Understanding The Risks of Commercial Real Estate Investing and How to Mitigate Them - Part Three
Modern Woodcrafts - Hartford, CT
Credit Risk
Typically, when one thinks about credit risk, they think of things like S&P ratings, profitability, and balance sheet strength. These are all important aspects of assessing the financial strength of companies. As it relates to CRE investments, credit risk is the risk that the property owner will suffer financial harm because a tenant is unable to fulfill their lease obligations. Most investors look to mitigate this risk by investing in properties occupied by tenants with a strong financial profile. This preference by property owners means that, much like bonds, properties with rental income from a publicly listed, investment-grade tenant trade at a significant premium to a similar property occupied by a typically capitalized, privately owned enterprise. Paying the premium to invest in properties with strong credit ratings can help mitigate credit risk, but it’s not the only option, nor is it a panacea.
Investors who seek properties occupied by strong credits are unlikely to see the tenant default on their lease obligations, but they are subject to one type of credit risk that investors in lower credit profiles are not. A company’s financial fortunes change over time, and when companies move from positions of strength to weakness, the income stream from the property they lease no longer commands the premium it once did, lowering the value of the property.
While most investors focus on mitigating the “...tenant is unable to fulfill their lease obligations” part of CRE credit risk, there are other, lesser-known options available. These strategies focus on the “property owner will suffer financial harm” portion of CRE credit risk.
Rental income streams are often viewed as similar to bonds, but when considering credit risk, there are important differences. One major difference is that, at the end of a bond, the borrower returns the borrowed money to the bondholder. If they default, it’s because they are unable to return the cash, and the lender collects only what it can recover through bankruptcy or other legal channels. In contrast, at the end of a lease, the tenant returns the property to the landlord. If a tenant defaults on their lease, they may cease paying rent and return the property to the landlord sooner. While this scenario may cause an interim disruption in the landlord’s cash flow, the landlord can find a new tenant for the property or sell the property, thus providing some assurance that the landlord’s capital is protected. In some instances, it may even be to the landlord’s advantage for the tenant to default on their lease, allowing the landlord to capture increased revenue that would not have been possible if the tenant had continued with their lease.
There is another important difference between bond credit and CRE credit, and that is how they are treated in bankruptcy. In bankruptcy, bonds are ranked in order of preference and may have a wide range of outcomes depending on seniority. In contrast, leases are entitled to receive full payment during bankruptcy, and tenants may only choose to affirm the lease in its entirety or reject it in its entirety and vacate the premises. This means that investments in properties that house critical operations for companies that cannot easily be moved to another location can see minimal disruption in cash flows, even in Chapter 11 bankruptcies.
While not always a perfect hedge, these differences provide unique opportunities to benefit from the greater yield from investing in properties with lesser credit without bearing the full risk of credit default that a bondholder would have. Effectively employing these strategies can tilt the risk/reward balance in favor of the lesser-credit investor.
Credit risk in CRE investments can be hedged with the following:
Select properties with tenants whose relative financial strength is more likely to improve or stay stable than deteriorate over the lease term.
Invest in properties that house profitable operations of the tenant and can’t easily be moved elsewhere.
Purchase properties at or near the price they would command if sold to another user.
Avoid properties with limited potential additional uses and those located in areas with limited activity.
Next time, we’ll turn our attention to another risk that is usually considered but not often properly analyzed: Sponsor Risk.
Dan Andrews
CEO