How to Measure Risk in Commercial Real Estate Investing - Caliber (2024)

What you should know before you invest.

How do you measure risk in commercial real estate? It’s a critically important question that any investor should carefully consider prior to committing any capital. It’s one thing to be comfortable with the investment’s project return profile; it’s another to understand what level of risk you may have to bear to potentially realize those returns.

‘Risk’ is a nuanced concept that doesn’t neatly translate from one investor to another. We can make some general assumptions, however, principally in the areas of leverage and the risk required to realize a return. We’ll also discuss how these two measures compare in different types of commercial real estate properties.

How do you measure risk in commercial real estate?

The two most common commercial real estate risk measures are loan-to-value (LTV) and capitalization rate (cap rate), which, taken together, provide a reasonable snapshot of a property’s risk and return profile. Let’s understand them in greater detail.

What is LTV?

Loan-to-value represents the level of debt a property carries, relative to the value of the property. At the simplest level, divide the property’s mortgage by the property’s market value. So, if an office building is worth $10 million and has $5 million of debt, the LTV is 50% ($5 million debt/$10 million value). Generally, properties featuring lower LTVs imply less risk than properties with higher LTVs.

At a high level, LTV offers a straightforward comparison. However, it can grow more complicated as you start to parse ‘loan’ and ‘value’ at greater levels of granularity. Consider: a property can have multiple loans at different maturities secured at different interest rates, all of which roll up into the “loan” figure. For example, suppose a hotel owner needs to complete property improvements to retain their flag (industry parlance for one of the major brands like Hilton or Marriott). It may not make sense to refinance their principal loan to pay for the improvements, so the hotel owner seeks a “bridge” loan instead. The primary property loan is likely a longer-dated loan (10 years or more) at a lower interest rate while the bridge loan is much shorter (10 years or less; usually closer to 5 years) at a higher interest rate. Optimally, both figures are reflected in the ‘loan’ figure, though that’s not always the case.

As a best practice, a reputable sponsor will provide their investors with a ‘good faith’ evaluation of a given property’s debt obligations in their property improvement proposal. Investors are encouraged to ask the sponsor[1] for the marketed property’s debt obligations if they feel the business plan proposal inadequately addressed the property’s debt level.

On the other side of the ratio, “value” can also be a highly subjective term. Unlike publicly traded investments, the value of a private investment isn’t re-evaluated every day. Practically, it’s unreasonable for private investments to be valued this often; that’s akin to asking to estimate the value of your home every day. One estimate and a list of comparable properties are often enough to get a sense of fair value if you’re actively selling your home. It’s not that different in private investments.

Often, “value” represents fair market value or the dollar amount the owner would expect to receive should they seek to sell the property on the open market. It’s worth mentioning that’s not uniformly the case, nor are sponsors required to use fair market value to represent ‘value.’ Less scrupulous sponsors may claim to use a ‘proprietary’ method for establishing a property’s value, often to either inflate or deflate the figure to fit their narrative. It’s not that common, but it does happen.

As a best practice, a sponsor may provide potential investors with comparable property values if the property business plan proposal includes selling or acquiring a property within a reasonable time frame.

LTV is synonymous with a property’s leverage, so if you’re looking to see how much leverage the sponsor may employ in the deal, LTV is an excellent place to start. How leverage can impact an investment’s reported internal rate of return (IRR) is important, though beyond the scope of this discussion.

What is cap rate?

Cap rate represents how much you could reasonably be expected to receive in annual income for every dollar paid to acquire an equity position in the property. It’s found by dividing a given property’s net operating income (NOI) by the property’s value. Generally, higher cap rates imply greater risk, though cap rates should be viewed in the context of like property types. Industrial properties like warehouses have different risk and return profiles than something like office buildings, a difference represented in cap rate trends for each property type.

Given that net operating income is one half of the cap rate figure, it becomes less useful as a measure of risk in development-intensive investments where net operating income is more likely an estimate than an actual figure. As a result, cap rate is best used at the start of your due diligence process to narrow down which property category may be the best fit for you.

In general, cap rates tend to be lowest in properties that exhibit lower sensitivity to changes in economic conditions. Historically, that meant that office buildings and multifamily properties offer the lowest cap rates on the basis that people need a roof over their head, whether they’re sleeping or working. Retail and industrial properties tend to be more sensitive to economic conditions than office or multifamily, though less sensitive than hotels and specialty[2] properties.

Arguably, multifamily and industrial properties have jumped office and retail as the property types offering the lowest risk and most potentially consistent income. The demand for multifamily (properties like apartments, townhomes, etc.). continues to increase as single-family home affordability worsens with higher interest rates increasing mortgage costs and the constrained home supply facing many communities limiting options for home buyers.

As with LTV, the ‘value’ denominator is often fair market value, though that figure can depend on the assumptions made in the property business plan proposal.

Together, LTV and cap rates offer investors a reasonable snapshot of a potential investment’s risk and return profile. At a high level, these two figures can help filter what property category and business plan is appropriate, given your risk tolerance and current portfolio composition. After reviewing the sponsor’s business plan proposal, investors should always review any investment documentation for a thorough evaluation of potential risks and costs.

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[1] In private equity real estate transactions, a sponsor is the firm seeking to raise investor capital to fund a proposed action on a given property. Often, a sponsor and the property developer are the same firm, though that’s not always the case.

[2] Specialty is a broad category meant to cover properties that don’t fit neatly into the other property types. Some common specialty properties include theme parks, marinas, and RV parks.

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About Caliber

Caliber – the Wealth Development Company – is a middle-market alternative asset manager and fund sponsor with approximately $2 billion in assets under management and development. The Company sponsors private funds, private syndications, as well as externally managed real estate investment trusts (REITs). It conducts substantially all business through CaliberCos, Inc., a vertically integrated asset manager delivering services which include capital formation and management, real estate development, construction management, acquisitions and sales. Caliber delivers a full suite of alternative investments to a $4 trillion market that includes high net worth, accredited and qualified investors, as well as family offices and smaller institutions. This strategy allows the Company to opportunistically compete in an evolving middle-market arena for alternative investments. Additional information can be found at CaliberCo.com andCaliberFunds.co.

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Investor Considerations

The information contained herein is general in nature and is not intended, and should not be construed, as accounting, financial, investment, legal, or tax advice, or opinion, in each instance provided by Caliber or any of its affiliates, agents, or representatives. The reader is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circ*mstances, desires, needs, and requires consideration of all applicable facts and circ*mstances. The reader understands and acknowledges that, prior to taking any action relating to this material, the reader (i) has been encouraged to rely upon the advice of the reader’s accounting, financial, investment, legal, and tax advisers with respect to the accounting, financial, investment, legal, tax, and other considerations relating to this material, (ii) is not relying upon Caliber or any of its affiliates, agents, employees, managers, members, or representatives for accounting, financial, investment, legal, tax, or business advice, and (iii) has sought independent accounting, financial, investment, legal, tax, and business advice relating to this material. Caliber, and each of its affiliates, agents, employees, managers, members, and representatives assumes no obligation to inform the reader of any change in the law or other factors that could affect the information contained herein.