Real estate is one of the most popular long-term investments.
According to a 2022 survey performed by Bankrate, 29% of Americans would put their money in real estate investing if they had to invest it for 10 years compared to 26% who would put it in stocks.
This is no surprise, given real estate tends to have similar returns to the stock market over the long run yet is historically less volatile. But does this mean real estate is a safe investment?
As with any investment, investing in real estate involves some risk. In this article, we’ll go over what the biggest risks are so you can be a more informed investor.
Let’s get started!
Contents
Market Risks
Market risks are often referred to as systematic risk.
General Market Risk
All markets have their ups and downs, including the real estate market. Just think back to the 2008 housing crash. At its core, the crash was rooted in a false belief that a rental property values always go up. But this isn’t the case.
Though real estate tends to appreciate over time, it can (and does) depreciate sometimes. Real estate investors who don’t understand this are more likely to expose themselves to too much real estate investment risk.
So what impacts the real estate market as a whole? Many things: supply and demand, the overall economy, demographics, interest rates, inflation, government policies, and unforeseen events like natural disasters.
Unfortunately, you can’t eliminate these risk factors and thus can’t ever fully anticipate market shifts or downturns either. Instead, you must keep a close eye on the market and be careful not to take on more risk than you can afford.
Location Risk
Success in real estate depends heavily on location. As they say, the number one rule in real estate is location, location, location.
Why? Because where you invest in real estate determines what property types are available, what type of tenant pool you have to work with, average rental rates, and the potential for property appreciation.
For example, a city that has a growing economy may attract new workers to move there, increase housing demand, and put upward pressure on housing prices. On the flip side, an area that suffers from high crime rates and has poorly ranked school districts may see less housing demand, and real estate properties may depreciate as a result.
Location also determines environmental risks. If you invest in coastal Florida, for example, you need to account for the real threat of hurricanes, which could seriously damage your investment properties (though flood insurance can help).
Before settling on a real estate market to invest in, research it thoroughly and study its historical performance (keeping in mind that historical performance does not guarantee future results).
Legislative Risk
Real estate is heavily regulated by federal, state, and local governments, which means real estate investors need to reckon with various legislative real estate investment risks. Here are just a few examples:
- Delays in getting building permits could slow down construction and delay how soon a real estate investment starts generating rental income.
- Changes to zoning regulations could impact whether certain property types are permitted. For example, a new ban on short-term rentals may require you to rethink an Airbnb real estate investing strategy.
- The passing of rent control laws could hurt your ability to increase the rent from year to year to boost profits or keep up with growing property expenses.
- Increases in property tax rates could lower your profit margins and hurt your cash flow.
- Changes to tenant laws could limit your ability to deny tenant applications or process evictions.
Property Risks
Negative Cash Flow Risk
Cash flow is the monthly rental income left over after all your monthly property expenses (e.g. mortgage payments, property taxes, maintenance, and home insurance) have been paid for.
If you have negative cash flow, it means the money coming in is less than the money going out. For example, if your monthly rental income is $1,000 and your monthly property expenses are $1,100, your monthly cash flow would come out to a negative $100 ($1,000 – $1,100). In other words, you’d be losing money every month.
Possible reasons for negative cash flow could be high vacancy rates, low rental prices, or costly maintenance and repairs.
So before investing in a property, it’s important to calculate the projected cash flow with a large margin of error. That way, your investment is more likely to yield a positive (instead of a negative) cash flow.
Vacancy Risk
Rental properties don’t generate income unless they have tenants. In fact, an empty property will cost you money, and the longer it stays empty, the more you’ll lose.
Unfortunately, some vacancies are inevitable (e.g. due to gaps between tenant contracts), but a high vacancy rate is also a risk that could hurt your real estate investment.
To lower your property’s vacancy rate, there are a few things you can try:
- Lower the rent
- Treat tenants well so that they stay longer
- Start looking for new tenants as soon as current ones give their notice to vacate
It’s also a good idea to build up cash reserves to cover vacancies when needed.
Tenant Risk
Unfortunately, even if you manage to keep your rental properties filled with tenants, there’s always a risk that you’ll end up with a bad one.
A bad tenant could be someone that:
- Pays rent late (or not at all)
- Intentionally damages your property
- Keeps an unauthorized roommate or pet
- Doesn’t report maintenance issues until it’s too late
- Or violates the rental agreement in some other way
Any of the above can result in lower rental income and higher maintenance and repair costs, which could ultimately hurt your property’s ROI. You may even need to process an eviction, which can be costly and stressful.
To lower the risk of getting a bad tenant, screen your tenant applicants thoroughly: Run a credit check and criminal background check, ask for referrals from their previous landlords, and check their work status and history (their monthly salary should be at least three times their rent).
