Commercial Real Estate Basics

The first question that must be asked in commercial real estate is whether or not the property is leased. Ideally, leased real estate provides a consistent source of income to repay debt financing. This suggests that real estate which is not leased is speculative, or for short, we say “spec.” If the real estate will be mostly leased by the property owner, we then refer to the real estate as “owner occupied.”

Spec properties are considered some of the most risky projects to finance. The project owner will need to make debt payments from their own personal resources until they find tenants to lease the property. Finding tenants will also come with costs, which include paying agents commission to find tenants, and possibly even building out the space for the tenant to operate.

Leased properties are considered lower risk, but they are still not without potential issues. Simply because a space is leased does not mean the tenant will have the ongoing ability to pay. It is not uncommon for a tenant to default on their lease. This means the project should be underwritten as if a new tenant could possibly release the space. This is done mostly by examining market rents and vacancy. Operating expenses of the property are generally unimportant, as tenants will likely be expected to pay their own maintenance, insurance, and their equivalent real estate tax for the space rented. This is usually agreed to in a triple net lease.

An additional risk to leased real estate is the timing of the leases. If leases expire before the debt matures, then some of the previous stated risks of spec real estate begin to become a concern. If an owner must find a new tenant, new expenses may be incurred. Also, the contents of each lease should also be examined. Leases may give the landlord or tenant special rights to demand higher or lower rent, or terminate the lease prematurely.

Owner occupied real estate has its own set of risks, although it’s generally considered the least risky real estate to finance. Risk is considered lower, because the owner doesn’t have to find or secure a tenant. This means the risk of repayment depends on the successful operation of the owner’s business. In a sense, this puts all the eggs in one basket, so the failure of the borrower’s business will lead to an immediate deterioration in the first source of repayment of the debt. This means even with owner occupied real estate, the project should still not be financed unless market conditions show a different tenant could support the property.

To summarize, leased real estate is preferred over vacant or “spec” properties. But, financing a leased property still requires analysis. The tenant’s ability to pay ongoing rent should be considered, as well as the type of lease the tenant has entered into. While owner occupied real estate mitigates some of these risks, it places all the credit risk onto one business or operator. Even with owner occupied real estate, market analysis is required to make certain the property could be remarketed.