Worst-Case Scenarios for Commercial Investments and How to Fix Them
Investing in commercial property can be a successful investment strategy however, it comes with its fair share of risk. While every investor strives for success, it is crucial to be prepared for the worst-case scenarios that can jeopardise your investment.
In this blog, we explore some challenges that investors may face with commercial property and discuss strategies to mitigate the risks and how to recover when things go wrong.
Economic Downturn
Worst-Case Scenario: A sudden economic downturn, similar to the Global Financial Crisis, can negatively impact the commercial real estate market. This can lead to falling property values, decreased rental rates, and tenant defaults putting a severe strain on your investment.
How to Fix It:
Stay Informed: To mitigate the risks of an economic downturn, it's vital to start well by not overpaying for an asset. Always conduct market research on rental rates and seek valuation advice to understand if a property has inflated rentals or hidden incentives that exaggerate the ‘face-rental’. Understanding where the property sits in the market and buying well initially will safeguard the investment during a future downturn.
Protect Yourself from Rent Reductions: Interest rate rises usually correlate to a decline in your net cash flow. Should market rents retract enough, the investment could become negatively geared. A 'hard-ratchet' mechanism within the lease agreement can protect your rental income from falling below its current level and mitigate a negatively geared investment. Additionally, including fixed or inflationary rental growth provisions in your leases will ensure that the rent continues to increase and help offset interest rate rises and increase your equity.
Re-Structure Tenant Leases: Reducing interest rates can be marginally achieved by securing tenants on longer-term leases. Banks often view properties with long-term leases more positively and may offer competitive interest rates. Consider taking steps to negotiate an early lease renewal or a new long-term lease with your tenant.
2. Tenant Defaults
Worst-Case Scenario: Tenants can unexpectedly default on their lease payments, leaving you with vacant properties and unpaid rent.
How to Fix It:
Due Diligence: Before signing a lease agreement, conduct thorough due diligence on your prospective tenant. Request their consent to review their audited turnover records to ensure that their occupancy costs are affordable. It is worthwhile benchmarking the Occupancy Costs vs Turnover to measure affordability for the tenant.
Obtain a Bank Guarantee or Bond from the Tenant: A bond or bank guarantee is a sum of money held to cover unpaid rent or damages. This allows you to call on the bond if the tenant defaults.
If a bank guarantee is not possible, ensure you obtain the personal guarantee of the directors and/or shareholders. Conduct due diligence to understand their individual assets, as their assets may be protected by a trust and cannot be pursued if the tenant defaults.
3. Property Damage or Natural Disasters
Worst-Case Scenario: Property damage due to natural disasters, fires, or accidents can lead to costly repairs and insurance claims.
How to Fix It:
Adequate Insurance: Make sure you have comprehensive property insurance that covers various types of damage, including natural disasters. Be aware that some regions may have higher excess requirements for specific risks, such as earthquakes. Explore an excess buydown policy to offset the excess and prevent significant unforeseen costs should any damage occur.
Maintenance: Prior to purchase, conduct due diligence on the property's maintenance, especially with regard to air-conditioning, roofing, and automatic/roller doors. Request maintenance records and an updated asset register from the maintenance contractor to understand the remaining lifespan of these critical components.
Capital Expenditure Planning: Create a capital expenditure forecast for the next 5-10 years to understand potential major costs. Consider maintaining a reserve fund or adjusting debt levels to proactively cover these larger expenses.
4. Tenant Retention
Worst-Case Scenario: Multiple tenants leaving simultaneously, this can lead to a significant decrease in rental income, increased vacancies, fit-out costs and a potential cash flow crisis.
How to Fix It:
Frequent Tenant Contact: Stay in regular communication with your tenant to understand their business needs and plan strategic property upgrades if required. This can help retain your tenant and potentially increase the rent.
Complete Due Diligence on your Tenant: Before purchasing a property, ensure that your tenant is satisfied with the premises and intends to occupy it for the long-term.
Property & Asset Management: Develop a robust asset strategy and consider improving property management to attract and retain tenants. At Insight Equity, we pride ourselves on delivering a premium asset management service to not just our Clients but all stakeholders involved, including our valued tenants.
Conclusion:
Investing in commercial property can be rewarding, but being prepared for the worst-case scenarios is crucial. By following the strategies outlined in this blog, investors can mitigate risks, weather storms and maximise the value of their investment.
Remember, informed decisions and proactive measures are your best allies in navigating the uncertainties of the commercial real estate market.
If you have any questions about the content above or wish to discuss your property requirements, please do not hesitate to get in touch.
