Real Estate Investment Risk: What You Need To Consider

Investing in real estate has long been recognized as a means to build wealth and generate a steady income — and for many investors, real estate properties are the main assets in their portfolios. However, this doesn’t mean that real estate doesn’t have any risks. In fact, there are several types of risks associated with this industry. Understanding each of these challenges is critical to ensure protection for your capital, increase the potential for high returns, and decrease the chance of loss.

In this post, Realized dives deeper into real estate investment risk and how to manage it. We will also discuss how to determine your own risk tolerance as an investor and best practices to minimize risks. Whether you’re a newbie or a seasoned investor, follow this guide to help increase the potential for success.

What Is Risk? Understanding Risk in Real Estate Investing

In real estate, risk refers to the general possibility that investments won’t perform as well as you expect them. As a result, you suffer financial loss and other consequences. Compared to other types of investment, however, real estate is still one of the lower-risk options. A property’s tangible nature gives it protection from rapid fluctuations, an issue that you might encounter with bonds or stocks. Even so, there are still various unpredictable factors that affect a real estate asset’s value and profitability. These include the following:

1. Changes in the local economy
2. Fluctuating demand for property
3. New laws and regulations
4. Natural disasters
5. Broader market conditions

As such, any investor must accept that risk is a permanent part of real estate investment. No one is exempted. Hence, minimizing risk entails understanding and managing it effectively. Failing to account for challenges will potentially increase your exposure, leading to high chances of substantial loss.

Types of Real Estate Risks

We can categorize risks into two main groups: systematic and unsystematic.

• Systematic: These risks affect the entire market, not just your particular niche. One example is economic downturns, such as a recession.

• Unsystematic: On the other hand, unsystematic risk is one that affects your particular industry. In real estate, a common unsystematic risk is tenant risk.

Let’s examine each one in more detail.

Systematic Risks

Due to how they affect the entire market, systematic risks are often difficult to avoid. As an investor, you must accept that there will always be a certain level of systematic risk. Here are some of the most well-known examples.

• Market Risks: In the context of real estate investing, market risk is the possibility of unfavorable changes in the broader economic environment. A few examples are recessions and high inflation rates. Thanks to these issues, the real estate market may also experience a downturn since people have weaker buying power. It may become difficult to sell property or refinance at a profit. One infamous example of a market risk making a profound impact on the real estate market is the 2008 recession.

• Interest Rate Risks: Interest rate risk is tied to fluctuations in interest rates set by the Federal Reserve or central banks. If interest rates rise, the borrowing costs increase at the same time. This growth also means higher mortgage payments for property buyers, making them less likely to proceed with the sale of a property. The overall result is reduced cash flow. This issue also affects investors who rely heavily on financing — they may find themselves vulnerable when interest rates go up.

• Environmental Risk: Environmental risk refers to natural disasters, climate change, environmental contamination, and so on, that could impact your investments. One example is a property located in a disaster-prone area. The high chances of floods, wildfires, or hurricanes damaging the property can lead to costly repairs or even total loss. While no property is immune to environmental risk, it’s important for investors to find assets that are located in safer areas to mitigate this risk.

Unsystematic Risks

Compared to systematic risks, investors have more control over unsystematic risks. Practicing due diligence can help you analyze these types of risks and follow practices that reduce their effects.

• Liquidity Risk: Liquidity risk refers to the ease or difficulty of turning an asset into cash. Real estate is less liquid than other types of investment, especially if it’s under a long-term contract like those of Opportunity Zones or Delaware Statutory Trusts (DSTs). It may take months or years before you can turn equity into cash. These delays may result in missed opportunities during favorable market conditions.

• Location Risk: The geographical area where the property is located can also create risks. Local economic conditions, crime rates, and population trends are a few factors that could influence the value or desirability of your investment property. As such, research is essential to ensure that the location of your property is experiencing steady growth or at least has a stable economy.

• Tenant Risk: Tenant risk stems from the inherent unpredictability of tenants in rental properties. Owners and landlords may face issues like rent payment delays, property damage, and high vacancy rates. Given how an investor’s cash flow is tied to the tenant’s ability to pay rent, these risks can have a major impact on your cash flow. You may struggle to pay operating costs like taxes, insurance, or maintenance costs, leading to further complications down the line.

• Regulatory and Legal Risk: This type of risk refers to the potential for changes in laws or regulations that could affect real estate investments. One common example is the increase in property taxes, reducing income. Stricter zoning laws and rent control regulations are also considered regulatory risks.

Determining Your Risk Tolerance

No investor has the same tolerance for risk. Tolerance, in this case, is the amount of risk you’re able to take based on factors like financial situation and comfort with uncertainty. Knowing your risk tolerance allows you to be more confident with your next investment ventures.

What Is Risk Tolerance?

Risk tolerance is your ability and willingness to endure the potential of losses as you chase after investment gains. Your risk tolerance is a critical factor to include in your strategies as it shapes the types of investments, strategies, and markets you’re going to participate in. For example, an investor with a high-risk tolerance may find themselves more willing to engage in development projects or up-and-coming markets. On the other hand, an investor with low-risk tolerance may prefer options like rental properties or DSTs.

