risk. These changes can be especially impactful for construction projects as they could require last minute changes.
The above are examples of regulatory changes that can have a direct impact on a property’s performance and leasing activity, but the risk isn’t always so obvious. There are other types of indirect regulatory risks that should be considered, especially with regard to real estate loans.
Indirect Regulatory Risk
Nearly all commercial property purchases are financed with debt from some type of financial institution, which is important to note because financial markets and commercial real estate lending are heavily regulated by federal authorities. They may place limits on the amount and types of loans that a lender can make and on the costs that they can charge to do so.
For example, financial institution regulatory authorities closely monitor the portfolio concentration risk associated with lenders (including community banks) who have a high number of CRE loans on their balance sheet. For those that exceed the allowable limits, they may be forced to reduce their CRE concentrations, which often means reducing the number of commercial real estate loans – including construction loans- that they make. The net effect of this change can make CRE lending more expensive through higher interest rates and fee pricing or more difficult through onerous underwriting criteria for borrowers.
Another type of indirect regulatory risk to be aware of is taxes. Not property taxes, income taxes. Changes in state or federal tax rates can impact market conditions and make it more or less attractive to purchase a commercial asset in a specific real estate market.
Mitigating Regulatory Risk
Again, laws and regulations can change at any time so it can be difficult to actively mitigate regulatory risk. But, there are a few sound risk management practices that can be applied for all property types and locations:
- Get Involved: While the announcement of a regulatory change can seem as if it came from nowhere, the truth is that they often have to go through several rounds of debate and public discussion before being signed into law. As a result, it is always a good idea for property owners and investors to get involved, especially at the local level, to make sure they are aware of potential changes. This means fostering relationships with local regulators and actively attending city council meetings to ensure awareness of proposed changes and to begin planning for them should they pass.
- Maintain Adequate Working Capital Levels: Because regulatory changes tend to impact a property’s cash flow, their impact can be mitigated when they are actively planned for. All properties should have adequate working capital reserves built into their underwriting standards to ensure funds are available to address any surprises. The soundness of planned working capital amounts should be subjected to regular stress tests to ensure adequacy.
- Limit Debt: Too much leverage can limit a property’s ability to respond to unexpected changes in cash flow. As a general rule, debt should not exceed 80% of a property’s value. If it does, it can raise the overall risk profile of the asset.
- Hire Experts: Regulatory rules, particularly those related to taxes can be incredibly complicated and difficult to follow. As such, it is a best practice to employ experts to help navigate changes. At a minimum, these should include a qualified CPA and real estate attorney.
These strategies, combined with years of experience and operational expertise can ensure that properties and their finances are well positioned to respond to unexpected changes.
Interested In Learning More?
First National Realty Partners is one of the country’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 we invest in.
When evaluating our own investment opportunities, we always survey the regulatory landscape and work with our lenders to understand their loan portfolio and any potential commercial real estate concentrations or CRE exposures and incorporate our findings into the risk assessment of the property.
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.