Avoiding Negative Outcomes: Risks to Consider in Industrial Real Estate Transactions

In my last post I made the case that the most important objective of any industrial real estate transaction is to avoid negative outcomes. Since risk is the probability of a negative result, evaluating and reducing risk is the way to reach the most important objectives in industrial real estate transactions. In general, a mindset which prioritizes risk avoidance is one that maintains company purpose, relationships, and leads to the best results overall.

But such a mindset is not simplistic in the sense there is more to evaluating risk than not doing or doing something. Risk avoidance in industrial real estate transactions often involves weighing a multitude of risks at the same time to understand the best course of action. Some risks, like environmental liability, can be existential risks for some companies while other risks, like opportunity risks, can be almost neutral in nature. Therefore, if you wanted to avoid a negative outcome, assuming the preceding sentence was true, you wouldn’t assume higher environmental risk just to lower your opportunity risk.

In order to properly weigh risk in an industrial real estate transaction, it is helpful to think about specific risks as relating to common elements of industrial real estate. Such common elements may include:

  • Property condition
  • Workplace environment
  • Location
  • Legal nature of agreements
  • Government or utility impacts
  • Opportunity risks

Although every transaction is unique, the type of risks are relatively constant from transaction to transaction. It is the amount of risk within those categories that must be assessed, weighted, and reduced if possible.

In this post I will cover risks and risk reduction relating to the condition of a property and the workforce environment. Subsequent posts will cover the other categories mentioned above.

Property Condition

Risks related to property condition include functional obsolescence, deferred maintenance, environmental, soils, and location-specific property condition concerns such as seismic retrofitting. Unlike some of the other categories of risk, property condition risks can usually be quantified using proper due diligence prior to entering into an agreement.

For example, functional obsolescence is usually identified when evaluating potential sites and is more likely in situations where there is a long-term hold for existing buildings being considered. Reducing the risk of functional obsolescence may include eliminating properties with older construction from consideration or adhering to a certain standard for amenities.

Many industrial properties without significant functional obsolescence may still have substantial deferred maintenance. Force majeure aside, the most consequential events during an industrial firms lease or ownership of a property are from deferred maintenance. They typically impact the utility of the property and, if the industrial firm is responsible, the overall operating costs of the operation. Consider what an electrical panel malfunction does to a manufacturing operation or what a roof replacement means if the tenant is responsible for the replacement cost. The early use of landlord questionnaires, property condition reports, and negotiating business and lease terms accordingly are a great way to reduce deferred maintenance risk.

As with deferred maintenance, reducing environmental risk should be prioritized in any real estate transaction. Due to the extremely costly nature of environmental liability, industrial firms who are exposed to environmental risk can experience a resource-draining remediation process and sometimes are forced to enter bankruptcy.

Environmental risks can also be reduced through the use of due diligence practices prior to entering an agreement with a landlord or seller. At a minimum, both prospective buyers and tenants should hire an environmental expert who will study the property’s potential for environmental liability and provide a baseline for future reference before purchasing or leasing a property.

Soil conditions are not always of concern in industrial real estate transactions. Typically, soils or geotechnical studies are recommended when there is a known concern, such as liquefaction in the area, or new development is anticipated.

Similarly, location-specific property risks are not always pertinent depending on where the property in question is located. In California, for example, seismic retrofitting may be required for certain industrial buildings to prevent their collapse during an earthquake. The best way for industrial firms to mitigate location-specific property risks is to investigate local and regional requirements which may impact the specific properties they are considering purchasing or leasing.

Workplace Environment

Risks associated with workplace environments would have been mostly addressed in property condition-related discussions in the past. Industrial firms would have sufficiently reduced the known risks to their workforce by making sure the property was in physically safe, there were no toxic or irritating substances present, and oversight agency guidelines were being followed for additional safety features.

With the advent of COVID-19, limiting the risk of illness to employees clearly requires more than just these measures. Although improvements and practices to mitigate sickness in the workforce are evolving, some of the best practices released by health and commercial real estate professionals include:

  • A workplace that can be easily and routinely cleaned
  • Isolation areas or rooms for workers who become sick on the job
  • Designing worker areas to provide isolation and physical distancing
  • Increasing ventilation and installing negative atmosphere areas where needed
  • Separate entrances and exits

This is a rapidly changing area of risk for industrial companies. Firms should continually be consulting experts in workplace safety and following their recommendations to mitigate the risk of infection to their workforce.

Avoiding Negative Outcomes: How to Focus on What is Important in Industrial Real Estate Transactions

If you were to choose the most important objective of any industrial real estate transaction, what would it be? Spectacular savings compared to market? Getting acceptance on all the important legal terms? Above market tenant improvement allowance? Operations is happy with the property condition? On-time occupancy?

While all those results would be fantastic and are certainly worthy objectives, they are not the most important objective of any industrial real estate transaction. The most important objective is to avoid negative outcomes. Why?

Because deep down in our collective psyche, avoiding negative outcomes is what people, and thus organizations, care about the most. We care about winning, but not as much as avoiding losing. In real estate terms, we care about positive results such as beating the market on pricing, but not in exchange for terms which increase risk.

This is the essence of our negativity bias and its impact on industrial real estate transactions. A negativity bias or negativity effect is when, all else being equal, things of a negative nature have a stronger impact on us than things of a neutral or positive nature. In fact, experts say that it can take five positive events to outweigh a negative one. In industrial real estate transactions, this ratio is probably understating the impact of certain negative events on what the firm would consider a successful project.

Since industrial real estate’s value to the industrial firm is largely its utility, the greatest risks lie in the inability to secure and utilize such assets while it is owned or leased. Therefore, we should focus our efforts to reduce the possibility of negative outcomes within the transaction process, both for the risk to utility but also because the industrial firm will most likely judge project success on the lack of negative results.

In other words, we should employ risk mitigation strategies to the extent they are reasonable and possible. Risk mitigation strategies are processes whereby risks are identified, prioritized, and reduced. In industrial real estate transactions, such processes should be defined and a part of the real estate organizations best practices or playbook.