Types of Real Estate Risk all Investors Should be Aware of

[Greg Barrett]

Every real estate investment involves risk. Some investment properties have substantially more risk than others. Real estate development is generally more risky than purchasing a stable core asset in a large market. In this post, I will list many of the common types of real estate risk. It is helpful to think back to your entry level economics class in which you studied supply and demand, because many of the risks involve a disruption to one or the other.

The overall riskiness of the investment directly correlates with the Discount Rate you intend to use when evaluating the opportunity.

Not each type of risk is necessarily applicable to each investment, and conversely, there could be additional types of risks that I have not outlined here. For example, most people didn't consider a global pandemic to be a risk associated with their real estate investment. Clearly, that risk was always there, even though it was never considered.

Tenant Credit/Default Risk

The financial position and operating ability of tenants determine their ability to meet the rental obligations outlined in the lease. The stronger the tenant credit, the more likely the tenant is to make it's rent payments.

Property values are determined by future cash flows. Properties with credit/investment grade tenants are much more likely to collect those payments than noncredit/local operators. Tenant credit is particularly important when a lease term is greater than five years. Note that in recent years, many "credit tenants" quickly lost their investment grade status due to high levels of debt, technological disruption, poor management, and other forces. You need to think about how these tenants will do relative to current trends. NNN lease investments are particularly sensitive to tenant credit because they behave like bonds--the only difference being that the investor should also consider the value of the property if vacant.

Vacancy Risk

Returns are directly correlated to occupancy and rental revenue. Vacancy erodes those figures. It can be quite challenging, costly, and time consuming to backfill a space or building that has been vacated. A large vacancy in a retail or office project could jeopardize the success of the investment.

Industry Exposure Risk

Too much exposure to a particular industry or sector within a portfolio can result in risk. If many of your tenants operate within the same industry, and that industry encounters some challenges, then much of your tenant base is at risk. For example, I was once looking at buying a portfolio of industrial properties in Midland, TX (Oil country). The buildings were all leased to oil-related service companies. When we were under contract to buy the portfolio, the industry took a major hit because of OPEC issues and reduced demand because of COVID-19 (the price of oil tanked). In short, we were fortunate to be able to back out of the deal do to this material change, but if we hadn't, then this portfolio of properties would have been exposed to substantial industry-related risk.

Also, buying properties in markets without a singular economic driver is risky. For example, suppose you are looking to buy an apartment complex in a town with one huge manufacturing employer. This would be risky, because if the company decides to shut down the manufacturing plant, then most of the renters will leave to find jobs in other cities. This was a recurring theme in many rust belt cities in the mid west that have seen population and real income decline for decades.

Operating Expenses Risk

Unanticipated increases in operating expenses result in a reduction in NOI. Operating expenses consist of utilities, landscaping, maintenance salaries, insurance, snow removal, and many other costs associate with running a property.

When tenants are under NNN leases (typically retail), and operating expenses increase, then it is much more difficult to raise rents because tenants directly bear the burden of these costs. Tenant's don't merely look at the face value of the base rent, but instead focus on the total occupancy cost (Base Rent + NNN's + additional rent). Under full service leases, like you will find in office buildings, landlord's cover the operating expenses; so any increase is a direct hit to NOI.

The cost of insuring real property has increased significantly in recent years. This is likely to continue due to the number of recent natural disasters and expectations that we will continue to see increased numbers of such events.

Market Risk

Every market is constantly evolving. We hope to buy properties in markets that are improving. In general you want to buy properties that are in the path of growth, meaning there is development taking place nearby (be cautious about direct competition). We also want to see strong and increasing population density, low crime, low unemployment rates, high median household incomes, and strong transportation characteristics (traffic counts, public transportation stops, etc.). This is particularly important for retail real estate. If the market conditions go in the wrong direction, then your investment could be at risk. Be careful about investing in properties if the market is in decline.

Interest Rate Risk

Increasing interest rates can be problematic for owners of real estate. The most obvious impact is when the property has an adjustable rate mortgage; the debt service payments will go up. If you need to refinance the property, and you face higher interest rates, than you could have much larger debt service payments. As interest rates rise, so do mortgage payments. Additionally, since rising interest rates equate to higher discount rates, the net present value of the property will decline. This could result an unacceptable rate of return for investors.

