Ongoing Risk Assessment is Important

Investors know that completing a risk assessment is an important part of acquiring any asset. Any pro forma, projection or budget is only as good as the assumptions that go into it (GIGO – garbage in, garbage out). The risk assessment is the validation process for those assumptions. Many risk assessment models have been developed, from the relatively simple to those requiring a supercomputer to complete.

I recently read a commentary by Joseph Ori, Executive Managing Director, Paramount Capital Corp., dated January 10, 2014 on GlobeSt.com titled "A Risk Assessment Program for CRE." He presents a simple to use risk assessment model that I applied to an acquisition analysis. It provided some good insights into the acquisition alternatives that are, granted, very subjective but in the aggregate paint an accurate picture of each property’s risk levels.

Ori identifies fifteen risk factors to be assessed on a scale of 0 (none) to 3 (high), not all of which are applicable to all properties. The fifteen factors are (with my additions in italics):

1.       Cash Flow Risk (volatility in the property’s NOI or cash flow)

2.       Property Value Risk (reduction in a property’s value due to physical or functional obsolescence)

3.       Tenant Risk (loss or bankruptcy of a major tenant)

4.       Market Risk (negative changes in the local real estate market, also called economic depreciation by appraisers)

5.       Economic Risk (negative changes in the macro economy)

6.       Interest Rate Risk (an increase in interest rates)

7.       Inflation Risk (an increase in inflation)

8.       Leasing Risk (inability to lease vacant space or a drop in lease rates)

9.       Management Risk (poor management)

10.   Ownership Risk (loss of critical personnel)

11.   Legal and Title Risk (adverse legal issues and claims on title)

12.   Construction Risk (development delays or cessation and payment defaults)

13.   Entitlement Risk (inability or delay in obtaining project entitlements)

14.   Liquidity Risk (inability to sell property or convert equity value into cash)

15.   Refinancing Risk (inability to refinance property)

To his list I would add one additional risk factor (although this addition could be considered a part of property value risk, I think it’s worth highlighting separately):

16.   Regulatory Compliance Risk (effect of environmental, energy and sustainability, ADA, etc. regulations)

But as Ori points out in his commentary, risk assessments should not only occur at the time of acquisition. They should be performed annually. Some of the reasons for annual risk assessments are that they guide ongoing decisions including, but not limited to:

·         Hold/sell a property

·         Refinance a property

·         Renew or not a management contract.

Now is a good time to initiate an annual risk assessment program for your property because some reminder events that you can tie to in the future are soon coming due:

1.       Annual financial reports to investors;

2.       Annual IRS returns; or

3.       County property appraiser returns.

In addition, a risk assessment should be conducted each time a property management contract is renewed to ensure that your property manager is addressing your property’s needs.

If you would like to discuss these thoughts in more detail, please contact me:

            Paul B. Hazlett
            Multifamily Investment Advisor
            Coldwell Banker Commercial - Benchmark
            904.421.8523
            PHazlett@CBCBenchmark.com