How to Manage Risk In Commercial Real Estate

Jul 30, 2018

If you’ve been a commercial real estate investor for any length of time, then you already know that there is no such thing as a risk-free deal.

Although there are some properties that are a fairly low risk, such as triple net lease properties, most commercial real estate has some risks, despite investors’ best intentions. In reality not all risk is bad: for many properties, the higher the risk, the greater the profit potential.

The key to success in commercial real estate is not to avoid all risk – but to know when it should be minimized, and how.

First Step: Decide Your Risk Tolerance Level

Your risk tolerance level will be different for each investor. Some investors may lean towards high-risk, high-profit potential properties. They may enjoy managing more volatile commercial properties that require a hands-on approach.

Other investors, in particular, older investors closer to retirement, prefer lower risk properties like triple net retail properties. These have slightly lower returns than other commercial properties but are resistant to the ups and downs of the market.

They also require little to no management, offer long leases so investors need not worry about vacancies, and are fairly liquid in the event an investor decides they want to cash out of a property.

To see where you fall out on the risk spectrum, you’ll need to look at the goals you decided upon when you first began investing in commercial real estate, and clarify as to whether or not they are still current.

lower risk commercial real estate property

If your goal is to build wealth as quickly as possible, then you know that value-adding will most likely be your main strategy.

If your goal is to add a steady stream of income – however small over time – in the hopes that it will eventually replace a full-time job or support you during retirement, then you’ll be looking for lower-risk deals.

Second Step: Identify the Risks of the Commercial Real Estate Property

The second step towards managing risk is to be aware of the types of risk you’re likely to encounter.

  • Market Climate

Some risks are uncontrollable, in that they are caused by external factors outside of the investor’s control. Economic volatility at the local and national level, inflation rates, unemployment rates, and unexpected geopolitical events are just a few of the factors that can affect commercial property.

The best an investor can do is keep apprised of local, national, and international events and observe their effect on the commercial real estate market. Making predictions about what might occur in the future is tricky and potentially dangerous since it leaves investors vulnerable to reacting to every blip on the screen.

Instead, savvy investors will look at how these trends impact commercial real estate over the long term, and then make a calculated guess as to whether these factors will have a significant effect in their market, for the property types they own.

  • The Unexpected

Certain kinds of events, unfortunately, can’t be predicted or prevented. These include natural disasters, man-made disasters (like oil spills), and terrorist or criminal threats.

  • Changes in the Competitive Environment

The development of new technology and changes in the location needs of the market also impact commercial real estate.

For example, Amazon’s decision to increase warehouse space close to cities in order to support same and next day delivery spurred tremendous growth in the industrial sector. Cities all around the U.S. fought to win a contract, with local governments offering incentives and tax cuts in order to woo Amazon.

But close on the heels of Amazon were dozens of other tech giants also searching for industrial space. Other companies, on the other hand, headed to the plains cities, searching for the ideal place to set up huge servers to support cloud infrastructure.

These too spurred an increase in demand: after all, a new mega-branch needs to hire employees, who will all need places to live, shop, and play.

Amazon’s success has led to other e-commerce companies experimenting with point-of-service stores as well, which means that though the market demand may be smaller than Amazon, investors in sectors like industrial and office could see some growth in niche areas.

Brick and mortars are also being forced to respond quickly and decisively to changing consumer demands, which in turn affects the types of tenants occupied by retail properties.

considering the competition in commercial real estate investments

In the office sector, the increasing willingness of companies ready to allow employees to work at home or in non-traditional environments has led to rapid growth in coworking spaces. Even large companies are reconsidering the mammoth campuses they once favored and are transitioning to smaller satellite offices.

All of these factors play a large role in commercial real estate. Here’s a list of the types of risks faced by commercial real estate investors:

  • Business risks that affect the bottom line performance of the property. These include increased operating costs, increased taxes, and increased labor costs. Topline risks include inflation, changes in regulation, rising costs, and technological advances that make the product or service obsolete.
  • Cash solvency risk
  • Interest rate risk
  • Risks that depend on the ups and downs of the market
  • Supply and demand
  • Building or zoning code changes
  • Changes in environmental regulations
  • Financial regulatory reforms
  • Tax code revisions
  • Changes in accounting standards
  • Risks connected to the property itself, such as the physical structure of the building, and its location
  • Management risks
  • Functional obsolescence

The Third Step: Create a Procedure to Respond to Critical Risks

The key here is to respond only to critical risks. Although the above list seems almost Herculean, the truth is that many of the above risks will be out of your control. Other risks will have a minor impact on your property or investment goals, and can thus be ignored.

That will leave you with a smaller yet serious subset of risks that if not dealt with, can cause permanent damage, resulting in loss of large sums of money, or property default.

strategy for monitoring the CRE risks

At the same time, a set of procedures that are put in place in order to monitor and respond to these risks can also result in being able to take advantage of a unique opportunity that actually makes you money.

Regardless of the specific procedures, you decide to put in place, two critical factors will affect whether or not you successfully manage risk. The first is to make sure you do your due diligence thoroughly and well. Whether you’re investigating a potential deal, deciding whether or not to take on a particular real estate partner, or considering selling a property, having the right information is essential.

And second: you must commit to leaving emotion to the side when it comes to making decisions. Base your actions not on how you feel, but what the numbers tell you.

Lastly, a good real estate team will provide essential support, ensuring you don’t take accidentally take the wrong step.

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