How to Reduce Risk in Real Estate Investments

by Petros Sivitanides,Ph.D.

Pursuing venues to reduce risk is a wise strategy when investing in real estate since the income a property earns is influenced by many factors that are out of the control of the investor.  Nevertheless, careful selection of property, location and lease/tenant characteristics can help reduce risk, especially in the case of an economic or a real estate market downturn. Here are some risk-minimizing strategies that commercial real estate investors can follow:

1)  When you invest in a specific market, the most important perhaps consideration from a risk point of view is to know what the more likely prospects of that market are.  Don’t invest in markets that, based on reasonable forecasts, are expected to go downhill or just remain stagnant. Invest in markets that are expected to be growing.  This strategy will reduce risk from negative economic influences, because even if a downturn hits due to the broader macroeconomic environment, you will probably be a lot better than if you were in a market that was predicted to decline or stay stagnant. 

2)  Investing in the strongest locations (the ones that are in high demand because they have the strongest locational advantages) for the property type you are interested in should also reduce risk; strongest locations for office investment will be different from strongest locations for retail, industrial or apartments; furthermore make sure that nothing is happening or is planned to happen (such as big transportation, infrastructure or other urban development projects) within the time horizon of your investment, that will make other locations in the market quite more competitive than the location you are considering.  In the case of a portfolio of commercial investments, location diversification (still targeting strong locations but at different metropolitan markets) can also help minimize risk, as an economic downturn in one market will only affect a portion of the portfolio.

3)  Invest in modern, high-tech, energy conserving buildings. This strategy is likely to reduce risk because such buildings are more likely to stay in demand by good strong-credit tenants even in the case of a demand downturn.

4)  Invest in multi-tenant as opposed to single-tenant buildings so that the loss of a tenant will result in a small loss of property income; on the contrary in the case of a single-tenant building the inability to collect rent from that tenant or loss of the tenant will leave you with no income from that property.

5)  Tenant-mix is especially important for retail investments, as it is crucial factor in maintaining the center’s attractiveness even in bad times; in the case of office investments, a diverse tenant mix, that is, having in the building tenants from different sectors of the economy, can also help reduce risk. For example, having tenants that are all in the same industry is clearly more risky because if that industry goes downhill, the impact on the building’s NOI could be quite negative.  Avoid tenants that are active in a declining industry if you can find tenants active in a stable or growing economic sector, even at somewhat lower rent.  These tenant-mix principles apply also within a property portfolio context.

6)  Invest in commercial properties with long-term leases and high-credit tenants.  Long-term leases shield the property’s income from market rent fluctuations to a significant extent; have in mind though that as the expiration of these leases approaches this protection expires too, since building income will have to adjust to market rents.  If these are considerably lower than the expiring lease contract rates, property income and value will decline significantly.  That is why having a mix of leases that expire at distinctly different time periods can also help minimize risk.

7)  Minimize property income fluctuations and losses by investing in triple-net leases that have the tenant pay for maintenance expenses that vary from year-to-year; also if you can  obtain rent guarantees from the seller for units or space that is vacant you can avoid loss of income while trying to find tenants.