Real Estate Investment Risk
No investment is completely risk-free, so be sure to familiarize yourself with the risks of investing in real estate and how to minimize them.
By Emily Southey | 10 minute read
If you’re interested in investing in real estate but nervous about the risks that come with it, you’re in the right place. Below, the experts at Wahi have put together a fool-proof guide to real estate investing risk that will help you understand what the most common risks are and how to avoid them.
What Are the Risks of Investing in Real Estate?
Let’s dive right in. The following is a list of some of the main risks.
The unpredictability of the real estate market
One of the main risks of real estate is that it is unpredictable. Therefore, when purchasing real estate, you have no guarantee that you will see a return on your investment. While the market could remain strong, raising the value of your property, there’s always a chance that an economic downturn will occur, thereby lowering the value of your property. The reason the real estate market is so unpredictable is that it is dependent on so many factors, from the economy and interest rates to government policies and even unforeseen events like global pandemics. That said, generally speaking, real estate values do tend to rise over time (even if slowly).
Choosing an undesirable location
Another risk of investing in real estate is choosing an undesirable location that makes it difficult to profit from your investment property. Location should always be a top consideration when buying real estate. Whether you’re buying a residential or commercial property, if the location is bad, you will likely have trouble finding a tenant and/or selling it for a profit down the line. Ultimately, location impacts the demand for properties and the potential for appreciation, which makes buying a property in an undesirable location another major risk of real estate investing.
“Every type of real estate property comes with risk. However, certain types of properties are known to be lower risk, such as long- and short-term rental properties and multi-family homes.”
Spending more than you make
Spending more than you make on your rental property results in a negative cash flow, which is yet another risk of investing in real estate. After all, one of the main purposes of investing in real estate is to generate some extra income. Negative cash flows occur when you spend more money on the expenses associated with the property (for example, mortgage payments, taxes, and insurance) than you are earning from it (in the form of rent from tenants). Some of the common reasons behind negative cash flows include charging too little for rent, maintenance costs that are too high, high vacancy rates, or high financing costs on a mortgage or hard money loan. Though spending more than you make is certainly a risk that comes with real estate investing, it is one that can be avoided with proper planning and budgeting.
High vacancy rate
No matter what type of property you invest in, if you hope to rent it out, then you run the risk of high vacancy rates. Since renting out a property is the main way of generating income in real estate investing, high vacancies in your area can spell trouble. They are especially risky if you count on rental income to pay property expenses like taxes, insurance, and maintenance.
Issues with tenants
Even if you avoid the risk of high vacancies and manage to find tenants, there is always a risk that the tenants will cause problems. A bad tenant can end up having serious financial consequences to your investment, not to mention the stress they can cause. Examples of common issues with tenants may include refusing to pay rent on time or not paying at all, hosting extra people or animals on the property, ignoring tenant responsibilities, and waiting too long to report maintenance issues or not reporting them at all, leading to more expensive repairs. For this reason, vetting all prospective tenants is crucial before leases are signed.
Lack of liquidity
One last risk of investing in real estate is the lack of liquidity. Unlike stocks or bonds that can be cashed out in a matter of minutes, real estate is far from a liquid investment. Because of the lack of liquidity, there is always a risk that investors will end up selling below market or at a loss if they need to gain access to cash quickly.
Mistakes to Avoid When Investing in Real Estate
While the risks of investing in real estate might seem overwhelming, there are ways to mitigate them. The first step is understanding what the most common real estate investing mistakes are and how to avoid them, which we outline below.
1. Not making a plan
A common mistake among real estate investors is jumping in without a plan. Before buying a property or even starting the property-hunting process, it’s important to make a plan. Consider the basics of real estate investing, such as what type of property you want to invest in and how you plan to generate income from it. Beyond that, you will need to consider your budget, ideal location, and the role you want to have in managing the property. If financing is needed, you should also research your options and get pre-approved for a mortgage.
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2. Barely doing any research
Doing your research is as important as making a plan. Before buying anything new, including real estate, ample research is required. Take the time to research qualified realtors near you, the best location for a rental property (which includes researching factors like vacancy rates, crime rates, average housing prices, amenities, and more), and the associated expenses, such as property taxes, permits, and insurance costs.
3. Failing to research the local market
Real estate markets are local, and they change rapidly. Another mistake investors make is forgetting this and assuming that one city’s housing market is the same as another’s. The reality is that the housing market within a city varies, with different neighbourhoods having their own micro housing markets. Therefore, being specific with your market research is key.
