Types Of Risk In Commercial Real Estate

Every investment involves a certain amount of risk. There are certain general sources of risk that influence all assets – things like geopolitical risk and global macroeconomic risk.

What makes each asset unique is the level of sensitivity that its rate of return has to those risks. Here are some types of risk you may encounter upon investing in commercial real estate.

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.

2. Risk Of Inflation

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.

3. Macroeconomic

Macroeconomic risk refers to how broad, national level economic activity impacts property cash flows and valuation. For example, during a period of high growth in GDP, most businesses have ample cash on hand and low unemployment. Property owners can increase rental rates and expect low vacancy rates and collection loss.

4. Interest Rates

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.

5. Liquidity

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.

6. Legislative

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.

7. Location

Real estate investment ultimately depends on having the right type of property in the right location. Cities, however, act as dynamic and evolving organisms. 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.

8. Space Market

Property owners purchase real estate with a specific expectation about market rental rates and the demand for space over the investment holding period. Space market risk refers to the probability that those expectations are incorrect.

As an example, consider the potential impact of a global pandemic on long-term corporate behavior with respect to remote working. If corporations suddenly start allowing a large percentage of workers to engage in remote working contracts, the market demand for office space will dramatically decrease from previous forecasts.

9. Construction

Any time a property undergoes construction, there is an additional source of risk to the property owner. Construction risk applies whether there is a new development or a significant renovation. The construction project may take longer than expected and delay expected rental income, cost more than the budget estimate, or expose previously unknown defects in the property that require additional time and expense to remedy.

10. Environmental

Environmental risk can come from land use regulations and environmental protection concerns. It can also come from the environmental conditions of a property. The first type of environmental risk can be hard to anticipate and to mitigate. The second type of environmental risk may be limited with a thorough inspection of the property and all historical records about the prior use of the land.

Specific environmental risks vary a bit with the region but may include problems such as asbestos and lead-based paints, radon or other hazardous chemicals, groundwater or soil contamination, wetlands, and protected wildlife. Environmental mitigation can be extremely expensive, so property owners should take the time to do their due diligence about potential sources of problems.

11. Management

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.

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