Risk management in commercial real estate investing exists on a spectrum. On one end, the safest investments have the highest prices and offer the lowest returns for real estate investors. For example, a single-tenant property leased to a national tenant may return ~5% annually but may sell for a premium because of its relative safety. On the other end of the spectrum, the riskiest investments may offer substantial cash flow and attractive prices. However, an investor has to take on significant risk to achieve them. For example, ground-up construction projects can be fantastically profitable, but an investor has to endure months or years of no income to get there.
No real estate investment is without risk. But, the trick to maximizing the chance for a positive return on an investment property is to identify the risks prior to making the investment and to employ risk management strategies to minimize them.
Common Types of Commercial Real Estate Investment Risk
One of the major differences between investing in real estate and investing in stocks or bonds is that a physical asset is acquired, which often helps an investor feel at ease. However, it doesn’t negate the fact that there are real risks that need to be considered to determine if a property or investment matches the risk tolerance and return requirements of the deal team.
In general, there are eight types of risk that an investor or deal team should consider when evaluating a real estate investment.
Macroeconomic or Market Risk
Commercial real estate prices are influenced by a variety of factors including inflation, interest rates, and unemployment. However, the impact of these variables isn’t felt equally in all real estate markets. As such, it’s critical to consider both the broader economic trends and their impact on the market in which the investment is located. For example, there’s been a long term macroeconomic trend where manufacturing jobs have been shifted from expensive markets in the United States to less expensive markets in countries like Mexico and China. As a result, local markets in Ohio and Michigan have been disproportionately affected whereas states like Florida and Texas haven’t felt nearly as much pain.
To mitigate both macroeconomic and market risk, it’s critical to have an awareness of how current and future macroeconomic trends will affect the market in which the investment is located. In addition, it’s important to invest in a diversity of locations to dissipate market-based risk.
Again, macroeconomic and market-specific factors don’t affect all asset classes the same way so it’s important to consider how levered a specific asset class is to both macro and micro trends. For example, high unemployment may have a disproportionate effect on retail shopping malls and hotel assets because they’re highly levered to discretionary income. As such a market like Orlando or Las Vegas may feel more pain than a place like Chicago or Los Angeles because those are much more diversified economies.
Again, diversification is key and it can come in two forms to mitigate asset risk. 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 may diversify their portfolio by investing in different markets that have a low level of correlation to their assessment of future economic trends.
By definition, real estate investments aren’t nearly as liquid as securities in publicly traded companies. But, even in real estate, liquidity, or the ability to sell a property, must be carefully evaluated. For example, a real estate asset may be much more difficult to sell in a place like Dubuque, Iowa than a place like Charlotte, North Carolina.
To mitigate liquidity risk, it’s important to begin with the end in mind by knowing what the exit strategy is before the asset is purchased and to make a careful assessment of how easy or difficult it will be to sell the property.
Any real estate 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. The stronger the tenant base, the less risk/higher price a property has. For example, an office building with a 30-year lease to a Fortune 500 company, would be more expensive than that same building leased to 5-year old paper supply company.
Credit risk can be mitigated by careful and thorough analysis of a tenant’s financial condition. If purchasing an existing property with multiple tenants, a “lease abstract” should be created for each tenant that outlines the length of the lease and the required payments. Those payments should be compared to the tenant’s financial statements to make sure they can pay. In addition, a tenant’s business should be considered within the context of broader market trends. For example, in 2019 the ability to continue as a going concern looks much brighter for a software company than it does a clothing store.
A real estate investment’s risk profile is directly proportional to its leverage, or debt. The more debt, the more risk because there’s less room for error before a property’s income isn’t sufficient to make the loan payments. However it’s a double edged sword because increased leverage can also boost returns so it’s important to find the right mix of leverage and return.
Mitigating the risk of excess debt is fairly easy. Don’t do it. Generally speaking, the rule of thumb is that a property’s debt shouldn’t exceed 75% of it’s value.
Property Specific Risk
Every property is different and they all represent some type of risk that is unique to their condition, location, and age. Property specific risk can present itself in the form of an unexpected repair bill or an unexpected event that suddenly and dramatically reduces a property’s income potential. For example, an apartment building may have spectacular views of a park, but a newer, taller building is built next door that blocks the park views will have a profound effect on values. But, it can also work the other way. Properties near New York’s High Line park sat vacant and unloved for years, but the addition of a new and incredibly popular park sent values soaring.
Property specific risk is mitigated 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.
Risk of Physical Obsolescence
Real estate is a physical asset, which means it wears out over time. In growing, high demand markets, it often means that there’s a point in a property’s life where the economics demand that the property either be renovated or replaced. Either situation is a costly endeavor, but it must be given serious thought because it may be required to maintain occupancy and retain property value.
To mitigate the risk of a commercial property becoming physically obsolete, careful thought must be given to 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 for a competitor to come in a build a new property all together. The theory is that, given the same rent, a tenant is going to prefer a newer property.
Prior to making an investment decision, particularly an equity investment, it’s critical to be acutely aware of the “Capital Stack” and the rights and payout priority of each participant. For example, senior debt holders are always paid first whereas equity holders are paid last. For investors considering an equity investment in a CRE property, they need to know how many people are in line ahead of them to receive a payout if the deal goes bad.
When evaluating a potential investment, it’s critical to understand exactly what the Capital Stack looks like and how the loan and operating agreements are structured to ensure that 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 for that institution. It doesn’t mean they’re always going to be right, but it does mean that a significant amount of resources are allocated to protecting the capital of the institution and its investors.
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.
Through our decades of experience, we’ve established a consistent and repeatable three-step investment approach to mitigate risk and increase the opportunity for profitable returns:
- Buy it – We acquire high-quality, income-producing assets at discounts to replacement costs
- Fix it – We rapidly and proactively address any capital structure, physical, or operating issues pertaining to the investment
- Exit – Once issues are addressed we refinance the investments and hold them for the long term. Our average hold period prior to refinancing is slightly more than three years
If you’re seeking a passive real estate investment option and have a long term time horizon, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.