Leverage (Debt) Risk

The more debt on the investment, the more risky it becomes. Yes, debt can juice returns, but it can be a huge risk if the asset faces NOI challenges. Make sure that your property meets the LTV (generally not more than 70%), DSCR (not less than 1.2), and Debt Yield (not less than 10%) tests to make sure you aren't overleveraging the investment. Too much debt can be problematic if occupancy in a property falls, or if tenants stop paying rent (like they did during COVID-19). If revenues fall, then the property may not generate an NOI in excess of it's debt service payments. Then the operator will have to dip into it's cash reserves to make debt payments. It this situation extends for a significant period of time, then there may be no cash to cover the debt service payments, and the lender could take back the property.

In addition to having the risk associated with debt service expense, there is risk that you may not be able to refinance when possible. Let's say for example, you acquire a property with debt that matures in three years. The property will need to be healthy enough to be able to refinance or sell at that time. I've seen several situations where the business plans were disrupted by changes in the market (some of the risks I've outlined here) which made it very challenging to refinance. Due to COVID-19, it may be very challenging for hospitality and retail property owners to refinance their properties at loan maturity in the coming years.

Liquidity (Ability to Sell) Risk

Real estate is a highly illiquid asset class. There are limited buyers and sellers and transactions are very complex and costly. The degree to which the property can sell determines it's liquidity. If a property cannot sell quickly at market price, then the owner faces liquidity risk. Property liquidity varies across product types, markets, submarkets, the property's tenants, capital markets, and other forces.

Physical Property Risk

Despite your efforts to inspect a property during your due diligence, there is no way to understand the physical condition of each and every component in a building. Small physical defects and some deferred maintenance are normal and expected costs investors will incur. Sometimes, however, those defects or deferred maintenance can be substantial and have a significant impact on the owner's ability to execute against their business plan.

Structural Risk

Structural risk relates to the investment's financial structure, not the underlying real estate. The rights and objectives of the individual stakeholders in the deal determines the level of structural risk. In a typical investment, you have the sponsor who finds, acquires, and operates the property. You also have equity investors and a lender. The senior secured loan gives the lender a structural advantage over any subordinated debt and the equity investors. The lender gets paid first, then the subordinated debt (if there is any), and then the equity investors. The equity investors are paid out last; therefore, they have the most risk.

Partnerships can take many forms in commercial real estate investments. These types of business structures also create structural risk. Understanding the incentives and strategic focus of each player in the deal is very important to know going into the investment. I was once involved in a JV agreement with another group. We had agreed to do certain things, and the partner was responsible for other things. The partnership encountered problems because our partner was not proficient in a few areas of responsibility; they were not generating the results we needed. I then took over their responsibilities and we ended up dissolving the agreement. It was a messy situation that could have been avoided if we had fully vetted their competence and ensured that our incentives were all properly aligned.

Asset Management & Property Management Risk

Poor asset management and property management can tank even the best property in the best market. There is always risk that the landlord and the property management team do not operate the property efficiently. The landlord and brokers they hire could do a poor job marketing and leasing the property. Poor management could result in deferred maintenance. Poor management could result in strained relationships with tenants and the local city officials. Property operations teams have a significant influence over the success of the investment, so be sure to invest with a company with the experience and competence to operate the asset such that it achieves it's full potential.

Environmental Risk

There could be any number of environmental risks associated with a property. It's important to obtain the necessary environmental reports and be comfortable with their findings before proceeding with an investment. Always be carful when looking at sites that are, or were, gas stations, factories, laundry or dry cleaning facilities and other uses that could contaminate the soil. Environmental risk can also come from land use and environmental protection concerns as well.

Entitlement Risk

Entitlement involves the potential risk that government agencies with jurisdiction over the property won't issue the necessary permits and approvals required to proceed with the project. This is typically associated with development or redevelopment projects, but can also be an issue for tenants seeking to get the permits and approvals they need for their use and their build out.

