The most straight forward risk in most investment real estate opportunities is the risk of vacancy.
Many investors focus on lease expiration, tenant’s likelihood of renewal and the rental market when evaluating this risk. In addition to this, investors should also evaluate the tenant themselves and the risks they face in their business which ultimately are also shared by their landlord. These risks often impact the tenant’s ability to complete their lease terms.
When a tenant does vacate, a new factor must be evaluated: how long will it take to replace those rents and how much will it cost to replace them? It is not merely a factor of determining when a new tenant will come, but more importantly, can a similar quality tenant replace them? How much will the landlord be expected to contribute to tenant improvements? What are the leasing commissions in the submarket? Is the type of lease structure to be replaced still in use or has the market shifted?
These questions not only determine the cashflow, (or lack thereof) but the value of the building itself when the tenancy changes.
Culture Shift Risk
The risk of whether or not tenants will continue to lease large office spaces, visit traditional retailers, require a drive thru, or even use grocery stores are all risks shared by the landlord with the tenant base.
Investors must have a good understanding of their submarket and the direction it is heading while making assumptions to price in these risks.
Expense Increase Risk
For lease types that require the landlord to assume some or all of the risk of expenses of maintenance, the obvious risks include mechanical failure and damages. A greater risk, however ,are issues outside of the landlord’s control known as “uncontrollable risks.” These include property taxes and property insurance.
These types of factors which are outside of the landlord’s direct control impact the profit, or absence thereof. It is for this reason, the market is shifting with a strong preference towards lease structures which require tenants to share in these risks.
Interest Rate Risk
At various times throughout history, variable interest rates have gained or lost appeal. These types of loans deploy the risk of increasing interest rates onto the investor.
A property with short term leases and a strong rental market can respond to this risk more easily than a property with long term leases (or even short term leases with a weak leasing market.)
As mentioned before, commercial loan terms are not typically self amortizing. This is due to the size and thus the exposure of a bank to interest rate fluctuations. Typical lending institutions will provide terms between 3 and 10 years which means many investors will have to take on a refinance at some point during their hold period.
Investors must attempt to make realistic assumptions about not only the future of interest rates at the end of the term, but the value of their property and the amount of leverage given on a new loan against that new value.
Market Shift Risks
Crime, traffic and even stop lights can impact the performance of a commercial property and its ability to command rents. There are a set of other factors to consider that impact rents in a submarket including competitive properties that could be constructed during the hold period that potentially could drive rents downward.
Typical in power center shopping centers which are anchored by major retailers, smaller retailers usually demand a co-tenancy clause. A co-tenancy clause can allow a tenant to either vacate or operate at a reduced rent in order in the event of the anchor leaving the center.
Other variations of this are occupancy clauses allowing similar relief if the occupancy of the center drops significantly.
Legislative risks are typically focused on a particular tenant. Examples of this are gun stores, liquor stores, payday lenders etc. Many of these tenants have clauses in their lease that allow them to vacate should the legislature pass a law preventing them for continuing normal operations.
It is also important to note that some product types, such as retail, are not able to respond to changes in a submarket by reducing rent as easily as other product types. That is due to the heavy investment retailers place in their locations related to the rent they pay. In short, the wrong location is the wrong location even if its free for a retailer who needs just the right access, co tenancy, etc.