Owning commercial real estate is an investment. Like any investment, there are risks associated with buying, holding, leasing and selling property. This article is intended to emphasize the importance of understanding the risk associated with commercial real estate investing and to highlight a few key tactics to effectively manage that risk.
Always review the fundamentals
While there are many variables that can and should affect investment strategies and decisions, there are some fundamental considerations that should always be evaluated prior to every commercial real estate investment. There are really too many to cover in this article, but to give you an idea, a few core factors include:
- The quality of the lease and terms
- The stability of the tenants
- The condition of the property
- Estimated after-tax cash flow
- Vacancy – today and projected
- Interest rates – today and projected
Always start your pre-investment analysis with the fundamentals. If they look solid, then the other secondary factors are just icing on the ROI cake.
Diversify your portfolio
Practically anyone that has money invested in the stock market will agree that the best way to manage against risk is through portfolio diversification. It’s no secret that diversification protects the investor because if one type of stock tanks, it probably won’t affect the others. Well, guess what? That same principle applies to developing a commercial real estate portfolio. Just like in the stock market, it is generally not a good idea to put all of your real estate investment eggs into one basket.
There are different diversification strategies available. For example:
- Property type – an investment portfolio could include a diverse mixture of land, office, retail, industrial and residential properties.
- Geographical region – a portfolio could include properties in different cities or states.
- Up-front risk factors – a multi-tenant retail property offering short-term leases to local businesses may carry a higher risk than a property with a single national tenant with a long-term lease. A diverse portfolio may include a combination of both.
Consider this … investors who focused all or most of their investment capital on office properties in the Wilmington area before the 2008 financial recession probably suffered significant losses in the years immediately following the recession. While the recession hit us all pretty hard, office properties in Wilmington were hit particularly hard. We’ve just begun to see office properties in our area begin to bounce back in the last year or so. Sure, all investment losses sting, but had these investors hedged their risk by choosing a more diversified portfolio, the sting would have been less painful and easier from which to recover. For instance, office properties in Raleigh and Charlotte suffered too, but they did not completely die, and they had a much faster recovery than they did in Wilmington. This is because Wilmington is considered a tertiary market and it typically takes smaller markets a longer period of time to bounce back – smaller markets tend to lag behind the larger markets.
Look at today and project conservatively
A realistic assessment of an investment opportunity comes from an effective combination of looking at the way things actually are today and projecting the way things will be in the future. I had a prospective client that owned an older retail property in downtown Wilmington. He was trying to sell the property for a price that, in my opinion, was not feasible. At the time I got involved, the property had 0 percent occupancy. On more than two occasions he walked me through the building telling me what the building could be, trying to convince me it could easily have 100 percent occupancy and be worth every penny that he wanted.
“If you just fixed this and added that, then this will be a great property,” he’d say. So, I told him, “If you fix this and add that, then maybe the property will be worth exactly what you want, but it is not worth that now.”
You don’t buy property based on what it could be, you buy it on what it is. If you can turn it to something better, great – but don’t buy on imaginings. My father used to say something has stuck with me. He’d say, “You make your money when you buy, not when you sell.” Projections and forward thinking are important, but if they are being used in the buying decision, make sure they are based on facts.
While we’re talking about projections, here’s another good tip for managing risk … always make your projections conservatively. In many aspects of life it’s great to be a “glass half full” type of person. However, when it comes to investment projections the smarter mindset is “if the glass fell below half full, would I still be okay?” So project things like occupancy, profits and gains on the low side; and things like vacancy rates, taxes and interest on the high side. Always make calculations using after-tax figures. If the investment still looks like a good one, even in the context of conservative projections, then it probably will be – and it’s likely to pleasantly surprise you when the real numbers come in better than your projections.
Find an agent you can trust and be transparent
If you’re having health issues and you go to the doctor for an exam, the last thing you want to do is keep secrets or be deceitful about symptoms, habits and behaviors that may impede the diagnosis. I realize that many people are private about their money. Some people may not want their real estate agents to know the details of their finances, like what tax breaks they may be getting, but the only way for the agent to provide the best property investment advice is by having all the facts. Transparency provides agents with the best opportunity to meet the specific needs of their investor clients. That’s why it’s important for investors and commercial real estate agents to build relationships based on trust.
In the world of commercial real estate, there are a lot of things that make up a successful risk management strategy. Basing decisions off of accepted fundamental considerations, portfolio diversification, conservative projections and financial transparency with a trusted adviser are definitely a good start to a rock solid strategy.
Grayson Powell is a Managing Partner at Coldwell Banker Commercial Sun Coast Partners (CBCSCP). CBCSCP leverages the vast experience of highly-skilled real estate professionals and developers and specialize in selling, leasing and managing retail, commercial, and investment property. To learn more about CBCSCP, visit www.cbcwilmington.com or call 910-350-1200.