Commercial Real Estate Investing Risk
If you’ve ever invested in real estate (Commercial or Residential), more than likely you have seen some things occur that were not in your plans. Buying real estate, like any other investment, is risky. Beware of the person who tells you that a project is risk-free or that all the risks have been mitigated. Whether real estate investing, or artwork, gold, race horses or antique cars, to name a few, risk is ever present. If real estate investing is so risky, why invest? Obviously, there are solid reasons to do it, but if you understand what the risks of an investment are, you can take some steps to minimize or assess the financial impact of the risk so you can make an educated decision to invest or pass on it. This paper looks at risk and why projects fail or don’t live up to their expectations. It discusses a model that is repeatable, the due diligence process and why projects don’t meet their expected returns.

Inherent Risks

In commercial real estate projects, risk can manifest itself in numerous ways. A recent report[1] indicated that there are 15 inherent risks. Based on the project, its location, its size and even the investor, there may be other additional risks. Rather than try to explain each risk, let’s say these risks fall into some broad categories. There are risks relating to the market climate, including the economy at both the national and local levels, interest rates and the state of inflation. Acquiring the property has its share of risks. These risks might include legal and title issues, construction, entitlements and other local government barriers, the timing of which can dramatically change and derail the financial assumptions and costs. Also, if a project is to utilize leverage, how it gets financed and the terms and conditions are paramount to making the numbers work. Once a property is acquired, there are risks related to owning and managing the property. These risks might manifest themselves in a reduction in the value of the property and/or tenant acquisition and retention. You should have a plan to address and budget for unexpected expenses and repairs. Poor policies and operations or perhaps the loss of critical personnel could directly contribute to the reduction of value and the loss of income, thus negating fundamentals used to either acquire the property or negatively impact anticipated returns.

In commercial real estate projects, risk can manifest itself in numerous ways. Click To Tweet

Why Projects Fail

Projects fail for many reasons. As investors start to evaluate “a deal”, a process known as due diligence takes place. This investigation period varies from weeks to months and is dependent on the project itself. Performing incomplete due diligence or not building in the right contingencies leads to failure. It is one thing to scrub the numbers for validity and reasonability, but one must build in contingencies for the unexpected. There are so many items you could include in this process, but that is a subject for a different discussion. At minimum, these major aspects of the process need to be analyzed:

  • What are the trends in the market?
  • What is happening around the property?
    • What is the competition?
    • What is similar property selling for?
    • What have been the occupancy/vacancy rates?
    • What are the rental rates?
  • Analysis of the financials – are the numbers actuals or pro forma financials?
  • What does your physical inspection of the property and area tell you?
  • Have you talked to existing tenants?
  • What plans and expectations does the city have for that area?
Performing incomplete due diligence or not building in the right contingencies leads to failure. Click To Tweet

Based on the age of the property, some assume that recently constructed properties or recently renovated properties are problem-free. Another pitfall is when the investor goes outside of his/her area of expertise (asset class or geographic expertise). That is not to say that with the proper advisement and research it is not possible to have a successful project. Other causes of failure have to do with the tenant mix, rent sustainability, leasing competition and the general dynamics of the immediate area. Focusing on either the short term or long term may be risky as both need adequate scrutiny. Probably, the single biggest reason for failure is chasing bad deals. It is very easy to fall in love with the deal or the property that we justify our conclusions regardless of what the numbers tell us. We will stretch for yield or write off red flags in order to justify the decision to invest.

Next in the series in Part 2, we will explore Analyzing the Financials of a Potential Investment.

[1] Natalie Dolce, “Ten CRE Investment Strategies for 2015.” (March 20, 2015): 6.

Image courtesy “Risk Management Jigsaw Puzzle” by jscreationzs

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