Commercial Real Estate Risk Management: Top Strategies 2024

Turbulence looms for commercial real estate markets, with Capital Economics pointing to 10% valuation declines in 2024 and another 5% in 2025 as the sector comes off pandemic peaks. Hands-on investors can take proactive measures to maintain strong risk management – helping safeguard portfolios against intensifying headwinds even as the landscape shifts.

How can investors adapt risk practices to counter growing threats in financial, climate, and demographic domains? By taking cautionary measures, GPs can carefully structure investments, tighten asset oversight, and build business adaptability.

Risk mitigation provides a way to steer around rising challenges while still maximizing returns. Firms willing to boost risk control efforts can end up with more stable portfolios and value protection down the road.

What is commercial real estate risk management?

For property owners, risk management spots and prepares them for what can go wrong across deals – whether underwriting, raising capital, or monitoring assets.

Firms can add risk response into their practices to build returns amid uncertainty. And by systemizing risk management, GPs can find durable growth even in dynamic markets.

Types of commercial real estate risks

Risk assessment involves evaluating several key areas that can threaten your real estate investments:

Economic risk

Exposure to economic contractions varies across the commercial real estate market. This risk may intensify in 2024 as forecasts anticipate a slowdown in consumer spending and total US GDP growth of 1%. Sectors like hospitality and retail mirror overall consumer cycles, while areas like medical office buildings may see less impact. Evaluate your risk to economic factors such as:

• Capital flow: Tight lending conditions and rising interest rates can compress property valuations.
• Business cycles: Portfolios heavily tilted toward highly cyclical sectors like hospitality or retail face heightened tenant industry risk.
• Inflation: Sustained higher inflation in utilities, taxes, and maintenance can outpace rent growth’s offsetting capacity.

Market risk

Supported by a US economy that grew 5% beyond pre-pandemic levels, commercial real estate rode an expansion wave as capital flooded in and lending conditions loosened. This growth fueled development across sectors. For example, in multifamily, 750,000 new apartment units came online nationwide in 2023, creating oversupply challenges in some markets. For all commercial property niches, GPs should assess factors like:

• Rental and vacancy rates: Evaluate if local rental rates and vacancies are on upward or downward trends.
• Market supply/demand dynamics: Analyze whether the local market is over or under-supplied for the property type as well as new developments in the pipeline.
• Local employment trends: Determine the status of employment rates in the region and the potential for reduced demand.

Location risk

The geographic placement of commercial buildings can contribute to or mitigate external exposures. Potential risks as you analyze commercial real estate projects include:

• Zoning and regulatory changes: Evolving regulations can constrain property uses and development potential.
• Infrastructure and accessibility: Transportation and essential service access increase a property’s appeal.

Property risk

Property risks are potential threats related to the physical buildings, equipment, sites, and surrounding land areas that are tied to commercial real estate assets.

Case in point, in 2023, the United States witnessed 28 climate-related events, each causing over $1 billion in damages, highlighting the increasing vulnerability of properties to natural disasters. This growing concern underscores the need for comprehensive risk management strategies addressing:

• External impacts: Weather, natural disasters, accidents, or criminal activity can cause damage, highlighting the importance of preparedness and resilience measures.
• Environmental risk: Hazardous materials, air pollution, and water contamination require monitoring and remediation efforts.
• Aging and obsolescence: As buildings age, they may fall behind current market standards in technology, design, and amenities, requiring periodic updates and renovations.

Tenant risk

For real estate investors in triple-net, office building, or medical office spaces, factors to assess tenant risks include:

• Credit risk: Regularly check ratings and financials to understand a tenant’s ability to fulfill lease obligations.
• Industry distress signals: Closely track tenant industries to spot early signs of reduced demand that could indicate move-outs or bankruptcies.
• Lease expirations: Lease expirations increase risk since openings allow distressed tenants to vacate the property.
• Build-out costs: Allowances to attract replacement tenants may require you to remodel spaces. These unforeseen capital costs can erode targeted returns.

Asset risk

Controlling risk in the lifecycle of your commercial property includes areas such as:

• Functional decline: Properties may fall out of step with evolving tenant preferences in layouts, technology infrastructure, or amenities, underscoring the need for regular modernization.
• Maintenance: Critical building systems such as HVAC, plumbing, and electrical require regular repair or replacement. Neglecting these can lead to unexpected capital expenditures.
• Materials/labor inflation: Construction costs that rise faster than rents present a major hurdle for value-add investors dependent on planned renovations.

