For some, investing in commercial real estate (CRE), is seen as the ultimate investment– monthly cash flow, value-add opportunities in a physical asset, and appreciation of the property, all with minimum effort from the investor. At first glance, investing in CRE seems like a no-brainer because of the incredible upside that can be realized through making the right investment;but, jumping into any investment without fully understanding the risk involved could be a recipe for disaster. Luckily, there are plenty of people and investment groups that have been verysuccessful in their CRE investments and are willing to share what they know. Partnering with a group like High Peaks Capital can help you uncover the right asset type for you and even uncover opportunities you wouldn’t be able to find on your own.
Anyone familiar with investing knows there is always a potential for risk no matter the type of investment, but there are ways to mitigate the risk before getting started – knowing and understanding what you’re walking into can help you navigate potential risk areas and avoiding an investment that could wind up costing you big. Keep reading as we uncover some of the risks involved with CRE investing
Commercial Real Estate Risk One: Is this the right asset?
Investing is a personal experience and what might be right for one investor might not be right for another. That being said, there are a variety of commercial real estate assets to fit almost any investor’s strategy. Developing a strategy with an experienced CRE investment advisor can help you evaluate the benefits and drawbacks of asset classes, with your specific goals and risk tolerance in mind. For instance, if you are looking for a low-risk investment, you might be interested in a mostly occupied, updated apartment building. However, if you are looking for a higher risk and higher return investment, you might be interested in a vacant/mostly vacant value-add opportunity that would require more work and upfront capital for improvements, but might have a higher return later on. Investing in the right asset will bolster your portfolio and help you achieve the returns you are after, but pursuing the wrong asset type could leave you in an undesirable position.
Commercial Real Estate Risk Two: Evaluating an opportunity incorrectly?
Real estate value is driven by several factors, including location, supply and demand, government regulations, current economic conditions, and the age and condition of an asset. There are also several ways to evaluate real estate depending on the type of asset and how the asset will be used – for instance, the way you determine the value of the house you will live in will be mainly based on the sales prices of comparable home sales in your area, but the value of an apartment complex or office building will be evaluated partly based on how well the property performs. When evaluating investment opportunities, investors have their own formulas for underwriting that help them anticipate how an asset will perform over time. Most often, investors have a target return they are looking to achieve and will back into this number by gathering information from the previous owner on rent roll and expenses, plugging in expected holding costs, capital improvements, and anticipated rent growth during the life of the investment. Since investors have different risk tolerances, it isn’t uncommon for several investors to value a property very differently.
Commercial Real Estate Risk Three: Credit/Financing
Typically, CRE investors aren’t going to pay cash for an asset – utilizing financing can help you leverage your assets into a larger investment, or allow you to invest in multiple opportunities. Any time financing is used, though, there is an inherent risk added to the investment. Just like investors underwrite a property to evaluate the potential for return, lenders underwrite investors based on their ability to repay. When buying a performing asset, lenders look at the creditworthiness of the borrower and the income produced by the asset (among other factors). Lenders make decisions based on previous history and a snapshot of the conditions at a particular time, then, if they approve the loan, they assume that the borrower will be able to meet their obligations even if something changes in the future. The basic chain of lending involves shareholders with the lending institution, lenders, borrowers, and tenants. When tenants pay what they owe on time it allows borrowers to pay the lenders who then answer to the shareholders. A risk CRE investors have conditions changing, rendering them unable to repay their liability. We are seeing this recently with COVID where tenants aren’t able to pay their rent, leaving borrowers unable to pay their mortgages. There can be a nasty domino effect when one part of the system fails, but doing your diligence on the front end of an investment can help you mitigate the risk of not being able to pay – understanding the current tenant mixture and creditworthiness of tenants, and then backfilling the asset with the right tenants can provide investors with confidence in their investment decision.
Commercial Real Estate Risk Four: Market fluctuations
Investing in CRE involves making certain assumptions about the future and how market conditions will change during the time you hold an asset. As mentioned previously, investment decisions are made by looking at a property’s previous history and a snapshot of the present day. Unfortunately, no one knows what is going to happen tomorrow, a year, or five years from now, but we can make educated guesses by looking at what’s happened in the past and projecting into the future what we think might happen.
Historically, values and rental rates have increased over time. When looking at a long-term period (10 yrs., 20yrs., 30 yrs., etc…) there is a positive trend in the value of real estate and in the market rental rates tenants are willing to pay. But, within the longer-term periods, there have also been times where values have decreased over the short term. Often a decrease in value is the market’s way of rightsizing – after a period of heavy growth where values have jumped substantially, there can be a downward adjustment that signals the end of an overheated market. Just as a property’s value can change, market rental rates can fluctuate over time. When space is limited and there is high demand by tenants to rent, rental rates will rise. Most of the time rent escalations are written into the lease contract that specifies how much a tenant’s rent will increase each year during the initial term of the lease. If a tenant has locked in escalations of 3% per year and market rates have increased by 10% per year, the tenant has gotten a great deal. Alternatively, if the tenant locks in 3% escalations and the market increases by 1%, the landlord wins. When underwriting commercial real estate investments, it is important to understand and account for market fluctuations during your projected hold time. CRE investments are generally held long-term and will trend positively over the life of the investment. Setting yourself up to weather the downturns can ensure your longevity as an investor and help you achieve your long-term goals.
Final Thoughts:
Investing in commercial real estate can be incredibly rewarding if it is approached in the right way. As with any investment, there is risk involved. But with the right strategy, tight underwriting, and the right people on your side who understand the market well, the amount of risk can be heavily mitigated. High Peaks Capital has the experience and relationships to learn your goals and expectations and create custom solutions based on your specific needs.