Know the Risk Factors

You can’t do away with uncertainty, but helping commercial real estate investors manage today’s top unknowns can make deals happen.

November 1, 2011

In good markets and bad, commercial real estate investment has risk. But don’t let the risk of failure make you miss a great deal. “For the risk taker, this is a great market because the opportunities for returns on your risk are the best we’ve seen in five years,” says Norman Miller, director of the Burnham-Moores Center for Real Estate at the University of San Diego and coauthor of Commercial Real Estate Analysis and Investment (Thompson Southwestern, 2007). Here we discuss the top risks facing commercial investors and how brokers can help buyers and sellers navigate them successfully.

Risk One: Interest Rates

“The biggest risk for commercial real estate today is interest rates and where they will be in two or three years,” says Ray Baca, CPM, managing partner of Monterrey Asset Management in El Paso, Texas. Because an increase of 200 or 300 basis points in interest rates can make or break a sale, “we’re advising our multifamily owners with a short-term investment horizon to sell now, when buyers can still get reasonable interest rates,” Baca says. Sellers may risk leaving a little money on the table, he says, but if higher interest rates materialize, “there’s a very real probability” that we will experience two or three years of very slow sales before the cycle turns, he says.

Risk Two: Cap Rate-Return Imbalance

Rising interest rates will also start moving cap rates “in the wrong direction” and push prices lower, says Andy Burnett, CCIM, investment advisor with Sperry Van Ness in Oklahoma City. He’s already steering his clients away from most single-tenant retail ­triple-net lease deals because he thinks valuations are too high and retailers are too vulnerable to declines in consumer demand.

The possible risk of overpaying is also surfacing as cap rates for major-market, Class A offices near 2007 levels. “The question is, ‘Is the market rational?’ ” says Ken Riggs, CCIM, CRE, president of Real Estate Research Corp. in Chicago.

For the next couple of years, he says, “there is a sense of logic” in the investment because buyers understand what their returns will be. For the longer term, investors need to consider whether they can live with the consequences of potentially higher interest rates, he says.

Yet, many real estate professionals believe that income increases will soon justify higher prices—and perhaps even new development. A forward-looking Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey released last summer found that developers were confident that fundamentals would catch up with prices by 2013.

In a similar vein, a survey of Florida real estate professionals conducted in the first quarter of 2011 by the Bergstrom Center for Real Estate Studies at the University of Florida found that positive sentiment among commercial real estate owners and investors had reached the highest level since 2008.

Not everyone agrees that climbing prices are justified. David Shulman, senior economist at UCLA, believes that “asset markets have gotten ahead of the underlying fundamentals of space markets.” Speaking at a mid-2011 Forecast Conference, he cited a June 2011 Green Street Advisor’s Commercial Property Price Index, which showed that values in top-tier properties were within 10 percent of 2007 highs. Shulman warned that “investors are partying like it’s 2006.” Since then, upward price momentum has waned but still remains in positive territory, according to Green Street.

“Rent growth remains the big question. In my opinion, it’s reasonably safe to build stable rent growth into multifamily projections. Retail, office, and warehouse are more likely to have flat or even declining rents as long as the economy is weak,” says Burnett.

Rents are also under pressure from former foreclosures, whose owners bought low and can therefore offer below-market rents, says Steve Wiegmann, CCIM, CRE, president of Wiegmann Group in Orange County, Calif. “It can devalue the whole rental market,” he says.

To guard against decreasing rental streams, pay close attention to lease-end dates, renewal options, and any other tenant “outs” that could reduce income, suggests Beau Beery, CCIM, CPM, vice president, commercial real estate with AMJ Inc. of Gainesville, Fla. Beery also carefully reviews cotenant clauses on retail properties. “You need to know how many other tenants will vacate if one major tenant leaves,” he says.

Risk Three: Inflation

Even if rents do rise, net operating income faces another major challenge: inflation. “Too often, investors overlook the risk of capital expenditures and how inflation can drive up expenses,” says Riggs.

“We haven’t seen any real inflation in a decade, and if it comes, I’m not sure those 2 percent per year increases built into most office leases will be enough to cover rising expenses,” says William O’Brien, SIOR, president of M.C. O’Brien Inc. in Brooklyn, N.Y. Lease clauses that tied operating increases to the Consumer Price Index were once commonplace, but today’s owners seldom have such protections, he says.

Multifamily rents have been rising in most markets and are up 3.8 percent in the second quarter of 2011 compared with the same period in 2010, according to Carrollton, Texas–based MPF Research, but higher inflation could quickly erode profits, warns Baca. He’s advising his clients who intend to hold properties for 10 years or more to make all upgrades and repairs now, while cash flow can support the cost.

Wild Card Risk: Fear Itself

Perhaps the hardest risk to evaluate and control in commercial real estate is the fear of taking risk.

“The greatest concern today for many investors is preserving capital, even though risk-adjusted return is probably a lot higher than it was before the credit crisis,” Riggs explains. “Buyers are concerned that history will repeat itself,” so they’re doing a lot more research and worst-case scenario analysis. That slows down deal velocity, says Beery.

Some buyers and owners are also fearful that there won’t be a viable market when they want to sell in five to eight years and move on to their next investment.

“When investors don’t see an exit strategy, they get skittish,” says Baca. Fears have lessened in the last year, however, he adds. Price increases are beginning to trickle down from Class A assets to lesser properties and second-tier markets. In July, research company CoStar reported that its Commercial Repeat Sales Index was showing comparable price increases in both investment-grade and general commercial real estate for the prior three months.

Commercial brokers have to walk a fine line between painting a realistic picture of market risk and adding to fears that may kill a deal, Wiegmann says. One option: Demonstrate to investors that the return on the investment reflects any added risk that’s present today.

Why Risk Predictions Can Go Wrong

If the financial crisis has taught investors anything, it’s that even really smart people don’t see every risk coming. A big part of the problem is that most investors—even sophisticated professionals—base their projections for future risk on what happened in the past, says Liang Peng, assistant professor with the Leeds School of Business at the University of Colorado at Boulder. “They don’t assume the correlation between risk and return can change over time,” he says.

Another difficulty, says Norman Miller, director of the Burnham-Moores Center for Real Estate at the University of San Diego, is that investors often spend their time focusing on less critical variables like cap rates and hold periods, but overlook key—but difficult to predict—risk factors that can have a much greater impact. For example, he says, “if I’d told you in 2006 that the CMBS market would be almost nonexistent in 2009, you’d have thought I was crazy.”

Analyzing critical factors such as vacancy rates, absorption, rent growth, refinance rates, and expenses helps create a clearer picture of risk, says Miller. So, too, can finding indicators of potential macro risk that affect real estate. In a soon-to-be published article, “Risk and Return of Commercial Real Estate: A Property Level Analysis,” Peng uses data from the National Council of Real Estate Investment Fiduciaries to determine which variables are indicators of commercial real estate risk. His findings: Commercial real estate risk is positively correlated with GDP growth and the change in the credit spread. Negative correlations occur with inflation, stock market volatility, and the change in the credit spread over 10-year Treasuries.