Risks in Real Estate for Investors and How To Manage Them
Real estate investing can be quite lucrative – but it also carries with it a lot of risk. Real estate investors should carefully consider each property that they are looking to invest in. It’s important to weigh the benefits and the potential cost that any property could bring with it.
It’s also important to know the various types of risk that you will come across in real estate. There are many types of risk, including liquidity risk, asset-level risk, general market risk, and much more. In this article, we’ll discuss the potential risks that you will come across in real estate investing, as well as tips for mitigating each type of risk.
Table of Contents
- What are the major risks in real estate investing?
- What is Real Estate Risk Analysis?
- What are General Market Risks?
- Types of Real Estate Market Risks
What are the major risks in real estate investing?
There are many risks involved in real estate investing. These risks include but are not limited to liquidity risk, asset-level risk, structural risk, high-vacancy risk, idiosyncratic risk, systemic risks, and over-leverage risks. Read on for an in-depth discussion of these risks – including what they entail and steps you can take to mitigate your real estate investment risk.
What is Real Estate Risk Analysis?
Risk analysis in real estate involves the analysis of the risks involved in purchasing properties as real estate investments. You can assess the risk by assigning a score to each property, with 0 being “no risk” and 3 being “high risk.” If the real estate investment risks associated with a specific property are too high, you can choose to look elsewhere.
What are General Market Risks?
General market risk has to do with what your investment is worth. There is always a chance of your real estate investment gaining or losing value over time. Another risk is the fact that rental rates and vacancy numbers can go up and down, making it harder to earn a revenue from your real estate investment. Being forced to lower rent is an example of a general market risk.
How to Manage the Interest Rate Risk
The interest rate risk has to do with interest rates rising and falling. If you have a fixed-rate loan, you transfer that risk to the lender. If you have an adjustable rate loan, you take on that risk, and it can positively or negatively affect the cash flow from your real estate investments.
Let’s Talk About Portfolio Diversification
One of the best ways to manage general market risks is to hold a diverse real estate investment portfolio. Your portfolio should be comprised of different types of properties in different locations. Owning investment property in different neighborhoods within the same town can be a great way to diversify. You’ll also want to consider single-family homes, condos or townhomes, and multi-unit properties as different options.
Liquidity risk has to do with how quickly real estate investors can raise cash to cover emergency expenses outside of their regular budget. Liquidity can become a problem if all of the investor’s money is sunk into real estate. They may find themselves needing to sell their assets at low prices to raise quick cash.
Learning the Market
Making smart decisions when making real estate investments can help to mitigate liquidity risk. Be sure to thoroughly research the properties you are looking to invest in. Are they in a good area? Will it be easy to rent them out? Will they bring a solid return on investment? Making smart decisions to begin with will prevent you from having to quickly sell any of your assets later on down the road.
The many types of properties you can potentially invest in are called asset types. Investing in any asset type will bring with it some sort of risk. Multifamily homes are considered low risk, as they are always in high demand, despite economic conditions. They also tend to bring in low profits. A high risk investment brings with it a higher potential for loss of capital. For example, a hotel is considered a high risk investment, but the potential profit margins are considerably high compared to other investments.
Knowing Your Assets Better
Be sure to understand the asset type that you are investing in before making a purchase. It’s important to know the rules and regulations associated with that asset class, so you can be sure that your plans for the property can be carried out.
Structural risk has to do with outside market risks that impact an entire industry. Structural risk is hard to minimize because you have little control over it. An example of structural risk is an eviction moratorium, like the one that occurred during COVID, which affected all landlords.
Analyze the structure
The best way to minimize structural risk is to be prepared to go through it. Make sure that the assets you purchase will actually rent out, and be sure to keep enough money in your bank account. When you are forced to sell your property, you can end up losing money, but if you have enough liquid cash in reserves, you won’t be forced to sell.
High-vacancy risk has to do with your property remaining vacant for too long, which will impact your return on your real estate investment.
Invest in High Demand Properties
The best way to avoid this type of risk is to invest in properties that are in high demand. This will help keep your vacancies low, and will increase your profit margins.
The Idiosyncratic Risk
Idiosyncratic risk has to do with your exposure to outside risks that will impact your investment. An example would be your exposure to hurricanes in Florida or your exposure to earthquakes in Tennessee.
Know the Market Factors
This type of risk is avoided by building a diverse investment portfolio. It’s also important to know the risks of the particular area you are investing in, and keep up with recent economic and political news that might be relevant to your investment.
Systemic risks are risks that affect an entire market segment. These risks are hard to avoid, as they affect everyone in the industry. The best way to mitigate a systemic risk is to diversify your portfolio and have plenty of cash put aside so that you aren’t forced to sell.
An over-leverage risk has to do with the amount of debt you have against a property. This occurs when you have more than a safe level of debt against your property. A general rule of thumb is to never have more debt against a property that you can pay off by selling the property fast. A good rule is to stay at 75% or less leverage.
What is financial risk in real estate?
Financial risk is the chance of your real estate investment losing money. It’s important to take steps to mitigate this risk. One thing you can do is diversify your real estate portfolio, or hold a variety of different types of investments.
Is real estate a high or low-risk investment?
In the short-term, it’s possible to lose money in real estate. But in the long-term, real estate can be a very secure investment. Properties tend to increase in value over time. The only way to lose money in real estate is if you find yourself in a situation where you are forced to sell. For this reason, having extra cash set aside is important, as it can help you avoid this scenario.