Every commercial real estate (CRE) investment carries risks, from macroeconomic trends to property quality. As the COVID-19 pandemic and rising inflation have prompted increases in market volatility, due diligence has become more vital than ever in ensuring accurate forecasting and efficient risk mitigation. In this article, we’ll cover the main types of risk to consider in any CRE asset investment, especially in times of shifting market fundamentals.
The commercial real estate market is subject to general economic trends that can adversely influence prices. National-level economic activity has a direct impact on the CRE market, from GDP growth to changes in inflation.
For example, a recession that prompts the closure of businesses and higher unemployment rates can lead to delayed rent collections and higher vacancies due to lost tenants. A sudden surge in inflation may increase operational costs and diminish returns on previously signed leases, especially in the case of long-term contracts. Furthermore, borrowers holding mortgages with floating interest rates can face increasingly expensive payments and higher refinancing costs if interest rates rise.
Individual market shifts have a significant impact on local property value. On a broad level, declines in demographic growth and local GDP lead to the depreciation of assets in affected submarkets.
Moreover, changes in local government and economic development plans directly affect public goods and services. For example, planned infrastructure projects such as train lines, motorways or retail centers have a positive impact on property prices within the project areas but negatively affect assets in less developed regions.
However, new infrastructure can lower asset value in time through oversupply. Planned improvements may lead to an acceleration in the development of new stock and increased competition. Changes in the composition of the supply can also impact a property’s desirability — such is the case when a new high-rise is erected in front of a building that previously boasted spectacular views, lowering demand for the older property. Assets in highly coveted areas require greater consideration in terms of property-level risks such as building quality, construction and improvement costs.
A significant portion of CRE risks is shared by every property in a particular asset class. These types of risks have become more apparent during the COVID-19 pandemic, when demand for office spaces dropped, vacancies surged and office listing rates stagnated or decreased on a national level. At the same time, the pandemic prompted a shift in office market fundamentals, as a portion of tenants have begun searching for flex space, more diverse amenity offerings or decentralized offices. Demand for retail space was also affected by pandemic restrictions, with tenants in the sector searching for shorter-term leases.
Of course, evaluating risk by asset type was a fundamental step in investment strategy prior to the pandemic. A telling example would be the migration of the U.S. manufacturing sector to less expensive markets in foreign countries and the subsequent decline in demand for this type of industrial space.
Diversified portfolios are significantly less prone to asset (and liquidity) risk than concentrated investment strategies but are also more likely to reflect, and be affected by, overall market conditions, as well as requiring enhanced oversight and more costly intelligence across multiple markets. Concentrated portfolios can have higher return rates with strategic investments and full operational focus on key high-quality assets.
While risks related to economic trends can only be managed through wider business strategies and due diligence, most property-level risks are under the direct control of the investor. Due diligence at the property level is a pivotal step in ensuring invested returns and cash flows match projections, especially in the case of large portfolio transactions that involve multiple assets.
- Replacement and improvement risks relate to construction required to redevelop, upgrade or repair a specific property to ensure its condition is at market standards. These considerations are especially important in the assessment of older buildings in high-demand areas, where properties can become obsolete at a more rapid pace. Replacement risk must consider whether lease rates can justify future construction costs, to ensure properties maintain their condition relative to the market even if new buildings are delivered in the area.
- Downtime risk refers to any factor that can hinder planned revenue collections. From expanding construction timelines to expiring long-term leases, a number of issues can lead to temporarily increased vacancies, which negatively impact projected returns.
- Liquidity risk is also highly relevant in the CRE market, as real estate is a particularly illiquid asset that cannot be sold immediately at market value. Exit investment strategies should be considered at the same time as the building due diligence process, since the degree of illiquidity depends on a property’s location, quality, asset type and the length of deal cycles in the market and asset class.
- At the property level, environmental risk refers to land use and environmental regulations for the location of an asset and issues such as the presence of asbestos, lead-based paints and groundwater or soil contamination.
To ensure projected returns for leased assets, properties should be leased to the tenants most likely to abide by lease agreements. In this respect, credit risks depend on the composition of a tenant base as well as individual tenants and their lease agreements.
As a property’s value is directly related to length of leases and tenants’ ability to pay their rents, careful evaluation of in-place tenants’ finances becomes paramount in risk mitigation. Properties that are occupied by national firms with long-term leases pose the lowest risk in terms of tenant credit, while smaller businesses and short-term leases will most often impact market value negatively.
The type of lease is also considered, as certain types of agreements transfer a higher share of property risks to tenants. Such is the case of assets occupied by tenants with triple net leases, which have become increasingly desirable due to their perceived safety. Triple net leases transfer property expenses such as insurance, taxes and maintenance to the tenant, in exchange for lowered rental rates.
Furthermore, assessing credit risk requires an added layer of market research, which pertains to the business sectors of potential tenants. For example, product-oriented businesses operating within physical spaces pose a greater risk than service-based companies.
Management risks refer both to the management of deals and the management of assets acquired through these deals.
High leverage risk
Leverage, or gearing, involves the use of debt financing to structure large-scale deals, which would have otherwise been inaccessible. While leverage allows investors to acquire assets with a smaller initial commitment, excessive debt can adversely impact income if inflation drops and prices decrease. Still, this type of risk has been greatly reduced following the Great Recession and is particularly uncommon in commercial real estate, when regulated lenders tend to be more conservative with their underwriting.
Deficient market analysis
Valuation risk refers to the due diligence process that assesses a property’s value against the local market. Reducing this type of risk involves looking at granular data such as:
- Localized supply and demand for space
- Leasing rates and lease spreads
- Construction pipelines
- Highest and best use reviews
One of the most important steps in the due diligence process is the evaluation of the capitalization rate (cap rate). Cap rates, which represent an asset’s unlevered return, reflect a property’s value through comparison to similar deals closed in the market. Acquiring properties at low cap rates most often happens when interest rates are low and capital is easily available. These conditions can lead investors to purchase high-quality assets at higher prices (and often with higher leverage) to strengthen their fundamentals — which essentially bets on a prolonged market expansion.
Pressure to invest idle capital
The need to invest unused capital is another type of CRE risk, which most often happens during times of economic growth. An abundance of cash can artificially create pressure to maximize returns through fast investments, particularly in the case of large funds that need to justify asset management fees. Deal cycles shortened under these conditions can be plagued by hasty due diligence regarding all risk categories.
Changes in legislation are the most difficult risk to mitigate as they fall outside the control of the property owner. Additionally, the many levels of regulation involved (local, state and country-level) can make it difficult to assess impact on an ongoing basis. Legislation involving zoning, building codes, taxes, access and environmental impact can change quickly and decisively, so owners need to stay ahead by developing their local network and attending local council meetings. Furthermore, the regulation of financial institutions that have high CRE concentrations can lead to increases in interest rates if financers are required to reduce their CRE loans.
Inadequate property management
Last but not least, poor management of an acquired asset represents a freestanding risk beyond the dealmaking process. Inadequate management can easily lead to lower valuations and high operational costs — whether due to improper income and operational oversight or higher vacancies resulting from strained tenant relationships.
Overall, commercial real estate acquisitions require rigorous, granular risk assessments, which are achievable only through strategic due diligence processes and complex economic analyses — particularly during times of market volatility.