The Four Risk Factors for Investments

By C. Brandon Chavoya, Director, Holliday Fenoglio Fowler L.P.

There are several risk factors that can affect an investor's yield expectations, especially in the net-lease space.

By C. Brandon Chavoya,
Director, Holliday Fenoglio Fowler L.P.

When it comes to investment in net-leased real estate, there are several factors that can affect an investor’s yield expectations. When analyzed appropriately, these factors can provide valuable insight into the intrinsic value of real estate leased to credit tenants.

As commercial real estate continues to vie with the equity and bond investment spaces as the most fledgling of the three primary investment categories, an increased institutional awareness and focus on commercial real estate has created additional opportunities for owners, operators and investors of net-leased real estate. Any additional amount of risk increases the expected yield an investor will require for the increased amount of risk and investor assumes. This increasing yield and the difference, or spread, between different levels of risk will help to explain the different return components of credit real estate.

Interest Rate Risk: Interest Rate Risk is the risk that the value of an investment will change due to a change in the absolute level of interest rates. Since the capitalization rate for commercial real estate is dependent on the overall cost of capital, real estate values a clearly correlated to interest rates. Interest rate risk accounts for most of the volatility in commercial real estate values.

The ability to secure an investment in real estate with attractive asset-level financing is the most significant factor to achieving maximum pricing from a commercial real estate offering. Volatility and the corresponding lender “spreads” have recently created uncertainty as to the current and continued ability to source additional funds in the real estate capital markets.

Credit Risk: Most important to this entire discussion is our definition of “credit.” Most frequently understood in the context of the credit ratings provided by third party agencies such as Moody’s and Standard & Poor’s, Credit Risk is simply the amount of risk tied to the continued viability of a specific business. The likelihood of default for rated companies, as shown in the adjacent chart, has a direct impact on the value of the future cash flows received from a tenant. Every company, from the most established national retailer to the local convenience store, has some form of credit.

The implication of a Baa (“medium grade”) credit rating is that in 20 years there will be a 12.33% chance that the tenant will default.

If we compare that rating of Baa to a rating of Ba (“lower medium grade”), we notice the later rating carries with it the implication that, in 20 years, there is a 37.17% chance that the tenant will be insolvent. This 24.84% increase in the chance of default represents the drop-off in implied strength between investment grade (Aaa – Baa) and sub-investment grade (Ba – C) credit.

 

Liquidity Risk: Due to the lengthy transaction time and high costs associated with transaction caused by contract negotiation and due diligence, real estate is largely considered one of the most illiquid investment classes available.

The inability to trade out of an asset efficiently makes the immediate realization of profit, or the avoidance of a potential loss, more difficult. As such, investors require a much higher yield from illiquid assets.

Real Estate Risk: Real estate risk is perhaps the most broad and challenging area of risk to assess. Generally speaking, the risks associated with real estate can include rental rate decline, tenant roll and vacancy, fluctuations in the local, state or national real estate markets, and so on.

From a net-lease standpoint, real estate risk increases exponentially as the lease nears its expiration date. Interestingly, real estate risk and interest rate risk maintain an inverse relationship (see adjacent chart).