Some areas of commercial real estate are inherently risky, and some have become even more so during the COVID-19 pandemic. Hotel real estate is a good example. Hotels are a cyclical business to begin with and are highly dependent on consumers and businesses being willing and able to spend money. And in the pandemic, travel demand has rebounded a bit but remains a fraction of what it was at this time last year, so many hotel operators are likely to be unprofitable.
However, like most areas of the stock market, it's not fair to generalize. Just like not all tech stocks are in the same boat when it comes to risk, there's a broad spectrum of risk when it comes to commercial real estate as well. With that in mind, here are some of the important things to look for when evaluating commercial real estate.
Key risk factors to look at
Obviously, I can't list every factor that could be an indicator of risk in a commercial real estate industry. However, here are a few of the key factors to consider:
- Subsector: Certain types of commercial real estate are simply more sensitive to things like recessions and other economic headwinds. Hotels are an obvious example, but retail real estate is also on the riskier side. On the other hand, healthcare, office, and industrial real estate are a few subsectors that are on the lower end of the risk spectrum.
- Rent collection: This is especially important in the current environment. Most real estate investment trusts (REITs) have provided updates regarding how much rent they've collected versus how much they billed to tenants. Many retail REITs, for example, have collected 70% or less of their billed rent in recent months while medical office and industrial REITs have collected most, if not all. Looking at rent collection rates can help you compare the risk level of two REITs with similar property types as well.
- Credit rating: This may require some digging to discover, but you can typically find a REIT's credit rating in a recent investor presentation or in its annual report. While credit ratings aren't a perfect risk indicator, they can help highlight which REITs may have less solid balance sheets.
- Dividend cuts/payout ratio: In the recent environment especially, many REITs have been forced to suspend or reduce their dividend payments. And by comparing a REIT's dividend to its funds from operations (also known as its payout ratio), you may be able to predict whether a dividend cut could be in the future.
- The coronavirus factor: The COVID-19 pandemic has been a major issue for most commercial real estate owners, but some are affected more than others. And just as important from a risk standpoint, the pandemic has created a disproportionate amount of uncertainty for some REITs. For example, all hotel operators are suffering -- but hotels that depend on large events like conferences to bring in business have a far greater uncertainty level right now than those that simply depend on people taking vacations.
The Millionacres bottom line
For one thing, commercial real estate stocks that were already volatile and/or risky before the pandemic are (for the most part) even riskier now. Retail REIT Seritage Growth Properties (NYSE: SRG) is one example that immediately comes to mind. The company's business model is redeveloping outdated retail properties and relies on rental income from its finished projects as well as asset sales to fund its operations. Seritage wasn't profitable before the pandemic but was generating enough money to keep its vision going -- now there's far more execution risk.
On the other hand, there are many types of commercial real estate that are just as low-risk now as they were before. Data centers, medical offices, and infrastructure real estate are some examples that are not only low-risk but could actually get some tailwinds from the pandemic.
And finally, the main thing to keep in mind is that when it comes to risk, it's very important to evaluate REITs and other commercial real estate stocks on an individual basis. Some retail REITs may be relatively low risk while others could be on the verge of collapse. By looking at some of the risk factors discussed here, you'll be able to get a sense of how risky (or not) any particular commercial real estate company is.
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