What Are the Major Risks in Real Estate Investing?

Every investment has risk. Earning a return above the risk-free rate means taking risk. The analysis of risk is a big topic. But there are some real estate risks that we can identify as being much higher than other risks. This isn’t to play down lesser risks. But at least knowing where major investment risks lie can provide a quick risk mitigation checklist for potential investments. 

Major Risks in Real Estate

Identifying risk is a critical skill when investing. In this section, we’ll go over several areas that present high investment risks.

Capital Risk

Capital risk is the loss of capital. Some considerations when evaluating capital risks include determining the downside of an investment. If things start going wrong, how much money can an investor lose? The worst case can be more than the initial investment.

Capital risks can extend beyond the initial investment capital. Did the investor put 80% of the net worth into the investment? If so, that is a big risk and can even lead to risk of ruin. Risk of ruin is a trading concept. It basically says that trading X% of capital can lead to blowing up an account. Real estate investors can utilize this concept to mean that investing a large amount of net worth into an investment with above-average risk can lead to significant losses.

Within the capital risk category is determining an exit strategy. If things start going against the investor, do they have a point at which it is viable to exit the investment?

It’s also important to have a handle on expenses. What are the low probability but high-cost expenses that can arise? These expenses generally fall into capital expenses and might include a leaky roof or broken HVAC.

Debt

Debt financing is often used in real estate investing. But the type of debt financing is important. Is the loan non-recourse? In that case, the lender requires collateral, which can be seized in the event of default.

Understanding what’s in the debt contract is also important. Lenders may have written certain debt covenants into the contract. If the borrower is unaware of these covenants, they can trigger them, creating adverse events.

The borrower should have an idea of what their debt coverage ratio will be before taking out a loan. The debt coverage ratio shows how much debt is covered by rental income. For example, a $1,000/mo mortgage on a property producing $2,000/mo in rent has a debt coverage ratio of 2.00. Lenders might write a specific minimum debt coverage ratio into a loan covenant, which the investor is expected to meet.

Liability

Properties must have adequate insurance in case someone gets hurt on the premises. However, insurance doesn’t cover everything. Contracts are important for covering most everything else. An arbitrage clause can help avoid costly court battles. 

Also, remember that cash should be set aside for insurance deductibles.

Liquidity Risk

Even perfectly laid out projects don’t always go according to plan. Overruns and delays are not uncommon. An investor might need to find additional sources of funding quickly. This is a matter of liquidity. How fast can an investor raise cash to cover emergency expenses that are out of budget?

Establishing a new loan will likely take too long. Investors might be unwilling to put more capital into a project. Sometimes the only source of capital is the investor. But if all of the investor’s funds have already gone into the project, then liquidity is a problem. This can mean the investor is left to sell some of her (illiquid) assets at fire-sale prices to raise cash immediately.

The liquidity issue is closely related to risk of ruin. Putting too much net worth into a project and draining liquid resources leaves little to no room for margin of error.

Market Risk

Market risk is related to trends in the overall and local real estate markets. If the economy is heading into a recession, it can impact all real estate properties within the economy. On the flip side, the economy may be doing well but local markets might be experiencing downturns.

This is where robust research comes in at the national and local levels. For a local neighborhood, consider what it will look like 10 years down the road. What are the current trends? Where are market rents going, crime, and schools? Do people maintain their homes and improve them?

Diversification of properties can help mitigate local market risk but can’t do too much for national market risk. Diversification means the more properties an investor has in different locations, the less likely vacancies may affect the investor at a portfolio level.

Over Leverage

Over leverage is using too much debt compared to the value of an investment. Debt is used when an investor doesn’t have the necessary capital to invest in a project. Or when an investor wants to boost their returns.

How much debt is too much is open for debate and varies with each scenario. But when an investor increases debt to a level that any cash flow problem can prevent them from making a loan payment or being able to raise cash to meet a loan-to-value covenant (if the property loses value), they are over-leveraged.

Over leveraging isn’t always determined by the amount of loan taken upfront. The type of loan can determine it. For example, an adjustable-rate loan can increase payments to a level the investor cannot make. A callable loan may be called when the investor doesn’t have the resources to pay off the loan. In both cases, the investor was over-leveraged.

When utilizing financing, investors should have properties that generate consistent and reliable income, which can cover required financing costs. Anything else can leave an investor vulnerable to being over-leveraged.

Knowing various risks that can arise in a real estate investment and being able to rank them is a fairly efficient risk analysis strategy. It allows investors to evaluate the highest risk first and waive off the project if they determine those risks cannot be effectively mitigated. This is much quicker than going through a larger, unordered list of risks.