Key Elements in Your CRE Financing Risk Management Strategy

As a commercial real estate lender, good CRE financing risk management is crucial. It helps you set appropriate loan terms and minimize potential losses. 

However, it’s equally important for investors and borrowers. It helps them assess potential investments and structure them in ways that benefit all stakeholders. 

What is CRE Financing Risk? 

Any time a lender extends credit for a real estate project, they take on a number of risks. The CRE loan’s potential for financial loss is called CRE financing risk.

CRE financing risk can come in many forms: 

• Credit risk: the risk that the borrower will default on the loan or fail to meet other loan obligations (such as missing payments or paying late)
• Market risk: the risk that the CRE market will change for the worse, decreasing the property’s value, cash flow, or both
• Interest rate risk: the risk that fluctuating interest rates will hurt the loan’s profitability or the borrower’s ability to repay 
• Property-level risk: the risks associated with the property itself, including its age, condition, operation, and tenants
• Regulatory risk: the risk that local zoning restrictions, building codes, or tax laws could change and negatively impact the investment
• Loan concentration risk: the risk of overexposure to a particular property type, borrower, or geographic area

Next, we’ll cover some of these CRE financing risks in more detail.

Assessing Borrower Creditworthiness

Before funding a CRE project, lenders must thoroughly assess the borrower’s creditworthiness which involves evaluating the borrower’s:

• Credit
• Current debts
• Liquidity
• Investment strategy
• Exit plan
• Experience
• Track record.

If the borrower performs well across each of these areas, you can be more confident lending to them (and vice versa).

Market & Economic Risks in CRE

Of course, some CRE financing risks have less to do with the borrower, and more to do with the real estate market and the broader economy. 

For example, if demand for the underlying property type falls (as it did with offices after the COVID-19 pandemic), this could hurt the property’s performance and make it harder for the borrower to repay the debt. 

Similarly, if the economy experiences a recession, some business tenants could face financial challenges, miss rent, and hurt the building owner’s ability to keep up with payments.

Regulatory Compliance & Legal Risks

Other risks in CRE financing involve regulatory compliance and legal challenges.

For example, lenders must comply with federal and state lending regulations regarding loan underwriting, documentation, and disclosures. Otherwise, failure to comply could lead to serious legal trouble and hefty fines. 

There are also legal risks associated with borrower defaults. If a borrower resorts to foreclosure or bankruptcy, lenders could face disputes over priority liens with other creditors. 

Loan Concentration Risks in CRE Financing

Loan concentration refers to a loan portfolio’s lack of diversification across property types, borrowers, or geographic areas, i.e. having all your eggs in one basket.

For example, if most of your CRE loans are held by the same borrower, this could put you at a serious disadvantage if the borrower ever faces financial challenges and defaults on their loans. 

Similarly, if your CRE loans are concentrated in one property type or geographic area, you could suffer significant losses if the market turns against them. 

Risk Mitigation Strategies – A Lender’s View

Now that you better understand CRE financing risks, here are some risk mitigation strategies:

Conduct due diligence. This involves thoroughly vetting the borrower, their proposed investment strategy, and the market. If the borrower seems inexperienced, their project infeasible, or the market unfavorable, you may want to refrain from extending credit. 

Perform stress tests. A stress test measures how well a CRE loan would perform under various adverse conditions. By evaluating the impact of hypothetical negative scenarios, you can make a more informed decision about whether the CRE loan is worth the risk.

Verify CRE financing laws. Before extending CRE credit, make sure you fully understand the relevant legal requirements and restrictions, or hire an experienced CRE attorney to review deals.

Diversify your portfolio. To minimize loan concentration risk, diversify your CRE loan portfolio across different borrowers, property types, and geographic areas. That way, your overall portfolio performance will be less impacted by a downturn in any one area.

Hybrid Financing Models

Another way lenders can minimize CRE financing risk is by offering hybrid financing models, which combine multiple forms of financing. 

For example, mezzanine financing is a hybrid model that blends debt and equity and sits between senior debt and equity in the capital stack. It can be an attractive option for investors who have already secured a mortgage but need additional funding.

Some lenders also offer bridge-to-perm financing. This combines short-term bridge loans with permanent rental loans so that developers can get funding for a project’s construction or renovation before wrapping it into a long-term loan once the property is stabilized. 

Frequently Asked Questions (FAQs)

What is a risk in the commercial real estate industry?

A risk in the commercial real estate industry is the potential for an investment to perform poorly.

What is the biggest problem in commercial real estate?

The biggest problem in commercial real estate currently is elevated interest rates, which can increase borrowing costs and dampen sales activity. 

What is a going concern in commercial real estate?

A going concern in commercial real estate refers to a property that is financially stable enough to operate and generate income for the foreseeable future. 

What commercial property has the most risk?

The commercial property type with the most risk can vary, but a recent drop in office demand has resulted in offices carrying outsized risk.

What is CRE risk management?

CRE risk management involves identifying, assessing, and mitigating the financial risks associated with commercial property investments. 

What are the risks of CRE?

The risks of CRE include market downturns, tenant defaults, interest rate fluctuations, and regulatory changes. 

What is CRE in finance?

CRE stands for commercial real estate, which refers to properties used to generate income.

What is CRE management?

CRE management refers to overseeing the operations, maintenance, and financial performance of commercial real estate properties. 

Conclusion

Whether you’re a lender, investor, or other stakeholder, understanding CRE financing risk management can help you improve your CRE investment performance.