10 Risk Factors to Watch Out for in Real Estate Investment Deals
Regardless of how promising any investment may seem, there is always an element of risk at play. Commercial Real Estate deals are no exception. There are actually a variety of potential risks to watch out for when considering investments. While there is no way to completely eliminate all risk factors, it is wise to understand where risks exist and how much of an impact they could have. Doing so will allow you to determine whether you are actually getting a decent size return on your investment.
We’ve identified 10 of the most common risks associated with Commercial Real Estate deals for you to keep in mind and avoid as much as possible.
- Tenant Risk – The quality of the tenants dramatically affects the overall risk of a real estate investment. Ideally, you should have stable tenants with solid creditworthiness. Large well-established companies are preferred over startups and smaller organizations. More risks are assumed to be involved when dealing with single-tenant properties, due to having all of your eggs in one basket. A good rule of thumb is that no more than 20% of an asset’s rentable area should be occupied by a single tenant. Staggered lease expirations can help to mitigate rollover risk. Merely looking for long-term leasing won’t suffice, it is usually priced into the assets. The last thing that you want is for a long-term tenant to default on their lease. One way to mitigate this is by conducting extensive interviews with your prospective tenants.
- Debt Risk – Many deals are thrown peril when too much debt is accumulated on a project or when that debt matures at an inopportune time. The latter is particularly problematic if it occurs during a market turndown since it can lead to foreclosure. An asset can become overleveraged if too many tenants are lost, causing the net operating income to drop. Good leverage should fall in the range of 0 to 80%.
- Leasing Risk – Leasing risks can be the ruin of otherwise promising deals. A prime example of such is when a vacancy exists within an asset and its sponsor assumes that it will lease-up over an extended period of time. The lease-up may not unfold as expected and it may take a lot longer to fill the vacancy. These types of risks can be mitigated to some extent by carefully considering various leasing scenarios and not rushing into any financial commitments.
- Construction Risk – When a real estate deal involves considerable construction, whether it’s in the form of new construction or redevelopment, there are risks involved. The construction work may end up being more involved or expensive than anticipated, or it may take longer than expected to complete. This scenario may also expose previously unknown issues or physical asset risks that may require attention and delay the project. It helps immensely to consult with someone who has experience with managing construction projects to assist you in mitigating these risks.
- Geographic Risk – The geographical location of an investment property dramatically influences its associated risks. This can be true on a state, regional, city or even neighborhood level. Large metropolitan areas or primary markets, tend to be more protected from economic downturns due to their diverse economies. The risks increase as the markets decrease.
- Capitalization Rate Risk – Prevailing capitalization rates are influenced by supply and demand. They can have a major impact on an asset’s exit value. Even tiny fluctuations can have a major impact on an asset’s residual value. Mitigate this risk by carefully assessing entry and exit capitalization rates. Is the entry capitalization rate competitive? Is the exit capitalization rate likely to hold up during the holding period?
- Market Risk – The health status of the local market majorly impacts real estate deals. Markets have their ups and downs. There is no reliable way to predict what will unfold. A healthy market is one that exhibits steady rent growth and strong occupancy rates. In an unhealthy market, you will usually find flat or reduced rents and low occupancy rates. A drop in demand or a boost in new development can trigger downturns within the market.
- Entitlement Risk – With new developments, the entitlement process is a significant risk factor to keep in mind. The outcome to strive for is to receive municipal approval to proceed with a project. Once the construction permits are issued, you are typically in the clear. In the meantime, however, all bets are off.
- Physical Asset Risk – The condition of a property can bring unexpected expenses to light that can put a deal at risk. This is particularly true about aging assets since they are likely to face costly repairs and renovations to major systems and structures. This risk may be mitigated by assessing professional third-party reports regarding the physical condition of the properties. Such reports should outline potential abnormal expenses so that new terms or rates can be negotiated if necessary.
- Sponsor Risk – Lastly, the ability and experience of sponsors are one of the biggest risk factors affecting real estate deals today. For example, asset management risk is assumed based on the effectiveness of the asset manager’s proposed business plan. Assets that depend on effective customer service depend heavily on effective property management. Property management risks have a strong impact on the overall success of a deal. With this in mind, it is crucial to work with reputable property management firms with a track record of keeping tenants and landlords happy.
In an ideal world, you wouldn’t have any risk factors to worry about when investing in Commercial Real Estate. However, putting your head in the sand is a surefire way to fall victim to one or more of the above risks. By being aware and knowing how to mitigate them, your investments will unfold much more smoothly.
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