How To Assess Your Risk Tolerance

A thoughtful and thorough examination of various related factors can help you determine your risk tolerance and create a clear risk profile.

• Financial Health: Your current and projected financial situation plays a huge role in your risk tolerance. Review your savings, income, and debt levels. With this assessment, determine if your financial obligations are manageable enough to allow you to invest in higher-risk assets or not.

• Investment Goals: Ask yourself if you’re going for a long-term or short-term investment. The latter is inherently riskier because of the brief investment period, but short-term investments also have a higher potential for sizable profits achieved at a quicker pace.

• Investment Timeline: The longer you hold an investment, the higher the exposure to risk. However, real estate assets generally appreciate, making them a safer option for investors with a low-risk tolerance.

Achieving a Balance Between Risk and Reward

An investor who likes to gain high rewards quickly may find themselves in high-risk situations. On the contrary, investors who focus purely on low-risk investments face the risk of missing out on higher returns.

An experienced investor will find a balance between these two extremes. You can achieve this by making a thorough assessment of your risk tolerance and diversifying your portfolio. This way, you have the right mix of assets that yield high rewards and assets that provide less but steady income.

Strategies That Minimize Risk in Real Estate Investment

Understanding risk is only one part of the process. You should also leverage strategies that actively mitigate these risks. Here are some of the most tried-and-tested methods for real estate investments.

Diversification

Having a diverse portfolio is one of the best protections against investment risks. You’ll want to spread your investment across various asset classes, geographical locations, and property types. It’s not good practice to focus solely on one type of investment property — if that market experiences volatility, then everything you own may be affected. Having diverse investments ensures that even if one area is facing volatility, you still have others that provide steady income streams.

Comprehensive Market Research

Another common strategy is market research, investors must evaluate local trends, economic indicators, and demand before committing to a property. Some specific factors you should research are the following.

• Property values
• Vacancy rates
• Local job markets
• Environmental hazards
• Demographics

Many tools are available to help with your research. However, accessing this data on your own may prove difficult. Working with real estate experts or financial advisors may give you access to more comprehensive data as well as the expertise to understand what the numbers are saying.

Following Property Management Best Practices

Practicing good property management strategies helps protect from two main risks: tenant and environmental risk. Rigorous applicant screening and keeping your property in the best condition can help you sift for high-quality tenants and secure longer tenancies. Regular maintenance also adds protection against natural disasters and environmental hazards, making your property less prone to these systematic risks.

Insurance and Legal Protections

Another way to protect your real estate investment from risk is by having the right insurance coverage and legal protections.

• Insurance: Insurance against natural disasters like floods or fires provides protection from environmental risks. On the other hand, liability insurance and similar policies protect from financial loss caused by accidents or property damage.

• Legal Protection: Your lease agreements and property management contracts, for example, should have robust verbiage that helps protect you from tenant defaults or disputes with property managers (financial mismanagement, property maintenance issues, etc.)

Debt Management

Borrowing and incurring debt are sometimes unavoidable in real estate investment. However, having too much debt puts you at a higher risk of financial loss. As such, you’ll need to follow good debt management practices to minimize your financial risk exposure. Make sure to keep your loan-to-value (LTV) ratios at reasonable levels, typically 80% or less. In addition, try to maintain sufficient cash reserves that can help cushion you against unexpected expenses. With these strategies, you can potentially avoid defaulting on loans or needing to liquidate other assets in case of economic downturns.

Alternative Investment Options

You should also consider alternative investment strategies like 1031 exchanges, Opportunity Zone Funds, or DSTs. These offer tax advantages and more opportunities for diversification. Plus, these options allow you to access markets that may not be available through traditional investments.

Exit Strategy Planning

Finally, we recommend planning for an exit strategy that helps you manage when to sell or relinquish your property. This plan of action defines how and when to sell or hold your property based on market conditions as well as the asset’s performance. Thanks to proactive planning, you can avoid selling at an inopportune time or holding onto underperforming assets.

Wrapping Up: The Basics of Risk in Real Estate Investment

Risk is an unavoidable aspect of investing, even in real estate. Since you can’t eliminate risk, the next best thing is to understand and control it. Protecting yourself from its effects requires proper knowledge about the various types of risks and the strategies to help manage them. When you approach real estate investment with these action plans, you can position yourself for long-term success.

Sources:

https://www.investopedia.com/articles/investing/122415/why-real-estate-risky-investment.asp

https://professional.dce.harvard.edu/blog/real-estate-investing-for-beginners-5-skills-of-successful-investors/

https://www.investopedia.com/terms/s/systematicrisk.asp

https://www.investopedia.com/terms/u/unsystematicrisk.asp

https://www.investopedia.com/terms/r/risktolerance.asp

https://www.investopedia.com/terms/l/loantovalue.asp