Rental Income Risk Scores: Clues to a Profitable Investment
By Narendra Srivatsa Director of Product Development, Verisk Commercial Real Estate
“Every person who invests in well-selected real estate in a growing section of a prosperous community adopts the surest and safest method of becoming independent, for real estate is the basis of wealth.”
— Theodore Roosevelt
Known for fiery replies and sometimes startling insights into fellow politicians and policies, Teddy Roosevelt was never revered for his advice on real estate. And while his statement is bullish for investors, what does it reveal about finding ways to fill investment properties with reliable tenants?
Read closely, the statement makes a series of conditions: Real estate must be “well-selected” and located in a “growing” neighborhood of an area that is already “prosperous.” Only then can the investment become the “surest and safest” possible. In the era of Roosevelt’s bully pulpit, definitions of those categories would have been derived primarily by well-honed market instincts. Whatever the end goal in real estate, the advent of data and analytics has changed what was formerly informed guesswork into reasoned decision making, although specific instruments are needed to make the most accurate assessments. What tools are now available to help find the “surest and safest” clues to a profitable investment? What are, for example, the most reliable criteria for telling a likely defaulter from a promising tenant? Given the increasing complexity of real estate transactions, a prospective investor should probably search for better ways to assess rental-income risks if only to flag potential delinquencies. Rental income can be considered a key to commercial real estate (CRE) investments in determining acceptable returns over the long term. While many recognize rental income’s role in CRE investment management, tools to assess risk of rental delinquencies have often not been applied to their fullest advantage. The current criteria using lease data makes the assumption that tenants can and will pay rent through their lease period — that’s a hypothesis that has been proven wrong time and again. Assessing risk from tenant delinquencies can be vital to improving the return on investment (ROI) of your CRE investment and avoiding loan default. The paradigm frequently used in investment decisions is that CRE follows the macroeconomy. That has often led to a reliance on econometric forecast models as formulated by Torto Wheaton, Moody’s, and other leading research organizations. Those macroeconomic factors generally assess supply-and-demand effects on rental income in a potential metropolitan statistical area (MSA) or submarket based on a number of data elements, including available inventory of space, absorption levels, rent per square foot, employment, demographics, and median income.Tried but Not True
The rental income assessment from this econometric research for an MSA or a submarket is then set beside the lease income of a particular asset to make comparisons and determine the attractiveness of the investment. And yet there’s often a huge gap, because this does not assess a major risk to specific rental incomes — the tenant’s inability or reluctance to pay rent isn’t part of the analysis. This has sometimes resulted in unexplained variances showing up in the investment manager’s quarterly reports and, in many cases, can lead to default. The challenge facing the industry is that macroeconomic factors don’t provide the granular level of assessment typically required to determine risk in rental income. More than 20 million businesses in the United States occupy some form of commercial real estate space in office, retail, industrial, or mixed-use property types. Of those businesses, only about 15,000 are public companies. Little information is tracked about other private businesses and their ability to pay their rent consistently. That has resulted in rental delinquencies, increasing losses, and larger investment risks. Having risk assessment tools at hand to forecast rental income risk can provide CRE investors with the opportunity to:- underwrite to higher standards and not just depend on debt-service coverage ratio (DSCR), loan-to-value (LTV) ratio, leasing, and macroeconomic data — all of which are often insufficient
- manage portfolios to timely and context-driven risk measurements that assess tenant risk concentrations and market conditions to rebalance portfolios
- aggregate the renter’s risk data at ZIP-code level and develop a rental income risk score to compare different macros and property types, just as can be done with unemployment, median income, and so forth — which can help assess market areas and property types for investment potential