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Commercial Real Estate

Risk and Potential Reward When Investing in Commercial Real Estate

Real estate can be an attractive investment, providing cash flow, appreciation and tax benefits. However, if a real estate deal is poor, it is possible to lose your entire investment, and in a worst-case scenario, additional capital. Because there is no prescribed list of disclosures required for real estate transactions, buyers must undertake their own due diligence to analyze prospective risks before moving forward with an acquisition. Below is an overview of several areas of risk inherent in real estate investments.

Location, Location, Location

One of the most fundamental risks of real estate is whether the underlying property will maintain its value over the course of the investment. While you don’t necessarily have to select investment property in a neighborhood where you would live, it is important to buy property where someone wants to live. To assess the current and prospective desirability of a property, you should understand the demographics of your location – the population in the immediate and broader vicinity of your property, local income levels, and other socioeconomic indicators. Is the population in the area growing or declining? Does the neighborhood have young families, seniors, or a robust mixture? Are land and housing prices trending upward or downward? Who are the major employers in the area, and are they diverse or concentrated in a handful of industries? If you have reservations about what the neighborhood may look like in five to 10 years, it may not be worth the investment risk.

Another aspect of location is zoning. The property must be zoned for your anticipated use. You should also understand the degree of flexibility to change the use to accommodate different types of tenants. Is there vacant property nearby that could easily be developed by a competitor? What about parking and other transportation options?

Tenant

Investment properties leased to third parties also have risks associated with the tenants’ ability to pay rent and perform other lease obligations. Single-tenant properties rely on the creditworthiness of one party, and perhaps a guarantor. You must assess whether the tenant will renew or extend the lease at the expiration of the term.

If the property has two or more tenants, there is likely to be at least some degree of common area expense and management. This could be limited to exterior areas like parking lots and landscaping, or it could be more extensive, including reception, meeting or fitness facilities. Your lease agreements should address not only payment of common area expenses and taxes, but also the use of parking and other common areas, hours of operation and the like. Some retail tenants may request you to refrain from leasing nearby space to their competitors, or that they be permitted to terminate their lease or pay reduced rent if an anchor tenant ceases operations.

In all cases, you should consider the ease of replacing tenants at market rents as space becomes available. Your estimates of income for the property should include reasonable reletting periods to get new tenants in place and to prepare the space for a new tenant.

Financing

Many real estate investors use financing to improve cash flow and to enable them to acquire more expensive property for the same equity outlay. The largest risk of any prospective loan is whether there is recourse, meaning that the borrower is held personally liable if the loan cannot be repaid in full when due. Most lenders will require individual borrowers to provide a personal guaranty for all loan payments, and any deficiency if the property is sold through foreclosure. Non-recourse loans are generally only available to business borrowers and parties with strong relationships with their lender.

The larger the amount of the loan in relationship to the value of the property and the projected income, the greater the risk. This is commonly measured by the loan-to-value ratio (LTV), which is the outstanding loan amount divided by the current market price of the property. The lower the LTV, the greater equity cushion you have to protect you if you need to sell the property and pay off your loan. Another measure of loan risk is the debt service coverage ratio (DSCR). This metric compares the amount of your loan payments with the amount of income your property generates (DSCR = net operating income/debt service). Lenders commonly offer more competitive rates or terms for properties with a lower LTV and or a higher DSCR. However, failure to maintain a LTV or DSCR may trigger a loan default.

Lenders often require borrowers to leave a certain amount of funds in reserve to protect against unanticipated loss in rental income and prospective capital costs. If a vacancy or capital need exceeds the reserves, the borrower will have to come out of pocket or risk default.

Location, tenant and financing risks are only some of the risks inherent in real estate investing. Property management issues, potential casualties to or injuries at the property, tax assessments, structural and environmental issues, and operational expenses are also relevant. Understanding and evaluating these risks before buying a property is critical.

Editor’s Note: For an in depth discussion of real estate valuation and due diligence in real estate deals, we also recommend this webinar and this webinar.

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