Demystifying Commercial Real Estate Investment Maturity Default Risk

Before we get into a deal we all have to know how we are getting out of it.  Decisions have consequences in this plane of existence and investments and loans in commercial real estate income-producing properties require all of us to consciously (or unconsciously) decide if the proposed commercial real estate investment passes the test for maturity risk as a precondition to deploying capital.  It’s a binary decision so it should be simple: either you believe the commercial real estate property can be sold-off at the end of the deal or refinanced at the end of the deal for an amount sufficient to give you the stated return or you don’t.  When we approach the commercial real estate maturity default risk assessment the subject property has to demonstrate that both scenarios present a reasonable proposition to sustain both outcomes (i.e.: would be expected to be sold off and would be expected to generate sufficient funds from a refinancing to make the stated return a reality).  The test is understanding the issues that create maturity default risk and how these issues have to be managed and mitigated proactively to prevent investment loss from becoming a painful reality.

The key driver of maturity default risk that has to be addressed is term risk.  Term risk is the risk the investment will fail to generate sufficient future income over the term of the investment to provide the stated return.  Maturity default risk cannot be said to exist in the absence of term risk so it follows that if you understand the conditions that conspire to create term risk and effectively manage those risks for profit, then the dreaded maturity risk default scenario is very hard to develop into a painful reality.

The key drivers of term risk are:

  • Execution risk – the risk management will fail to do the job resulting in an investment loss.  This is a manageable risk.
  • Regulatory risk – the risk the government will take away your business opportunity in some way resulting in an investment loss.  This is a manageable risk in most situations.
  • Bankruptcy risk – the risk the property will have insufficient liquidity to whether an unforeseen liquidity crisis and be forced to file a bankruptcy petition resulting in an investment loss.  This is a manageable risk.
  • Asset obsolescence risk – the risk the property’s capital assets will become less efficient in terms of their ability to generate new sales due to increases in competition resulting in an investment loss.  This risk is driven by innovations and advances in technology (technology risk) that were heretofore thought to be unmanageable but are in fact now manageable risks.

There are many other risks that can contribute to the maturity default risk calculation of investment loss severity risk exposure but the risks outlined above are the key to managing the vast majority of the investment loss exposure.  Asset obsolescence caused by advances in technology and innovations – and not a failure to simply maintain the assets in optimal operating condition – is the most important risk of all, as this risk inevitably impacts the investment preferences of the capital markets and these changing investment preferences can create significant maturity default risk exposure.  The key is understanding that proactive forecasting and a continual underwriting review process each month of the investment holding period is the only way these risks can be brought to heel.  The challenge in the past has always been the cost – in terms of both the time it takes to complete an underwriting review and the cost associated with that review.  INVIZEN offers an affordable and proactive solution for this dilemma but in its absence you can manage this risk issue if you understand the fundamentals of market analysis and are willing to take the time to do it right.  Either way, failure to do so opens the door to taking a loss you don’t have to take.

There are no villains in this world and there are no victims – there are only volunteers.  What are you volunteering for today?

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