Risks of Real Estate Investing
Real estate is an excellent addition to a quality investment portfolio. Being the fifth largest industry in the United States, with more than $16 trillion in Economic impact, real estate has an average annual return of 9.5% for commercial real estate and up to 11.8% for REIT. You can also benefit from a passive income stream, property appreciation, and reduced taxes.
Turnkey real estate investing especially makes the process easier. You purchase a fully renovated property, a “turnkey investment property,” and rent it out immediately. This piece of real estate can be a house, a duplex, or an apartment building.
However, real estate investing goes beyond owning a fancy building or profit projections without considering all the potential costs and risks. To maximize returns, you need to know the basics. And there’s no better place to start than with the risks that can affect your profits.
6 Types of Risks in Real Estate Investing
Navigating the Perils for a More Secure Investment
Real estate investing is a great investment scheme, and you may find it much more profitable than other land-related investments. However, it can be very costly if you don’t fully understand the risks. Knowing the potential pitfalls can help you create a profitable portfolio as a real estate investor.
Let’s consider six types of risks you may face in owning an investment property.
1. Market Risk
Real estate property costs and investment returns are never constants. Factors affecting potential returns may include fluctuating supply and demand at different times of the year, recession, and inflation.
To limit this risk, look outside your local market. That’s one benefit of REITs (real estate investment trusts), where you can explore foreign markets. Also, despite the market instability, having a longer time horizon may guarantee better returns in real estate investing.
2. Liquidity Risk
Real estate investing, like in turnkey properties, can be very profitable, but you can’t just convert your property to cash without significant loss. As it’s a physical asset, you must find a suitable buyer and go through specific procedures before becoming liquid.
It may not be easy to sell for the right price and become liquid, especially when your property isn’t in an attractive location. This highlights the importance of location when considering real estate. With a great location, liquidating becomes easier. However, you may also want to consider maintaining some cash reserves outside your real estate investment portfolio or have an investment you can quickly liquidate.
Additionally, there's the option of fractional ownership, where you own a portion of an asset and sell it off when you need money.
3. Credit Risk
The value of your property investment is in how well and for how long it generates income. This part depends on the kind of tenants you rent to. Defaulting on or refusing to pay rent means no property income.
Even though you’ve just bought a residential building, you shouldn’t accept every tenant. It’s important to prioritize getting information like previous rental records, financial status, and references from previous landlords.
4. Operational Risk
The goal of owning real estate is to profit from your investment. Before getting returns, the building must be functional for tenants to live in and pay for. This means that problems with managing or maintaining a property can harm its investment returns.
Sometimes, maintenance issues can cause tenant dissatisfaction. Natural events like floods or hurricanes can also cause property damage.
One way to address this problem is to inspect your property constantly. Put appropriate management measures in place to address any issues in your absence. This may mean that you need to hire a building manager or administrator. Insurance coverage will also help in case of fires, natural disasters, and other damages.
5. Legal and Regulatory Risk
Market rules and regulations differ from state to state and are subject to change. For instance, there are building codes that protect tenants. Also, the tax rate in a particular location can affect expected investment returns. There may also be an instance where your property violates real estate investment laws. All these legal and regulatory measures can severely affect your real estate ROI.
To mitigate this risk, seek legal and regulatory advice from local professionals before investing in any property. Do due diligence to avoid violating property acquisition and renting laws.
6. Leverage Risk
Personal income and savings may not always be enough to fund your real estate investment; you may need a loan to finance it. However, you run a risk when your turnkey investment property yields poorly, so it’s essential to be careful when getting a loan.
Leverage can inflate how much you owe (debt) compared to how much you own (equity).
To avoid overleveraging, calculate the costs and projected rental income before purchase. If it has the potential to be very profitable, you can invest a significant amount of personal funds in your investment financing, or you can use a payment plan. With this payment plan, you can spread payments into months or years. Also, consider fixed-rate loans to predict future costs accurately.
