All investments have risk – some more than others. Investing in the commercial property market, particularly, is nuanced; you need experienced, knowledgeable CRE brokers to work with if you want to make sure your investment reaps returns. This type of real estate, while dependable and largely predictable, is often volatile and high stakes.
Before you invest in a commercial construction project or a retail space to lease, consider all facets of risk associated with the project. The commercial property developer you’re working with should be able to identify every one and explain to you the best way to mitigate them so your investment stays safe and grows.
10 Types of Risk in Commercial Real Estate
1. Credit Risk
In commercial real estate, every party in a given land or property transaction poses some financial risk. As a purchaser, you pose the risk of taking out too large a loan, not being able to make the payments, and hurting your credit. This is also a risk to the entity lending the money. As a landlord, you risk the tenant failing to pay or vacating the lease and having to carry another mortgage you don’t have the capital for.
Credit risk can be managed with due diligence. Thoroughly vet your commercial tenants and carefully negotiate your leases. Consider the tenant’s viability in the scheme of the broader market, as well as the portfolio of commercial and industrial buildings you lease. National tenants and long-term leases are always less risk than short-term leases and local tenants.
2. Macroeconomic Risk
This type of risk describes larger economic factors that are beyond your control but will nevertheless affect commercial property values. National economic trends like GPD can affect things like vacancy rates and rent caps. Recessions specifically are troublesome because of higher unemployment, less commercial growth, increased vacancy rates and property devaluation.
Manage macroeconomic risks by keeping a diverse CRE portfolio, both in sector and location. This can allow you to offset a loss from a bad market with stability in a strong one, letting you ride through recessions more easily. As a landlord, manage this risk by being extremely specific about the type of tenant you lease a commercial space to and what terms are built into that lease.
3. Geographic Risk
We’ve all heard it before: location, location, location. Geographic risk is about the long-term viability of the location of your commercial building, whether you’re the lessor or the lessee. As we saw during COVID, everything can change on a dime, and if your location suddenly becomes undesirable and stops attracting growing businesses, property values will plummet.
Manage location risk by thoroughly researching past and present market conditions in your target area, as well as predictions of future property value trajectories and economic climate. In our region, commercial real estate developers and investors can easily mitigate this risk, because the area has been in a growth stage for decades, and it’s not slowing.
4. Environmental Risk
This type of risk is defined by everything you use and do during a commercial construction or renovation project. Environmental safety regulations differ by location and tend to be either very vague or particularly specific. Risk comes with proceeding through an industrial build or office renovation only to find out the materials you used aren’t up to code or that you didn’t do due diligence for your pre-development plant and wildlife surveys.
Manage environmental risk by working with a commercial real estate development and construction company that’s well-established in your target area. They’ll be knowledgeable about best practices for planning, survey, land development and sustainable commercial construction, and they’ll have subcontractors you can be sure are only using compliant building methods and materials.
5. Construction Risk
No matter how well you planned or how well the build site is managed, there is always some risk with commercial and industrial construction, and it can be costly. For instance, those supply lines COVID wiped out delayed lumber distribution for weeks and drove the price of building materials up. Adverse events, unexpected expenses and delayed timelines can all pose a risk to your investment by delaying the ability to lease or sell the building.
Manage construction risk by partnering with that same commercial development and construction firm through the whole process. They will be able to forge the safest path to get your building project to completion and ready for a tenant to move into or a company to acquire.
6. Liquidity Risk
While the nature of investing in commercial or industrial real estate is long-term, investors must still consider exit strategies and contingency plans. The goal of any investment is to be able to turn an asset into money. If you fail to consider how difficult it would be to offload a given industrial property in your portfolio, for instance, it could become a danger more than an asset.
Manage liquidity risk with thorough market research and detailed exit analyses. Know the supply and demand of the property type. For instance, in the Cincinnati-Northern Kentucky real estate markets right now, industrial spec buildings are on the rise, because the demand for warehouse and distribution space is high, and vacancies are low. That means an investor in an industrial construction project in our area can be reasonably sure it will sell at a profit once it’s completed.
7. Interest Risk
Often, mortgages for commercial and industrial properties have floating interest rates. Interest rates can be volatile; they’re affected by everything – income, credit, prospective profits, economic climate. Rising interest rates increase mortgage payments, which increase rent rates required to generate income for the investors. Rising interest rates also lessen present value of cash flow, and can turn a once-profitable investment to a non-starter.
Manage interest risk by negotiating a loan with a low interest rate. The lower your interest rate is, the less you’ll be hurt financially by any unexpected increase in rates. Commercial real estate brokers and developers in your target area will be well-versed in alternative financing options and negotiating transactions optimal for both parties.
8. Inflation Risk
Inflation is a given, and standard practice is to allocate 2-3% each year for standard inflation rates. However, the inflation risk comes when bad things happen, such as Q2 2022, when inflation topped 9.1% nationwide. Extreme increases in inflation are advantageous to tenants who’ve already negotiated long-term leases, but can become undue financial burden to real estate developers dealing with increased cost of operation.
Inflation risk is difficult to manage. On one hand, as the lessor of a given commercial property, you can’t set rent rates too high just in case, because you won’t attract the tenants you need. At the same time, you have no control over whether or not an inflation crisis will occur at any time. Suffering the consequences of high inflation is a risk everybody in every type of business deals with; in fact, we all deal with it personally on a day-to-day basis.
9. Space Market Risk
Real estate brokerages purchase commercial and industrial properties with some level of expectation as to what they can expect rent rates to be, long-term. Space market risk is the uncertainty of that expectation: will any mitigating factors come into play that decrease projected rent rates? For instance, COVID and the switch to remote work hurt owners of office facilities, which now have a higher vacancy rate and decreased demand.
Manage space market risk by consulting the right commercial real estate firm; one that is local to the area and has a decades-long track record. They will be able to help you avoid pitfalls like getting in on a building boom too late or starting a commercial construction project with too high risk of demand long-term.
10. Administrative Risk
Risk doesn’t stop once the paperwork is signed. When leasing industrial or commercial properties, the team that provides the site management services can make the difference in what quality of tenants sign leases and how long they stay with you. Ensure that the property management team you employ keeps the quality of your investment safe by providing quality tenant services.
Manage administrative risk by working with a vertically-integrated group of real estate development companies throughout your entire venture into commercial real estate. Schueler Group has an in-house property management division that manages millions of square feet of office, retail, medical, and warehouse space throughout the Cincinnati-Dayton-Northern Kentucky corridor. Because they’re a part of our group of companies, tenant services and communication are seamless, business values are shared, and mutual pride in services means they have a portfolio’s worth of long-term, happy tenants.
Be Confident in Your Commercial Real Estate Ventures
Investing in CRE is one of those times you definitely want several sets of expert eyes on each financial move you make, including your place in the financial structure of the project. A local, well-established property developer that specializes in commercial real estate in your desired area can help ensure you make the right decisions with your money with long-term growth in mind.