Any type of investment comes with risks. Consequently, the higher the risk, the higher the potential for rewards or losses. There are also different risks associated with the different real estate assets. Risk is unavoidable with commercial real estate investing, but what you can do is educate yourself and act proactively in handling the risk. Here are 6 types of commercial real estate risks.
Also known as default risk. This is a risk that someone will not be able to make a payment on time. This could look like a tenant not making a rent payment to their landlord or a borrower not making their monthly payment to their lender. These late/incomplete payments can cause a serious issue in cash flow for the owner.
Additionally, the value of a property ties to the length of leases and the certainty that the tenants will make their payments. For example, a property that is fully occupied by national tenants on long term leases provides less risk than a property fully occupied by local tenants on short term leases.
Liquidity is the ability of an asset to sell for cash (market value). Commercial real estate is considered an illiquid asset, because if it were needed to be sold ASAP, it could be, but well below the market value. Typically, liquidity is tied to the demand in the market, property type and location. Liquidity or illiquidity is something to be considered before making any purchases.
Inflation is an increase in price and decrease in demand, or purchase power that happens over time. Normally, you can expect the inflation rate to be 2% every year. Therefore, property owners can set their leases with the expectation of a 2% growth in market prices. The risk in this, though, is this 2% expectation being wrong. For example, if a property owner sets a lease for a tenant allowing a 2% growth, but the market actually grows 10%, then there is a bigger risk for the owner in maintaining operating costs since they now have a smaller amount of income from their tenant.
The thing that many people worry about with interest rates is them increasing. Rising interest rates affect borrowers because an increase in interest rates means an increase in monthly mortgage payments. Additionally, increasing interest rates affects the present value of investment cash flow. In that, rising interest rates increase the required rate of return, which then decreases cash flow for an investor.
Any sort of construction, whether it be renovations or a new development, provides a risk to the property owner. For example, it could take longer than expected, exceed the budget or uncover unexpected defects that need additional repairing. These risks affect the property owner’s cash flow.
The commercial real estate market is always fluctuating with inflation, interest rates, and other market trends. These things are typical, but can be better handled with knowledge on the current market and a strategy. You can check out our blog on current 2021 market trends for better insight.
This is not a comprehensive list of commercial real estate risks, as there are many. Commercial real estate risk is unavoidable. The best thing you can do is research and understand what risks are associated with the property you are interested in prior to making any purchases. Being proactive is vital in making smart investments and making sure you get the biggest reward for your risks!