What are the risks when investing in commercial real estate?
The most notable risk to the sector as a whole is the current global and macroeconomic situation. The pandemic has affected office buildings and retail significantly, with rising vacancy rates and lowered rents causing a downturn in property values. Rising interest rates have affected commercial loans, which are almost always on shorter terms with adjustable interest rates, as opposed to the fixed 30-year terms common in residential real estate. When rates get adjusted upwards, it cuts into cash flows and can quickly turn a profitable deal into an unprofitable one. Additionally, when interest rates increase, investors will demand properties with higher cap rates, lowering the amount a property can sell for. With inflation rising, interest rates rising, and hybrid work becoming commonplace, it is a potentially difficult time for commercial real estate. That being said, there are certain sectors that have performed well, particularly industrial real estate, and can continue to do so going forward.
Harder to value
Commercial real estate is much harder to accurately value than residential real estate and with so much of the valuation based on potential income, even small differences between projections and actual numbers can affect the viability of an investment. Oftentimes a lot of assumptions are made when projecting the performance of a property, so whenever doing your own due diligence on a property or examining a third party’s due diligence make sure to map out how the building will project in pessimistic scenarios.
All real estate is fairly illiquid, but commercial real estate even more so than residential real estate. There is a much smaller market for a distribution center than a single family house. As such, your money may be tied up for a significant period of time, even if you may be receiving distributions in the meantime.
Cash flow risk
The most common risk factor affecting the cash flow of any property is the lack of rental income, whether that is because a unit is vacant or because the tenant is not paying. For retail properties, which usually only have one tenant, a vacancy can ruin an investment. For office buildings with many tenants, it is still a risk, but not to the same extent. Additionally, in a lot of commercial properties, buildings are customized and adapted to a specific tenant (restaurants, laundromats, factories, warehouses, etc) and if that tenant leaves, it can be difficult to find a replacement. Cash flow can also decrease when interest rates rise, as commercial mortgages often have an adjustable rate or a balloon payment that necessitates a refinance.
While unexpected maintenance costs and capital expenditures (“capex”) are less of a concern in commercial real estate with the prevalence of NNN leases, the risk still must be considered, particularly if the costs are still the landlord’s responsibility. If a property only projects well with low expenses and low vacancy allowances, chances are it will not work out well in reality.
For crowdfunding projects or any property that is not self-managed, there is a risk that the property management team or sponsor does not do a good job. It is vital before investing in any non self-managed property to vet the management team because they are ultimately going to be a large part of whether a property’s cash flows meet expectations.