Managing risk is an essential part of investing in any asset class. Risk and return are positively correlated in many asset classes, and real estate is no exception. This is the reasoning behind the idiom, “the higher the risk, the higher the reward.”
That’s why investors need to understand the different types of risk they face when investing in a specific asset class. This article will explore the different types of risks investors face when investing in commercial real estate.
Let’s dig in.
Different Risk Types CRE Investors Need To Be Aware Of
All investments come with risk. The experienced investor knows how to read the markets and manage risk accordingly. Even if you aren’t investing in commercial real estate directly and instead are investing through REITs, REIT ETFs, or crowdfunded CRE platforms, it’s essential to understand the risks of the asset class.
There are seven types of risk commercial real estate investors analyze when deciding whether or not to invest in a CRE project.
- Market Risk
- Asset Risk
- Liquidity Risk
- Credit Risk
- Debt Risk
- Risk of Physical Obsolescence
- Financial Structure Risk
- Property Specific Risk
Let’s explore each in further detail.
What is Market Risk?
Different markets feel various types of risk differently. Each market is affected by multiple economic factors that ultimately affect prices in that particular market. Commercial real estate is no different.
What are some economic factors that contribute to market risk?
- Wage Stagnation
- Interest Rates
- Supply Chain Shock
- Offshoring Labor
Investors need to understand how macroeconomic trends might affect the markets they wish to invest in.
What is Asset Risk?
Asset risk refers to the tendency for certain risks to impact an entire asset class but not others. For example, certain asset classes will be significantly affected if unemployment is high, and others will not be affected.
To get more specific, let’s say there are two investors. One has invested in commercial retail and the other in residential real estate. High unemployment will have a devastating impact on commercial retail investing because people are likely to shop less during times of economic hardship. However, people will have to pay rent to live.
Therefore, commercial retail has a different asset risk than residential real estate. An investor needs to understand this to make an informed decision.
What is Liquidity Risk?
In finance, liquidity refers to how easily an investment can be converted into cash. Stocks have high liquidity because they can be sold quickly for cash in the stock market. Commercial properties are considerably less liquid.
A property’s liquidity is also affected by the demand in the market. If a market doesn’t have high buyer demand, it will be harder to sell, making it less liquid than a comparable property in a high-demand market.
What is Credit Risk?
There is also the risk that tenants won’t pay their monthly rents. This is called credit risk, and any commercial property that leases space to tenants has to account for it. Credit risk is directly tied to a property’s value, so investors need to understand how it will impact their investment.
A commercial property with long-term leases and well-known, nationally-recognized tenants has much less credit risk than a commercial property with short-term leases and local, relatively unknown tenants.
What is Debt Risk?
The amount of debts tied to a commercial property also affects the amount of risk it has for investors. This type of risk is called debt risk. The net rental income of a given property will be reduced proportionally to its operating expenses and the property’s debts.
Properties with a higher debt risk will likely generate fewer profits, even if that property’s initial gross rental income is high.
What is the Risk of Physical Obsolescence?
There was a time when that old, stingy office building from the 70s was a new asset. Buildings age and grow obsolete. This natural process of obsolescence is another risk that investors need to consider.
How will the property age? What new technologies, features, and amenities will put your property in the same bin as that old, dingy office from the 70s? Obsolescence is a significant risk in high-demand markets because tenants will want the latest and greatest. To keep up with newer constructions on the market, your development team will need to perform costly upgrades and renovations to stay competitive.
What is Financial Structure Risk?
Investors also need to consider where they sit in the capital stack. The capital stack refers to prioritizing who gets paid first. Senior debt holders receive the payout from profits before equity partners. Investors positioned lower on the capital stack take on more risk than those people higher on the capital stack.
Knowledge is Half the Battle
Now that you know more about the risks you face as an investor, you can better address which properties will make better investments. Each person’s aversion to risk is different and depends on various economic factors, personal tastes, and other miscellaneous factors.
Are you ready to start investing?
About the Author
Roni Davis is a CRE investor, blogger, and legal assistant operating in the greater Philadelphia area.