Inflation Risk

We've been in a low inflation world for an extended period of time, but there is always risk that increased inflation will occur. This is could be particularly damaging if inflation exceeds the rental increases in leases. For example, if a tenant has a 10 year lease and four 5-year options (meaning they can tie up the space/building for 30 years), and the rental rate increases by 2% every year, the owner of the property could be at great risk if inflation increases to 3% or more. The rental rate will quickly fall below market. If operating expenses increase with inflation, the property owner could be in major trouble.

Construction Risk

Anytime a property undergoes construction, whether that be ground up development or the repositioning or an existing asset, significant construction risk exists. If not managed effectively, projects can be delayed and come in way over budget. You always run the risk that the contractor does a poor job on the actual construction of the improvements, resulting in defects that cost a significant amount of time and money to repair.

Eminent Domain / Right of Way Risk

The government has the right to seize private property without the owner's consent. Of course the government is required to "properly" compensate the owner of the taking; however, that compensation does not rid a property owner of this risk. I've seen road improvement projects where the city adds a lane to a road which reduces the buildable/usable square footage of the property. This can negatively impact current tenants or the potential to redevelop the site. I've also seen the road expansion projects include a median which resulted in drivers being unable to access the property from the opposite side of the road. Always be sure to check with local government bodies to be aware of any potential taking that could impact the property.

Government Legislation/Regulation Risk

Government risk refers to any change in regulations that could negative impact the real estate. This could be changes to the zoning code, building codes, or access to public utilities. This could also be changes to tax rates. In the post-pandemic world, states and city governments are going to have to find ways to make up for lost revenue, which will likely result in increased tax rates. Be concerned not just about property taxes, but all taxes impacting tenants and consumers. You can see how increased tax rates and governmental intervention have caused people to flee states like California and New York--this can't be good for real estate.

Replacement Cost Risk

As lease rates go up in older properties, there comes a time when new construction becomes economically viable. This will cause developers to develop new product, which both increases the supply and creates new-build competition. These new developments could make your property obsolete. You will likely lose your tenants and/or new entrants to pretty new buildings. This will cause your occupancy and revenue to fall.

Functional Obsolescence

Functional obsolescence is defined as "the impairment of functional capacity of a property according to market tastes and standards". In other words, the design of the real estate is no longer attractive to potential users. Functional obsolescence is generally related to the age or look of the property. A few examples that I've come across in my career are office or retail properties with really low ceiling heights. Too little parking for office users can also make a property functionally obsolete. Industrial or warehouse properties with clear heights below 20 feet can be functionally obsolete for most users. Large format restaurant buildings (6,000 SF or more). Office buildings with minimal glass--companies want a lot of glass now. Properties without enough power (amperage) to meet the need's of today's companies. When acquiring properties, be sure that the design and structure is in alignment with current trends.

Economic Obsolescence

Economic obsolescence refers to the loss of value caused by factors external to the asset. This could be changes to the market, changes in traffic patterns, or the construction of public nuisance type projects. For example, a retail property could become economically obsolete if a new interstate exit is built. After the new exit is built, all of the retailers want to relocate to the new developments at that new intersection and your property is no longer of interest to tenants.

Another issue could be related to increasing levels of crime. I've also seen properties face economic obsolescence when the property was annexed by another city which had a negative impact on the schools and increased property taxes.

I've also seen, in many small towns across America, where Walmart will cause the entire retail trade area the relocate from the old downtown area to the area immediately adjacent to the Walmart (typically near the interstate). This could leave many properties in the older area economically obsolete.

Black Swan Events

Pandemics, wars, natural disasters (earthquake, hurricane, tornado, fire, terrorism, etc.). Clearly, we will be more cognizant of these potential issues after living through the COVID-19 pandemic.

Technological Innovation

Can technological innovation disrupt the demand for the property? If so, this could pose a technological risk. For example, as e-commerce becomes more prevalent, the need for physical retail space is in decline.

As you can see, investment real estate comes with a whole host of risks. No investment is completely immune to risks and some face substantially more risks than others. This is why commercial real estate returns are generally much greater than the risk free rate of return. Be sure to consider these risks, and others, when purchasing a real estate investment.