How to Minimize Risk in Real Estate Investing
Now that you know the risks of real estate investing, the question becomes, “Is real estate investment worth it?” The answer here is “Yes.” However, you must take the proper steps to identify, evaluate, and control the risks. The following are essential risk-reduction techniques:
The most crucial step is to understand the world of real estate investing. Read articles and attend training programs. Take a hands-on approach to demystifying investment concepts. Additionally, getting a mentor can help on your investment journey.
Diversify Your Portfolio
Market shocks are inevitable, but you can prepare better as an investor. Try various investment strategies, including buying and holding long-term and flipping renovated houses.
Do Due Diligence
Knowing key details about a potential investment property is crucial before purchasing. Inspect the property's location and find out vital stats like crime rate and neighborhood ranking. Also, understand how the local laws and property rights may affect your investment and prepare an estimate of potential cash flow.
Build a Strong Team of Professionals
Real estate agents, investment consultants, and lawyers can provide expert opinions and guide your risk management decisions. Your choice of professionals should have a good track record and advise you on your investment goals. Additionally, getting a mentor comes with the benefit of one-on-one guidance.
Develop a Comprehensive Risk Management Plan
Identifying your attitude toward risk is crucial to purchasing the right investment property. Assess whether you’re buying for the short or long term. Then map out a strategy to deal with each risk that may arise.
Adopt a Conservative Financial Approach
Always stay within your finances when investing, no matter the potential return on investment. Avoid high-risk loans that will jeopardize your debt-to-equity ratio and maintain a healthy cash reserve for unexpected expenses.
Utilize Technology and Data Analytics
Several PropTech (Property Technology) tools provide innovative solutions for finding, buying, and managing real estate. Roofstock, for instance, helps you remotely search for and evaluate properties before purchase. Analyzing digital real estate data can also help monitor supply, demand, and fluctuating rental rates.
Continuously Monitor and Adjust Your Strategy
An excellent property investment strategy is not a rigid plan. Understand that the market never stays the same. Learning as you go is crucial; constantly monitoring your portfolio and adjusting as needed. Losses may occur short term, but you can be confident of long-term profitability. More so, you can use the experience to develop a healthier portfolio.
Frequently Asked Questions
Your financial goals, how much money you have to lose, and your preferred time horizon are key factors in determining your risk tolerance. Also, a financial advisor can ask a few questions to identify your risk profile.
Owning a rental property, or turnkey real estate investing, is one of the safest types of real estate investments. Another type is purchasing REITs (real estate investment trusts). With a REIT, you can receive dividends without owning physical property.
It’s impossible to avoid risk in property investments or any investment. However, in this article, we’ve discussed various strategies to mitigate the impacts on potential returns.
The risk in real estate investing is relatively safe compared to that in the volatile stock market. It also offers better returns and increased liquidity than bonds and certificates of deposit (CDs).
Speaking to an attorney can be very helpful. Also, make sure to join a community of fellow real estate investors, attend relevant events, and stay up-to-date with industry news.
Common errors include having no real estate investing strategy, taking a complete DIY approach, overbidding, and underestimating property conditions and future expenses.
Determine your risk tolerance, get expert advice, research the property before investing, and transfer risk with appropriate insurance coverage.
Investing in CRE (commercial real estate) is typically less risky than investing in RRE (residential real estate) due to longer rental agreements. Industrial properties are riskier due to the possibility of long-term vacancies and high tenant dependence.
Analyzing real estate market data can be very useful to an investor. You’ll gain insights into market demand projections and future opportunities to exploit.
At BPM REIA, we provide multiple programs to help you get started owning investment properties. You can book a discovery call now.
Risks in real estate investing come in various forms, from an unstable market, operational issues, and overleveraging to changing legal policies and regulations. But you can stay ahead of the curve with a few simple strategies.
One proactive step is using a diversified portfolio across different geographical regions. Advice from an investment mentor or market professional will also make decision-making easier. Plus, you can’t effectively manage risk without analyzing data from the real estate market.
Most importantly, there’s no substitute for learning about the real estate market. With knowledge and a willingness to adjust to instability, real estate investing is a great way to invest in your future. Begin your investor journey today.