The bigger the risk the bigger the return. We’ve all heard this old adage. Basically, what is means is that for someone to engage in risky behavior they must expect a commensurate return. One of the underlying principles of economics is that people behave rationally; meaning they will act in ways that they believe will result in the optimal level of benefit or utility. When this principle is applied to risk it means that people will make decisions that will minimize their risk and maximize their return.
This middle ground is where investment decisions are made. Investors must assess their risk tolerance. In commercial real estate that means the variability of return they can afford, stomach, or are willing to assume. In short, investors are willing to accept a lower return for a sure thing and will require a higher return in direct relation to the risk associated with the investment/property.
Risk tolerance is subjective. Risk is more objective. Understanding and being able to identify the various risk factors associated with a commercial real estate investment is fundamental to being a successful investor. Here are some of the risk factors to consider when investing in commercial real estate:
Economic – The business of real estate is leasing space. The demand for that space is based on micro and macro-economic conditions. When a butterfly flaps its wings in China…
Liquidity – This refers to how quickly an asset can be bought or sold at a price that reflects its market value. Real estate sales require due diligence. This takes time. This results in real estate having low liquidity and thus high-liquidity risk.
Marketability – Closely related to liquidity, the marketability of an asset contributes to its risk. Big box stores are starting to suffer from this new reality. If there are not users/buyers for an asset it can be difficult, if not impossible, to sell a property unless sold at a significant discount.
Leverage – Why use your own money when you can use someone else’s? Leverage is a beautiful thing. It allows investors to put less money down to purchase a property. It also has the ability to increase returns if the cost of funds is less than the return the investment generates. Still, those mortgage payments are due each month and the more leveraged you are the more risk you incur. If you can’t pay the bank takes your property along with all you’ve invested.
Capital Market – Real estate competes with stocks and bonds for capital. Debt capital shortages like we saw in 2008 can affect both liquidity and marketability. High interest rates, which increase the cost of money, can have the same result.
Management – This can be broken down into two parts: property management and asset management. Property managers handle the day-to-day operations and physical maintenance of properties (the proverbial 2:00am call for a clogged toilet). Asset managers are involved in the financial performance of an investment property and are involved in decisions ranging from economic concessions to tenants to capital improvements. If you don’t have efficient management you could be leaving money on the table and hurting your position within the market.
Taxes – The only two sure things in life are death and taxes and unfortunately we have little control over either. Changes in tax laws can greatly impact an investment’s performance. Sometimes it pays to be politically active.
Environmental –The existence of hazardous materials or other natural contaminants can negatively impact a real estate investment’s value. Investors should always do their due diligence when purchasing an asset such as Phase-1 and Phase-2 Environmental Site Assessments (particularly with industrial properties).
Political – Real estate is the only investment class where insider information is not only legal but is often the foundation of a good deal. Changes in national, state, and particularly local laws can have significant impacts on a real estate asset’s value. Community groups can increase costs associated with (re)development or stop it altogether. Wise investors stay up-to-date and informed of what is going on in the community in which they invest.
Unknown – You can know what you know and know what you don’t know, but true risk lies in what you don’t know you don’t know. True risk lies in the unknown and can only be mitigated to the extent of the margin an investor includes in their risk and return profile.