All investment carries risk. And this includes real estate investment.
Many people wrongly assume that investing in real estate is a sure thing, but the sad thing is, unfortunately there are risks involved. And in fact, there are several of them.
In this guide, we’ll be drawing your attention to 8 types of real estate risks every real estate investor should know about.
When you go into something like real estate investment, you should be clear before you go in on what can happen to your money, since big potential rewards often come with big risks.
But forewarned means forearmed, and if you take the time to learn about the different risks involved in real estate investing, then you can better strategize before you buy.
8 Real Estate Risks
1. Fluctuating Economy
Real estate investment is subject to the nation’s general market conditions. The market conditions fluctuate over time, and sometimes quite considerably.
There could be increases in interest rates, inflation could go up, and there could be other market trends to be concerned about too.
Unfortunately, this can be hard to predict at times, because you can only truly know current market conditions and model the future based on that information.
For this reason, it is common for investors to put together a diversified portfolio, investing money in multiple opportunities, so that if they lose money in one investment, they may still gain in another one.
It’s basically a means of hedging your bets, and it can help protect you from booms and busts.
2. Asset Class Risk
The type of real estate you invest in also influences the risk that comes with the investment, because there is a greater demand for some types of property over others.
For, example, there will always be demand for residential properties such as houses and apartment blocks. And while the economy is doing well, businesses should thrive too.
However, office blocks, hotels, and summer homes are considerably more sensitive to fluctuations in consumer demand.
To elaborate further, some enterprises are subject to the seasons and the tourism trade, and hotels and shops frequently warrant consumer demand in certain parts of the year compared to others.
Therefore, investments in residential real estate are considered a lower risk investment than that of commercial properties.
3. Specific Risks Pertaining To The Property
Also known as idiosyncratic risk, this type of risk refers to risks that are specific to the particular property and the plans for that property.
For example, if you intend to build on the land to make the land more valuable, then this carries risk in the sense that during the construction period, you may be unable to collect income in the form of rent.
Another issue may come in the form of entitlement risk. For example, you may wish to build on the land, but there’s a chance that the government agencies with jurisdiction over the project could turn it down.
Another example of idiosyncratic risk is the real estate’s location. Locations in busy areas are often in greater demand than quieter areas, due to the easy accessibility to more shops and amenities.
4. Liquidity Risk
A real estate investment only leads to money in your hand if you can sell it when the time is right, so you need to consider your exit strategy before you invest.
If for some reason the asset becomes hard to sell, perhaps due to the location or the quality of the asset, then it can be difficult to get out of the investment, which could be quite problematic if there comes a time when you need to access your wealth.
This is quite the contrast to investment in stocks and shares, because stocks and shares are relatively easier and quicker to sell compared to real estate.
If there aren’t many buyers around the table when you want to make the sale, you may end up selling it below market value. The worst case scenario is that you make a loss.
5. Credit Risk
What really drives value when it comes to real estate investment is the length and stability of the property’s income over time.
For example, if a large, big name brand business were to rent the available facilities for a decade or more, then this would attract a larger sum when you come to getting a return on your investment.
However, if the property is a commercial, one where small businesses come and go, or if it’s a residential property where the tenants can’t keep up with their rents and move out, then the property’s income stream is clearly less stable, and thus more volatile.
So, if you want a good, predictable income stream from your real estate investment, this is something you should really take into consideration.
6. Structural Risk
The structural risk of the property relates to the investment’s financial structure. (It has nothing to do with the building’s structure.)
When a real estate investment takes place, there are 3 parties, the equity investor, the sponsor, and the lender.
In the event of liquidation, repayment is based on rankings, and it is the equity holders who are last to receive the payout, as the senior secured loan will be the first to receive payment. Therefore, as the investor, you will carry the highest degree of financial risk.
If you invest in real estate as a joint venture, this too comes with structural risk. In this instance, it’s important to know how much of the equity is being invested by the limited partners versus the manager.
7. Replacement Cost Risk
Buildings may last a long time in many instances, but I can assure you that they don’t last forever.
If you invest in an old building, there are likely to be high maintenance costs, due to the amount of work that will have to be carried out in order to keep the property in good working order.
And if you don’t have the funds to carry out this additional work, then those who are renting the property from you could be tempted to go elsewhere, especially if there are better facilities in the location with comparable rent.
Worst case scenario, there may even come a time when the facility needs replacing altogether. And to prepare for such a risk, it would be prudent to look into replacement costs.
8. Debt Risk
Taking on debt is quite common in real estate investment. And it is not always an issue. But one thing you should perhaps be wary of is the possibility of over leveraging, which is when a property takes on more debt than it can service.
Normally, banks won’t lend out below a debt coverage service ratio of 1. However, if the property loses tenants, and the income generated does not cover the debt owed, then this is what is known as a debt maturity risk, and puts the investor at risk of default.
Real Estate Risks – Final Thoughts
So, before you part with your hard-earned money, you should be sure to ask questions about your real estate investment in relation to the 8 types of risk mentioned above.
If you’re going to take the plunge, you should do so with your eyes wide open, and be 100% clear on what you’re getting yourself into right from the start.
Frequently Asked Questions
What Is The Biggest Risk To A Real Estate Investment?
There are a number of different risks associated with real estate investment. From risks associated with the building itself, to risks associated with the money needed to purchase real estate as an investment.
As a real estate investor you will encounter all of these risks, but the biggest concern is usually the fluctuating economy. This risk factor is totally out of your control as a real estate investor, so it can have a huge impact on your investment.
Is There Risk In Investing In Real Estate?
Yes, there absolutely is risk associated with investing in real estate. But, there is risk associated with pretty much any type of investment.
Ultimately, successful investing requires you to look at the risks and the potential rewards, and then decide if the risk is worth it. Real estate investment is no different.
How Do You Minimize Real Estate Risk?
It is possible to minimize real estate risk, but it is impossible to remove it entirely. The best way to minimize the risk associated with real estate investment is to learn a lot about the field.
Build your knowledge about different types of real estate investment, about different areas where you could invest, and the type of real estate investment that is right for you.
Knowledge is power, so learning about real estate risk will help minimize the risks associated with this investment.
Paul Martinez is the founder of BendingDestiny.com. He is an expert in the areas of finance, real estate, and eCommerce.
Join him on BendingDestiny.com to learn how to improve your financial life and excel in these areas. Before starting this blog, Paul built from scratch and managed two multi-million dollar companies. One in the real estate sector and one in the eCommerce sector.