We spend our lives with risk.
There is everyday risk like driving to and from work, school, or some event with our spouse. At any moment, we put ourselves on the road with other people who may or may not be in full control of themselves whether it be from alcohol, lack of sleep, or relationship induced stress. Some of these people are just plain morons who should not be allowed to drive - but they're given a license anyway and we willingly chose to get on the road with them.
A collision could cost us financially from as little as a few hundred dollars to fix a ding to hundreds of thousands of dollars in medical bills. However, we’ve learned to accept and manage this daily risk as we go about our lives.
There’s also the health risk we must accept just being part of the human experience. Genetic health issues may cause elevated concerns throughout our life or they may show up in later years. Poor food choices or bad exercise habits may not elevate our risk immediately, but sustained patterns will eventually result in some sort of health concern. This is risk we either accept or ignore, but it’s there nonetheless.
People are killed every year by lighting. People have been killed by an air-conditioner falling out of a building window. Life is f'ing dangerous, at times.
Yet, even the riskiest adventurers as well as the experts in covert operations have learned to mitigate their risks. They don’t jump out of planes without parachutes and they practice repeatedly so that an actual event becomes second nature.
We can’t escape risk so, therefore, we all must learn to deal with it.
Investing is Scary, Isn't It?
Risk is part of investing in commercial real estate.
A risk of disaster is always on an investor’s mind. Natural disasters such as earthquakes, hurricanes, and tornadoes can destroy a building. In the winter of 2008-2009, over 93 inches of snow fell in my part of the country. This led to several buildings having their roofs collapse, including one of the highest producing grocery stores in the city. That winter had a great impact on several landlords, some of whom have still not fully repaired their buildings.
There is risk of man-made damage. An inattentive driver can accelerate over a curb stop into the front of a building (which is what happened in the picture to the right). Or a fire can start in a vacant neighboring building and burn your apartment building replacing 103 residents. That happened while I was a property manager.
Even small damage like graffiti can cost hundreds, if not thousands of dollars, over time in both man-hours and materials to repair.
There is also the risk of a tenant defaulting (not paying rent/breaking a lease). Even once grade-A retailers are now teetering on bankruptcy. Sears was a big deal forty years ago. Now, it’s leaving the industry with a whimper. You can do your best to vet a tenant with credit checks, background checks, and industry reports, but in the end, you are still at the risk of changing consumer demand as well as how well the tenant operates their business.
A risk related to financing also exists. When the market turned sour in 2008, many banks were unwilling to lend. This left many landlords in a tough position when it came time to refinance their loans. Banks can ask for additional funds to be applied to a loan if the Loan-to-Value ratio (LTV) changes drastically. Again, when the market turned and property values cratered, many landlords found themselves in the position where their loans were underwater (the loans were higher than the worth of the property). When they went to refinance, they had to put more money against the loan to get refinancing on a property they had owned for years.
Mitigate, My Friend!
Here’s the thing, though, you can mitigate these risks.
You can get insurance for hazards such as earthquakes, fires, etc. While you might not be able to stop the actual event, you can lessen the risk with proper care.
Man-made damage can also be mitigated through careful planning. Better lighting, traffic control, etc. may stop costly damage to a property. It won’t be eliminated, but you can reduce it by early attentiveness.
While you can’t stop every tenant from defaulting, you shouldn’t be caught totally off-guard either. You or your property manager should have regular contact with your tenants and ask how they are doing, not only in your location, but nationally. If they are a national tenant, follow how they’re performing in the national news reports. If you start to see or hear warning signs, it’s time to get prepared.
Commercial lending is different than a residential loan. While the amortization schedule may be close to the same period (20-25 years), the actual period they will carry the loan is much shorter. Banks will often call the loan due in 10 years, thereby requiring a balloon payment or a refinance. Unfortunately, many landlords don’t prepare for this moment, even though they knew it was on the horizon and was getting closer with each approaching day. They will pull every dollar out of the property like an ATM, putting themselves in a poor position when the time for a refinance comes, especially if the market has turned. It’s better to keep a cash reserve in place in case additional money is needed at the time of refinance. You may also make accelerated principal payments to pay down your mortgage quicker which help with the Loan-to-Value ratio.
It's not often the most exciting path to take, but it’s about risk mitigation. Saving a person after they’ve fallen off a ledge and are hanging by their fingernails is exciting news and will get you in the paper. However, if that person had taken care in the first place and never gotten near the ledge, no one would have ever needed to rescue them.
How is your level of risk in investing, whether it be commercial real estate, residential investment real estate or the stock market?
Are you thinking ahead of what might happen?
Or are you standing on a ledge, expecting for everything to work out fine?