Risk management in investing is a multi-pronged approach to preserving investment capital by containing or managing the many factors that could lead to a loss.
Risk management is an essential element of a prudent investment strategy, especially when you are considering real estate investment properties since risk is unavoidable with these assets. There are many approaches investors can take to create a comprehensive risk management plan, but they all essentially boil down to one thing: Information.
In this article we’ll examine key aspects of a risk management plan and steps real estate investors can take as they attempt to manage risk in real estate investments.
What are the Primary Risk Factors in Real Estate Investing?
Real estate investors face a slew of potential risk factors on each and every property they are considering adding to their portfolios. These include:
- Illiquidity
- Financial structure
- Asset class
- Location
- National and regional economic downturns
The more information investors gather about these conditions and economic factors can help them better quantify the level of risk they pose to potential real property investments.
A comprehensive risk management plan, therefore, requires a full accounting of these factors and many others, such as potential gains/losses, rising interest rates, demand, fluctuations in real estate values, oversupply, changes in regulatory environment and zoning laws, Sponsor risk if purchasing interests in a Delaware Statutory Trust, and other key metrics that could negatively impact an asset’s performance.
Investors who wish to create a risk management plan to determine the feasibility of an asset for investment purposes should identify and analyze the potential impact of these risk factors and then form an action plan that might help them manage or reduce these risk threats. Your risk analysis should examine the likelihood of a risk factor being realized (probability of occurrence) and the impact it could have on your investment (marginal to catastrophic).
After identifying potential threats to an investment, you’ll create a risk response plan that’s designed to either: A) eliminate risk; B) reduce the probability of occurrence; C) lower the impact of a particular risk threat to your investment objectives. One example of managing/eliminating risk would be purchasing fractional shares of a Delaware Statutory Trust rather than direct property ownership, since DST ownership structures can provide a host of different protections to investors. Another would be purchasing real estate with a triple-net lease since much of the responsibility for the property is shifting to the tenant. Others include limiting personal exposure by creating LLC or LPs to purchase assets, pooling resources with other investors, diversification by asset class and location, and simply avoiding certain investments altogether.
Prudent investors might revisit and reassess risk factors from time to time through a risk audit to ensure thorough monitoring and reclassification of these potential threats after purchasing an investment property, especially in times of severe economic and market fluctuations. A comprehensive risk management plan also includes a backup or economic recovery plan since many of these risk threats lie outside of investor control. Lastly, investors need to gauge the overall risk of an investment against their overall appetite for risk -- also known as risk tolerance.
The Bottom Line
The best risk management tool at your disposal is information. There’s no such thing as zero risk in investing, and risk in real estate investing can never be fully eliminated no matter how hard you strive to create assurances against risk.
The best you can hope for when creating a risk management plan is to find investments that fit within your tolerance for risk after you have identified and analyzed the many fundamental risk factors that could negatively impact your investment and implemented a game plan in an attempt to hedge or create buffers against those risks. At the very least your efforts might help you preserve your investment capital and maintain solvency in your investment.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Consult with your tax advisor regarding your individual circumstances. The actual amount and timing of distributions paid by programs is not guaranteed and may vary.
There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.
There is no guarantee that companies that can issue dividends will declare, continue to pay, or increase dividends.