You may also want to insure your property against damage caused by bad tenants.
Repair Risk
Physical properties deteriorate over time, which means real estate investing may require expensive repairs that could eat into your profit margins. This is especially true of older and poorly maintained properties.
Unexpected large repairs can cost a lot. For example, the average cost of a foundation repair is $4,500, while severe foundation problems can run up to $25,000 or more. Similarly, roof repairs average $1,000 but can run up to $15,000 or more.
As a real estate investor, you must reckon with the risk of large repair costs. One way to limit this risk is to always make sure you get a thorough home inspection before you buy. This can alert you to any needed repairs or red flags. You can then figure the cost of repairs into your ROI calculations, negotiate for a lower price, or walk away from the deal.
When it comes to commercial property, buildings are rated as Class A, B, or C based on their condition (and other desirability factors). So use this as a metric to gauge the risk of your investment property requiring costly repairs at some point.
Financial Risks
Leverage Risk
Leverage refers to how much debt you take on to fund an investment. Often, it is calculated in terms of a debt-to-equity ratio. For example, if you use $60,000 in borrowed money and $40,000 of your own money to buy a $100,000 property, the investment would be considered 60% financed ($60,000 ÷ $100,000 = 0.6).
The more leveraged a property deal is, the higher the risk. Why? Because the more leverage you use, the more dependent you become on expected returns for paying back the debt. Though leverage can magnify your returns, it can also magnify your losses.
Leverage risk is also known as structural risk, which has nothing to do with the physical structure of the property but the structure of the deal.
Some other factors that play into leverage risk include the following:
- Loan interest rates. The higher the interest rate, the higher the total debt and associated risk.
- Required collateral. The type of collateral required for the loan (and how much) determines what’s at risk of being seized if you default on the loan.
- Debt maturity. This refers to when the debt is ultimately due. If it’s due at a time when the property’s net operating income is lower than expected or when the market is down, you may be forced to liquidate your position at an inconvenient time and lose money as a result (covering outstanding debt with a new loan is also hard).
As a rule of thumb, real estate investments shouldn’t be leveraged more than 70%. Otherwise, you may end up with cash flow issues or an asset that is worth less than what you owe on it (aka being underwater).
Avoid becoming overleveraged and use controlled leverage instead.
Liquidity Risk
Another risk inherent in real estate is illiquidity. Unlike other assets like stocks, you can’t easily sell a property once you own it. Selling takes a lot of paperwork and time. The closing process is long and involves a lot of moving parts: buyer and seller agents, home inspectors, appraisers, mortgage lenders, and sometimes lawyers.
This can make it hard to get out of a bad investment, and in some cases, you may be forced to sell at a loss.
That said, if you need cash, you can tap into your property’s equity via home equity loans, cash-out-refinancing, reverse mortgages, and other means, but these processes still take time and won’t completely liquidate your position.
Asset-Level Risk
Different types of properties come with different levels of risk.
For example, there’s always demand for apartments, so they are a relatively low-risk investment. Hotels, however, come with more risk because they depend on the travel and tourism industries. They may provide high returns during peak travel seasons, but they may also be impacted by travel restrictions (like the ones imposed during the COVID-19 pandemic) and have a negative ROI as a result.
As an investor, you need to be aware of the different levels of investor risk associated with single-family, multi-family, and commercial properties.
Asset-specific risk will also require rental property analysis to be sure you understand and can mitigate the known risks of your individual property.
Mitigate Real Estate Investing Risk
At the end of the day, there’s no such thing as a real estate investment with zero risk, but there are ways to minimize the risk.
For example, you can do your due diligence on specific markets, properties, and tenants to help ensure they don’t pose an inordinate amount of risk.
You can also protect your investment through diversification. Instead of putting all your money into a single property, you can invest it across several properties with a real estate fund. So even if a single property performs poorly, it won’t devastate your overall returns because it only makes up a fraction of your total investment.
In addition, a private real estate fund like the Invest.net SFR Fund I can help you diversify against public markets. How? Since it’s a private fund, it’s less correlated to public stocks and bonds or even publicly traded real estate investment trusts (REITs).
So if you want to invest in real estate with minimal risk, consider investing alongside real estate experts at Invest.net.
This not only helps you mitigate risk but it provides you with a truly passive investment. We take care of all of the property sourcing and management so you don’t have to. You can sit back and relax while collecting regular dividends.
Contact us today to learn more. We look forward to chatting!
- 10 Real Estate Investment Exit Strategies To Consider - November 2, 2023
- Investing in Residential vs. Commercial Real Estate: Which Is Better? - September 6, 2023
- What Is Private Equity Real Estate Investing? - April 4, 2023
