Not all risks investing in real estate are equal. The risk of investing in commercial real estate is very different to owning a residential rental property. Some of these risks can be managed as owner but the most valuable point is to know these ahead of time before the acquisition so the forecast returns can be judged fairly in light of all of the risks factor the investor is taking.
Commercial Property Risks
We start off by listing out the key property specific risks which are in control of the investor
1. Building Quality
In most instances as commercial real estate owner, you can have more control over the management of the property compared to owning an individual apartment in a broader complex.
This also means that the responsibility for repairs and maintenance as well as capital expenditure to fix and upgrade the asset sits entirely on the investor.
It is critical that before purchase investors should commission a building technical report which is a detailed report of the building quality, maintenance and condition of the mechanical equipment and compliance with building and fire codes.
2. Liquidity risk
Given the typical value of commercial real estate being a multiple size of residential units or houses there will be a smaller pool of buyers at exit.
During bull markets this can work to the investors advantage as buyers scrambling to gain foothold in the market will more likely to overpay.
However in downturns the liquidity can really dry up and it will take 3 to 6 month to sell an asset at market prices.
Note that liquidity risk is highly correlated with the quality of the building and the tenants. The better the building such as prime office buildings or supermarket anchored neighborhood centers in a strong demographic areas means ultimately the asset will be more liquid compared to say non CBD office or regional shopping malls.
3. Tenant Credit Risk
As landlord income is more dependent on just a few of the tenants. It is must susceptible to the quality and the credit risk of the tenants. That is why it is important in selecting the right tenants and it maybe payoff in the long run if the better quality tenants are given a discount to market or have more flexible terms.
4. Leasing Risk
Leasing risk refers to the risk of pro-longed vacancy after the current tenants lease the premises. Long leases terms is always preferred as it provide income security to short term leases where there is always a risk of vacancy in the investment period.
However in specific instances such as potential development sites short term leases can be prefered so the redevelopment opportunity can be unlocked.
5. Downtime Risk
Downtime or the vacancy period between tenants occupying the space. It is reasonable to assume there is always a period of downtime between leases as there is unlikely the chance that the income tenant will time their moving or lease expiry date perfectly with availability of the space.
Macroeconomic Risk Impact on Commercial Real Estate Values
These are set of risks commercial property investors face which is outside their control but can affect asset values. This is mostly managed indirectly by improving the lease term, quality of tenants and overall management of the property.
6. Valuation Risk via Market Rent and Cap Rate
It is interesting that two of the most important drivers of value, market rent and the cap rate are outside the control of the investor. The rent is set by the market via supply and demand of comparable real estate and tenant pool growth in the area. The stock in the market can be affected by developments or if existing buildings are taken out of the market for other uses.
Market rent will always be the anchor for the negotiation between tenants and landlord. While every piece of real estate is different there is a commodities aspect to it in which if the asking price is beyond market the tenants can find better value elsewhere. Conversely if the owner want to fill the space quick to meet cash flow shortfall they might set the rent below market.
The cap rate is the other important factor which can affect value. Commercial real estate cap rates expand and compress over the cycle. Assets trade around the market cap rate and it is rare for transactions to deviate too much from the trend.
7. Finance Risk
8. Location Risk
The basic axiom of all real estate investing is location, location and location. The quality of the location changes overtime based on amenities , tenants perception of the area and transport links. The common theme running through these feeding into location is that does people like the area and do they want to be located here? If the positive are outweighs the negative overtime then the location risk will fall overtime.
Commercial real estate risk for locations can further separated into macro location and micro location. For example macro location refers to a precinct or suburb i.e NYC while micro location can refer to specific part like Midtown which can impact the value of the asset. For example retail rents on 5th Ave NYC can differ materially from Hudson Yards.
Knowing these are key in commercial real estate risk management
The list above shows that there are number of risk factors in investing in commercial real estate. The importance of each point will have varying degree of impact from asset to asset but they will touch all properties eventually.
For long term investors it is important to be aware of these factors in evaluating projects and property investments and take it into consideration in the context the return offered.