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.
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:
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.
We can categorize risks into two main groups: systematic and unsystematic.
Let’s examine each one in more detail.
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.
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.
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.
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.
A thoughtful and thorough examination of various related factors can help you determine your risk tolerance and create a clear risk profile.
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.
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.
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.
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.
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.
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.
Another way to protect your real estate investment from risk is by having the right insurance coverage and legal protections.
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.
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.
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.
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://www.investopedia.com/terms/s/systematicrisk.asp
https://www.investopedia.com/terms/u/unsystematicrisk.asp