Risk of negative cash flow
There are multiple risks associated with investments in commercial real estate. In this article we discuss the risk of the negative cash flow.
Just like any other business or investment, investment in real estate can create losses. The loss of cash flow may occur at the beginning of the holding period when vacancy persists or the costs are not optimized yet, and a loss of capital is possible when a property is sold for a lower price than it was purchased for.
Whenever you finish with less money than you started with, you will create negative cash flow and since real estate is a highly illiquid investment the risk is present long term up until the actual sale of the asset. The risk of going negative on a deal can be reduced if you have knowledge and understanding of the market and did proper research.
Below are sources of increased risk of negative cash flow which you would want to make sure are minimized:
* High unmanageable in-place vacancy. If you are buying into a value-add deal where the main strategy is repositioning a building and leasing vacant space, be especially careful with choosing the right manager for the transaction. There are plenty of undermanaged properties on the market but unfortunately there are not as many professional managers able to give an asset another chance. When the promises of a manager do not bring positive results, you might be left with negative cash flow both during the holding period and upon sale. In many cases when a manager is able to do a good job, negative cash flow would only occur during the period when it was budgeted or shorter, so you will not incur any losses since the negative cash flow will be covered from the reserves set aside and included in the initial capital contribution.
* LTV is too high. This is usually the case when the cash flow projection is not performed properly. Before entering a deal, it is tempting to go for as much debt financing as possible to minimize an initial capital contribution and increase the projected returns on investment. However, when there is not enough margin of safety above the debt service level and unexpected costs occur, or when a sponsor overestimate potential cash flow levels, losses will occur. In addition, if the loss persists you risk defaulting on the mortgage. Remember when you take out a loan, the bank becomes entitled to the property and thus your potential default on covering the debt service would result in losing the property. Make sure an LTV is optimized.
* Low quality of tenants. Make sure proper due diligence is performed for the rent roll and lease agreements. If the property is well diversified and a tenant defaults, this may not be a big deal. If, however, a property is poorly diversified, each default of a tenant would result in significant decrease in cash flow. When the risk of tenants defaulting is high, the risk of negative cash flow in a particular period increase.
* Scattered lease terms. When you look at the rent roll and see that 5% of the leases expire every year, this means that only 5% of the cash flow is at risk in any given year. However, if you look at the rent roll and see in year 3 for example 50% of the leases expire, this puts 50% of the cash flow at risk. If none of the tenants extend their leases and new tenants cannot commit immediately there is a high risk of loss until tenants are replaced.
* Exit strategy. The exit strategy for the deal must be thought through carefully with proper projections made for potential fees and taxes. When the sale price will be the same or below what you paid for an asset and some of the high transaction costs add up, you will lose on a deal.
* Unexpected maintenance costs. Make sure a building inspection is performed thoroughly during the due diligence in order to minimize the risk of any unexpected expensive repairs. Any unexpected and expensive repairs raise the risk of negative cash flow.
Investing in commercial real estate is associated with uncertainty of the cash flow. However, choosing the right partner who is both transparent and able to react to unexpected changes should protect your investment.