4. Not obtaining the necessary financing
Obtaining financing for an investment property can be difficult, but in many cases, it’s necessary if you want to be successful. While you might be able to get some financing, you should never purchase a property unless you have enough financing to do so. Otherwise, you could be stuck with a long-term mortgage you can’t pay off, which could significantly eat into your profits.
5. Overpaying for the property
The last mistake investors make in real estate is overpaying for a property. This usually goes back to mistake #2, not doing enough research. Overbidding on a property can have major short- and long-term consequences. Working with a realtor can help ensure you do not overpay for a property. They will do a comparative market analysis that determines the prices of comparable homes in the area, helping you identify whether a home is fairly priced or not.
Tips on How to Reduce the Risk Management in Real Estate Investment
Now that you understand the most common risks of real estate investing, as well as the top mistakes to avoid, we are going to provide some tips on how to reduce risk management in real estate.
- Look for properties with below-market rents: The best-case scenario is to find a rental property where a significant percentage of rents are below the going rate. This way, you are almost guaranteed to make money on your investment, even just by raising rents to the market standard.
- Find affordable financing: If you need to obtain a loan to fund your investment property purchase, look for one with the lowest possible interest rate. A lower interest rate can instantly increase cash flow and reduce risk.
- Make a higher down payment: If finding a financing option with favourable conditions proves tough, consider increasing your down payment. High debt often backfires, and although a larger down payment can reduce your initial return on investment (ROI), it might be the best option in the short term (you can always try to refinance later).
- Look for properties that do not need many renovations: Unless you are looking to enter the world of house flipping, choosing properties with minimal repairs is usually the most cost-effective option. Before buying a property, make sure to pay for a thorough house inspection so you know exactly what you’re getting yourself into. If a house inspection reveals major damage, such as roof or structural repairs, it’s best to move on.
- Diversify your portfolio: One final tip for reducing real estate investment risk is to diversify your portfolio by investing in other assets. One of the best ways to protect your entire financial portfolio is to make multiple investments. For example, in addition to buying a rental property, you might also invest in stocks, bonds, or mutual funds. The greater diversity in your portfolio, the better odds you have of surviving economic downturns.
- Don’t skimp on property insurance: Property insurance is a must, especially for real estate investors. The right insurance policy can protect your investment against all kinds of risks, from fire and water damage to theft, vandalism, earthquakes, and more. Work with an insurance company or broker to determine the right coverages, limits, and deductibles for your rental property.
Frequently Asked Questions
How to identify the right property to invest in?
Learning how to identify the right property to invest in is an important skill that you will need to acquire if you want to be a successful real estate investor. To help you learn this skill, we’ve put together a list of factors that can help you identify a worthwhile piece of real estate.
Income potential: When considering a property, calculate the current rental revenue and think about if there are any obvious ways to boost it. You should also look up average rents for the neighbourhood to determine whether the current rent price is below or above average.
Location: Location matters, so spend ample time scrutinizing the location. Do not assume that properties in the same area will have the same rent, and consider all kinds of location-related factors like nearby schools, parks, retail spaces, and crime rate.
Property expenses: The expenses associated with a property are another factor that can help you identify a good property. Consider what the ongoing expenses for the property would be, as well as how much insurance and basic utilities like heat and electricity cost. This can help you determine how much profit you could earn by investing in a given property.
Repairs: Make a note of any repairs that need to be made, both major and minor. Depending on the number and extent of the repairs, they could significantly affect your profit margin. To identify if a property is worth investing in, you must be aware of all necessary repairs upfront.
Is there a zero- or no-risk property type in real estate investment?
No, every type of real estate property comes with risk. However, certain types of properties are known to be lower risk, such as long- and short-term rental properties and multi-family homes.
What is a physical asset risk?
Physical asset risk is the risk of loss or damage associated with a physical asset, such as a piece of real estate.
Are there risks with leased or vacant properties?
Leased and vacant properties come with several risks, including but not limited to theft and vandalism, squatters, tenants who refuse to pay rent or pay rent later, and physical damage caused by fires, water, and more.
What is cap rate risk and how should I avoid it?
Cap rate risk is a measure of the perceived risk of the income stream that comes with a property. The higher the cap rate, the higher the perceived risk. To reduce your cap rate, and your risk, investors should aim to purchase properties below market value and sell them above market value (such as by renovating for house flipping).
Can I avoid risk if I work with a real estate investment partnership?
It is impossible to completely avoid risk in real estate. However, working with a partner can help mitigate risk. If you choose to enter into a real estate investment partnership, make sure to discuss the partnership structure to ensure both parties are on the same page.