Ray Martin Easton, CT
Examples of Risk in Commercial Real Estate
Updated: Feb 3
Every investment involves a certain amount of risk. There are some sources of risk that influence all assets. What makes each asset unique is the level of sensitivity that its rate of return has to those risks. In addition, specific types of assets have risks that are unique to that asset. In this article, we’ll look at types of risk in commercial real estate investment.
Credit risk, or default risk, is the risk that someone will not be able to meet a financial obligation. Lenders face default risk that a borrower will not be able to make a monthly loan payment on time. Similarly, leased property includes a risk that tenants will not be able to make timely lease payments as expected. Late payments can create cash flow problems for the property owner, but the situation can be worse if the tenant goes out of business and moves out of the space. Then, the property owner faces an unexpected shortfall in lease income along with additional costs to get a new tenant in the space.
Inflation is the general increase in prices and decrease in purchasing power that happens over time. In the United States, the inflation rate has been around 2% per year since the year 2000. So, planning for 2% inflation each year would be a reasonable estimate in this market. Property owners, therefore, can set lease rates that allow for this 2% annual growth in overall market prices. Inflation risk, however, is the risk that this expectation is wrong. What if a tenant just signed a 10-year lease with an expectation of 2% inflation, but one year into that lease inflation goes up to 12% annually? The tenant ended up with a pretty great deal, but the property owner may not be able to keep up with the rising cost of operating expenses if inflation rates are this much higher than expected.
Interest Rate Risk
The type of interest rate risk that most people worry about is the risk of increasing interest rates. Borrowers holding a mortgage with a floating interest rate are negatively impacted by rising interest rates. As interest rates increase, so do the monthly mortgage payments. Borrowers could also be negatively impacted by higher rates when refinancing debt at the end of a loan term.
Rising interest rates also impact the net present value of investment cash flows. When market interest rates increase, the required rate of return or discount rate also increases. This change causes the present value of future cash flows to decrease. In some cases, this can result in the cash flows no longer creating an acceptable return for an investor.
Real estate is a highly illiquid asset. A liquid asset is one that can be sold immediately at market value. If an owner had to sell a piece of real estate by the end of the day, chances are that it would be for a price far below market value. So, real estate is illiquid compared to most other types of assets. The degree of illiquidity varies according to location, property type, and market cycle.
Regulatory and Legislative Risk
Legislative or regulatory risk refers to any change in regulations or law that can impact real estate owners or tenants. These changes may take place at the local level or the national level. These may include direct risks such as zoning changes, building codes, or access to public goods and utilities. More indirect risks could be changes to local or federal tax rates, mortgage deductibility requirements, banking regulations, etc.
Increases in tax rates not only impact the property owner’s taxable income but also cash flow of the tenants. Additional limitations on mortgage deductions on federal taxes reduce the property owner’s after-tax income and the overall rate of return on the investment. Changes to bank regulations could influence the cost of borrowing and ease of obtaining financing for a property owner. Even if changes to laws and regulations do not directly impact real estate, they may indirectly impact property investment through financing or business cash flows.
Real estate investment ultimately depends on having the right type of property in the right location. What is a prime location for office and retail space today may be empty 20 years from now. Location risk comes from the external environment and the contribution that the neighborhood makes to a property’s value. Changes in city growth or transportation patterns or reductions in public goods and services can all negatively impact the desirability and value of a particular property.
Even the nicest property in the best location can be an unprofitable investment without the right management. Property managers establish relationships with tenants and make decisions about lease rates and concessions as well as the operating budget. Poor management can result in high vacancy rates, below market rental income, and high operating expenses. All of these factors reduce the property income for the owner and the return on investment. Thus, knowledgeable and competent property management is essential to success in real estate investment.
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Ray Martin Easton CT
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