Investing is fraught with risks. Investing is legalized gambling and we all take gambles – so may the odds always be in your favor. Commercial real estate investing offers opportunities for making huge gains or taking terrible losses. Commercial real estate developers, sponsors and finance professionals often ask, “what are you looking for?”, when we are about to conduct and underwriting analysis and due diligence review of a propose commercial real estate private placement offering investment opportunity. It happens often enough that we thought we would share our thoughts on the topic in hopes it helps the investing-public and industry participants make better decisions on how, when and why capital is invested and how risk may be more effectively managed to keep the odds in your favor.
You worry about what happens after you put your money in the pot and the commercial real estate developer or sponsor worries about what happens if you don’t. This creates a conflict-of-interest between the parties, so it may make investment decisions that much easier if you remember the three (3) key factors to understanding commercial real estate investment risk assessment:
- Future Value. The future value of the property when you want to get out of the investment is one of two ways you can get your money back. That value tells you what the odds are of being repaid. The odds of being repaid are generally referred to as “maturity risk”. Commercial real estate investing generally forces you to hold onto the investment for an extended period of time and that period of time is what works to compound the risk of not getting repaid. If you decide to invest, you need to keep on your toes and make the business continually prove to you it will be worth your money staying in it.
- Income Output. The amount of income a business is likely to generate is the other way you can get your money back. The income-generating capacity review (i.e.: “capacity underwriting”) serves to forecast what the reasonable expectation for income-generation may be, all other things being equal. The risk the business will not generate enough income to pay you back over the time you own it is called “term risk”. Term risk is the key to creating maturity risk, so if you effectively manage term risk, the maturity risk cannot become a material issue in 99% of cases. Term risk is a function of how the market changes over time, so keeping an eye on market trends and the sales opportunities the business may be expected to have as the market changes is the most important thing you can do to help guard against term risk. Managing term risk means you have to understand what the business is doing to address the market opportunity it has to sell its goods or services in the future and that means you need access to market forecast information and be able to monitor the resulting decisions made on that information.
- Business Boo-Boos. Believe it or not, all of these highly-educated and experienced business people are human and make mistakes just like you do. Administrative issues can lead to accidental/unintentional foreclosure by a lender because someone didn’t pay the property taxes, didn’t pay employee benefits, didn’t bother to renew a required business license or took too much money out of the business. Administrative foreclosures are a huge risk and are part of what is known as “technical default risk”. Much of technical default risk exposure is manageable, so having someone monitor the operations (shameless plug here for INVIZEN) is probably one of the most important things you need to do to keep the investment vehicle out of the ditch.
Nobody likes to lose and business works when everyone wins. Keep these thoughts in mind and perhaps it will be helpful for your investing goals.