It’s essential to understand the risks and uncertainties involved in commercial real estate (CRE) investing, whether you want to own stabilized assets, develop a property from the ground up, or manage existing CRE properties.
In this blog, we will talk about the four categories of risk in this industry. But before we discuss these risk types, let’s examine the three major factors that affect each type of risk:
Factor #1: Property quality
Commercial real estate properties are classified as Class A, B, or C, with Class A properties being the best quality and functionality. These buildings and developments are usually newer and more modern. Class B and C commercial real estate assets fall on the spectrum of functionality, appearance, quality, and condition.
Note that it can be tricky to determine the class of a particular property because it depends on the surrounding competitive properties and the market. For example, a Class B building in a primary market may very well be considered a Class A property in a secondary market where competition is lower.
Factor #2: Market type
Commercial property markets are generally separated into three categories:
- Primary markets (also known as Tier I or gateway markets) refer to densely populated major areas with diverse demographic and employment bases. Some of the best examples of primary markets in the US include Los Angeles, Miami, New York City, and San Francisco. Primary markets are characterized by high levels of commercial real estate transactions. They attract mainly large investors, including pension funds and REITs. Tier I markets have the lowest cap rates of the three types.
- Secondary markets (also known as Tier II markets) are less dense and have lower transaction activities than primary markets. These are in areas with populations of anywhere from 1 to 5 million. Some examples include Denver, Charlotte, Austin, and Nashville.
- Tertiary markets (also known as Tier III markets) are low-density areas with less than 1 million populations. As a result, they tend to have less diverse economic bases and the highest cap rates of the three commercial real estate market types.
Factor #3: Lifecycle stage
Understanding where a property falls in the lifecycle is critical to understanding the type of investment required by the asset. In general, a fully stabilized asset is less risky than an existing property that requires repositioning, and a property that needs repositioning is less complex than development.
Levels of Risk-Adjusted Return
There are four types of risk-adjusted returns in commercial real estate:
Opportunistic property investments are the riskiest but also potentially the most profitable. Executed correctly, they may offer the highest returns for the investor’s efforts.
Some of the best examples of opportunistic real estate investments include ground-up developments and distressed/entirely vacant buildings that need repositioning.
Opportunistic investments usually don’t have any income at acquisition and may require a sizable capital investment and several years of effort to produce income. Therefore, active management is typically needed to turn around these types of properties.
These commercial real estate properties need effective active management from experienced CRE professionals to achieve stabilization. In addition, they often produce some income, have major vacancy issues, and require significant capital for physical improvements.
These are high-quality and relatively stable properties with some room for improvement in terms of condition or performance. Some minor renovations or significant repositioning efforts can improve their income. This can mean transitioning the building to a base of better-quality tenants, filling some vacancies, and other such strategies to improve its cash flow stability.
These refer to the most stable and highest quality properties in the market. Low risks and low returns characterize them. Core assets are typically Class A properties with steady incomes and long-term leases. They require only essential active management and are owned mainly by prominent investors, including insurance companies, pension funds, and REITs.
These assets have LTV ratios of around 50% (which means that they have low amounts of debt compared to the three other types). This low ratio shows that owners of core properties usually have a low-risk tolerance.
Which risk strategy is right for you?
Now that you understand the types of strategies and the levels of risk involved with each one, how do you know what types of commercial properties to pursue? Which CRE properties are too risky for your circumstances? To answer this question, you have to look at two factors:
1. Your level of experience
If you have almost no knowledge of actively managing commercial properties, it might be best to avoid opportunistic and value-add investments. This is generally true even if you have years of experience in residential real estate investing.
After all, managing a single-family home’s renovation and repositioning is dramatically different from renovating and repositioning a commercial office building. Therefore, it’s essential to be realistic about your abilities. Don’t take on a commercial property that comes with problems you’re not prepared to handle.
2. The cost and availability of capital you can access
Core properties in significant markets usually cost tens and even hundreds of millions of dollars, so only big investors can acquire and manage these commercial properties effectively. Smaller investors typically have to start with properties that offer higher potential returns.
The bottom line
To decide what level of risk you are comfortable taking, you have to be honest about your ability to actively manage properties and access the necessary funding level for certain commercial real estate assets. You can expand your investment options later as your experience level rises and you gain more access to financing outside traditional banks.