The 4 Biggest Risks of Investing in Commercial Real Estate

When raising equity to fund deals, commercial real estate investment firms will generally put together what’s referred to as a Private Placement Memorandum, or PPM.

This clearly describes the property being acquired or developed, the partnership structure which investors will be subject to, and information on the rights and responsibilities of the sponsor running the deal.

One of the most important parts of a PPM is the section that talks through the risks associated with investing in the deal, and even though every deal is different, I’ve noticed a few very concrete patterns in risk factors that exist across almost all commercial real estate investment opportunities.

So in this article, we’ll walk through four of the most common (and impactful) risks associated with investing in commercial properties, and how seasoned real estate investors protect their downside in a worst-case scenario.

If video is more your thing, you can watch the video version of this article here:

Liquidity Risk

Unlike ownership of stocks or bonds, you generally can’t just trade in and out of interests in commercial real estate, and going through the process of selling a property often takes a very long time.

Most commercial real estate investors will take 1-2 months just to pick a listing agent, another 1-3 months cleaning up operations to prepare for the marketing process, and another 2-4 months to find a qualified buyer, work through due diligence, and ultimately complete the sale.

This results in what’s often a 4-9 month timeframe from the time an investor decides to put a property on the market to actually receiving sale proceeds, and this is a main reason why you’ll often see large institutions focusing almost exclusively on core, gateway markets like New York, Chicago, San Francisco, Boston, Los Angeles, and Washington, DC.

These markets often have active buyer pools in all economic conditions, which can help mitigate liquidity risk during recessions (when equity investors have traditionally pulled back on deals in secondary and tertiary markets).

Interest Rate Risk

One of the most commonly cited risks in PPMs is the risk associated with refinancing a property, since, if property values have fallen at the time the original acquisition loan matures, investors run the risk that new loan proceeds from the refinance won’t be able to cover the entire outstanding balance.

Interest rates are also a key factor in loan sizing, or the process lenders use to determine the total loan proceeds they’re willing to issue to a borrower, which makes changes to interest rates extremely relevant during the refinancing process.

Many lenders will require borrowers to meet a minimum debt service coverage ratio (DSCR) requirement, which measures the number of times over the property’s net operating income (NOI) can cover its scheduled debt service.

Since higher interest rates result in higher monthly loan payments, this means that loan proceeds will inevitably need to decrease as interest rates rise to keep the DSCR above the required threshold.

And aside from refinancing risk, changes in monthly debt service also represents a very impactful risk for investors using floating rate loans, since these are subject to monthly changes in interest rates.

In a rising rate environment, this can result in extremely fast increases in monthly payment requirements, which can expose investors to significant reductions in cash flow distributions.

This is why risk-averse investors tend to use moderate to low levels of leverage and generally don’t underwrite a refinance scenario in an initial acquisition analysis, and if they do underwrite a refinance, these investors will usually use a much higher, conservative interest rate assumption.

Leasing Risk

When a commercial tenant vacates a suite, that suite can often sit vacant for 6-12 months or more, depending on the demand in the market for that particular location and the demand for the specific layout of the suite itself. And when commercial suites that make up 10%, 20%, 30% or more of the total leasable area of a property become vacant, this can result in a huge hit to investor cash flow on a deal.

And to lease up a vacant commercial suite, investors also generally need to make capital investments up front, with leasing commissions and tenant improvement allowances incurred by the landlord sometimes amounting to the entire first year (or more) of base rent scheduled to be collected.

And even though leases are legal, binding contracts, there’s always the possibility that a tenant could file for bankruptcy and stop paying rent altogether. In these scenarios, a property owner generally won’t be able to recover these up front leasing costs, and in many cases, even uncollected rent payments owed by the tenant will need to be written off entirely.

This is why conservative investors focus so heavily on tenant credit and lease term remaining, since buying a property occupied by Google with 20 years left on their lease removes a lot of the uncertainty that inherently comes along with an investment in real property.

Operating Expense Risk

The price of labor, building materials, and other goods and services necessary to run a commercial property have a significant impact on a property’s NOI and value, and increases in the Consumer Price Index (CPI) can materially affect the economics of a deal.

And while labor and material costs have a clear impact on things like payroll, repair, and maintenance costs, property taxes and insurance can also see significant year-over-year increases in an inflationary environment, and these are often two of the biggest operating costs incurred by commercial real estate investors.

On the property tax front, increases in building and material costs can slow the supply of new product, resulting in property values increasing and higher assessed values.

And since insurance costs are based on the insurer’s potential exposure, if disaster were to strike and the property had to be repaired or rebuilt completely, increases in the cost of labor and materials will also lead to increased insurance premiums.

This is why conservative investors will often look for properties with a tenant base which already has extremely healthy balance sheets, whether those are creditworthy office, retail, or industrial tenants, or high-income individuals that could take on a corresponding increase in rents or expense reimbursements if the cost to operate a property increases significantly.

How To Learn More About Real Estate Investment Analysis

Commercial real estate investing can be extremely profitable, but just like any other investment vehicle, there are inherent risks associated with investing in commercial properties that are worth digging into before getting started.

And if you’re looking to learn more about identifying risk and analyzing commercial real estate investment opportunities, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam. This exam covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.

As always, thanks so much for reading, and make sure to check out the Break Into CRE YouTube channel for more content that can help you take the next step in your real estate career.