Financial risk

Financial risk refers to potential threats related to the financial capacity and flexibility associated with a commercial real estate asset. Deloitte’s 2024 commercial real estate outlook reveals nearly half of leaders expect capital availability to tighten, while another 50% see the cost of capital heading higher over the next two years. These trends increase risks such as:

• Excess leverage: High levels of property debt become challenging to service as income declines, highlighting the importance of balanced financial planning.
• Debt risk: Interest rate increases lead to escalated expenses, underscoring the need for strategic debt management.
• Inflexible equity terms: Fixed return requirements to real estate investor partners may restrict GP’s cash flow cushion, emphasizing the value of flexible financing arrangements.
• Inadequate reserves: Having insufficient capital to address large, unexpected expenses points to the necessity of maintaining robust financial reserves.
• Limited contingency financing: The inability to access additional capital when operating funds are inadequate stresses the importance of diverse financing strategies.
• Insurance coverage adjustments: Recent industry surveys indicate that more than 60% of commercial real estate insurers have increased deductibles for multifamily properties and tightened policy exclusions.

Credit risk

Credit risk includes the financial stability of key business partners associated with commercial properties. Key vulnerabilities to assess include:

• Tenants: Financial distress lowers tenants’ ability to fulfill lease payment obligations and requires allowances or vacant periods upon departures.
• Lenders: Tightening credit standards, risk adjustments, or losses can prompt changes to loan terms, reserves, or restrictions, minimizing flexibility.
• Partners/investors: Changes in profitability, liquidity, or strategic direction can impact willingness or capacity to fund capital calls critical for initiatives.

Management risk

Management risks are potential threats resulting from ineffective oversight and poor decision-making by sponsors, asset managers, or property managers. Avoiding risk includes understanding gaps in the following:

• Financial controls: Shortcomings like poor budgeting discipline, inadequate reserves, and lacking procurement policies can impact asset quality and profitability over time.
• Reporting deficiencies: Insufficient monitoring and transparency into property performance limits situational awareness and allows problems to go undetected until reaching critical stages.
• Market intelligence failures: Inability to understand tenant needs, benchmark competitive offerings, and recognize disruptive influences can undermine tenant retention and relevance.
• Maintenance and lifecycle planning shortcomings: Inadequate capital needs budgeting for resilience measures, building system upgrades, and functional modernizations, decreasing value.
• Human resources: Inconsistent hiring and talent management practices produce skill gaps that lead to operational execution breakdowns or expose properties to compliance risks.

Commercial real estate risk management strategies

What strategies can commercial real estate professionals use to mitigate risk in 2024?

1. Detailed market research

Conducting market analysis helps assess demand and if commercial investment opportunities meet your risk thresholds. Market research as part of due diligence includes:

• Review occupancy, rental rates, and absorption trends in the local submarket area to set your baseline performance expectations and track progress.
• Forecast leasing demand growth by linking property type demand drivers like demographics, employment expansion, and infrastructure development.
• Estimate future competitive supply coming online by tracking new development permit filings.
• Create tenancy mix strategies for drawing differentiated tenants from various industries.

2. Create a risk management plan

Develop a risk management plan that can evolve with your portfolio to address changes in market conditions, asset status, financial arrangements, and management practices. The plan should outline preventative actions, regular monitoring procedures, and response protocols.

Examples could be offering shorter lease terms if you see reduced tenant demand or adapting a building to a different tenant mix.

As you buy and sell commercial property, revisit the plan and align it to fit your current scenario.

3. Property-specific risk management

Managing risk at the asset level provides a first line of defense for your portfolio. Developing plans tailored to the dynamics of each property helps to isolate and control threats specific to individual holdings. Preventative measures at a property level include:

• Evaluate physical attributes, operating systems, usage patterns, and other singular exposures of each asset.
• Continuously check market competitiveness and tenant credit health to gauge external risks.
• Document risk scenarios and continuity responses so you can act decisively when incidents strike.

4. Maintain properties

Ongoing maintenance limits hazard exposure and safeguards your assets over their lifecycle. It can be tempting to defer maintenance, but real estate investors can combat this tendency by taking a proactive stance on property care. This includes annual inspections and scheduling preventative upkeep.

5. Commercial property management tools

Using technologies like commercial real estate management software allows you to gain oversight into key risk factors. Stay ahead of common risks with centralized financial reporting, maintenance tracking, and document storage.

6. Maintain records

Disorganized or lack of business records exposes assets to elevated risk, ranging from compliance gaps to inadequate attention. Implement centralized digital filing policies for all property documents, such as leases, contracts, and permits.

7. Buy commercial property insurance.

A sound insurance program provides an added layer of financial protection by covering critical loss exposures that your internal protocols alone cannot always prevent. Buy commercial insurance policies to cover property damage, business interruption, and specialized risks like cyber incidents.

Key takeaways

• Continually assess your core risk exposures in commercial real estate – across markets, properties, finances, and management.
• Implement risk management by analyzing markets, stress-testing assumptions, structuring finances conservatively, maintaining asset quality, and monitoring performance.
• Risk avoidance capabilities better prepare real estate organizations. Build team skills in due diligence, asset systems, and leadership to control risks and seize opportunities in turbulent times.

Modified Date & Time : 15 Mar 2024, 12:33 pm

Author

Jamie Stadtmauer

Jamie Stadtmauer is the Vice President of Business Development at Agora and has over 20 years of experience in commercial real estate investing.

•