It is said that with great risk comes great reward. All sorts of investments come with some degree of risk. And to ensure the highest success, all investors need to realize the risk versus the return rate, and so is investing in real estate.
If you are thinking about investing in real estate, do not be allured by a building's magnificent structure or great projected returns. Whether you are a new investor or an experienced buyer, here is a list of the eight basic risks you need to consider before you commit your hard-earned money on real estate. Let's dive in!
When buying property, location needs to be your primary consideration. Is the area urban or suburban? What is the crime rate in the area?
Location also influences the factors that affect the return of your investments- demand of properties available for lease, rental rates, tenant pool, etc. Moreover, what if you invest in a property situated in an area under jurisdiction? It will definitely affect your chances of gaining a profit. Therefore, you need to be an astute investor.
Many people take huge amounts of debt for real estate investments that amplify their investment risk. Interest rates are always uncertain and can accelerate financing expenses, which is bad news for any investor. It can affect both residential and commercial property investors.
High financing expenses on loans can also cause negative cash flows, which is another real estate investment risk. Cash flows refer to the fund that is left after settling all mortgage payments, insurance, taxes, and expenses. Negative cash flows mean the money you are spending is more than the money you are making. In other words, you are losing money. Some other causes of negative cash flows are expensive maintenance, high vacancy rates, not following a good rental strategy, not demanding sufficient rent, etc.
To minimize the risk of negative cash flow, take enough time to calculate your expected expenses and income, do sufficient homework before purchasing your property, and ensure that it is in a satisfactory area.
High financing expenses on loans can also lead to foreclosure. This occurs when someone becomes incapable of paying their mortgage. But this can also be dealt with. Now the question is, when is it too late to stop foreclosure? There are steps you need to take before the sale in order to stop the foreclosure process at the last minute.
Like all other markets, the real estate market has ups and downs. Demand and supply, government policies, interest rates, demographics, the economy, inflation, and unanticipated incidents, all influence the real estate trades, including rental rates and prices.
Therefore, the real estate market can also be called unpredictable, and the value of your investment can depreciate. To lower this risk, conduct thorough research and regularly monitor your real estate possessions.
Capitalization rate or cap rate is an important benchmark to assess your decision to invest in real estate. With the help of the cap rate, the probable return rate of an investment can be calculated. A small shift in cap rate has a great effect on the value of the property as well as the profitability. Therefore, cap rate can be a substantial risk to your property's selling price.
To reduce the cap rate risk, make sure to observe the entry or going-in cap rate at the time of purchasing your property and the projected exit or terminal cap rate at the end of the holding period, and make sure that both rates are in proportion to the ongoing market. Also, the projections should not show a disproportionate reduction from entry to terminal cap rate without absolute justification. At times, this may be too contentious to project greater returns.
Whether your property is an office building or flats suitable for single families, to produce rental income, you must lease out all the units at a certain rental rate within a certain period. Sadly, the risk of high vacancy rates is common in real estate property. Therefore, many units remain empty for a long period.
High vacancy rates are particularly risky when someone depends on their rental income to pay the mortgage, maintenance, taxes, insurance, and other expenses.
The first and foremost way to avoid this risk is to invest in a property in a good area. Keeping the rental rates inside the standard range for the location, searching for new renters immediately after the recent one gives notice for moving out, and offering rewards and incentives to keep the renters happy are other ways to mitigate the high vacancy risk.
Also, do not forget to keep your property well-maintained, clean, and tidy. Another good method to mitigate leasing risk is to promote, market, and advertise your property, in both traditional and online, keeping in mind where your targeted tenants may search for property information.
You wish to fill all your property units with tenants to prevent vacancy risk. But this can give rise to another risk- the tenant risk. Having no renter at all is better than having a bad one as they can cause more financial drain sometimes. Not paying on time, trashing the property, hosting additional roommates (animals or humans), not reporting maintenance problems till it is too late, ignoring the tenant's responsibilities, breaching the lease term- all these are the features of a bad tenant.
It may not be possible to mitigate the tenant risk completely, but you can minimize it by carrying out a thorough renter screening process. Make sure to check each applicant's credit and criminal background, and if possible, reach the previous landlords of the applicants to find any red flags, such as property damage, late payments, and evictions.
It is also recommended to look into the work history of your potential tenant. Make certain that they have enough salary to reasonably cover living expenses and rent. It is also smart to find out if they have a scattered work history. Someone who changes jobs too often may have difficulty with rental payments and may even need to relocate before the termination of the lease term.
Also, investment properties with several tenants engaging a small percentage of the entire property is safer than properties with only one tenant. When there is only one tenant, the tenancy rate is either 0% or 100%. This can get down to uncertain income flow when the occupant leaves. Therefore, diversifying tenants is another good way to mitigate tenant issues. This way, the departure or evacuation of one tenant won’t significantly affect your profitability.
Asset risk means your property will induce unforeseen expenses because of its structural condition. This is particularly seen in poorly maintained or older properties. Such properties may need expensive repairs or upgrades, remediation for asbestos or mold, and cost thousands of dollars, affecting the profitability of the investment.
You can minimize this risk by finding out if your desired property maintains all the recent building regulations or codes, assess its environmental condition, structural stability, and the condition of its electrical and mechanical equipment, for example, air conditions, lifts, etc.
If necessary, hire a reputable and qualified property inspector, pest control technician, and mold inspector. If any problem is located, deduce the amount of money it will take to repair, then work that amount into the deal, or if you feel this would impact your profitability, walk away.
Development risk is associated with properties that require marked development or redevelopment. This can be either entitlement risk or construction risk.
Entitlement risk arises when you obtain a property with a certain purpose, but because of the jurisdiction over the property, you can not proceed with the project. This risk is true for new projects where construction approval needs to be acquired by an additional entitlement process. And this approval is required before you commence the project. Sometimes it takes a long time before the approval is permitted, pushing back the construction timeline. This can significantly affect the profitability of your investment.
Construction risk occurs when a project can not be finished within the anticipated period, which leads to higher construction expenses. Therefore, if there is a development aspect in your real estate investment, make sure that your sponsor is sufficiently experienced in managing construction projects.
The Bottom Line
Real estate investments have always been considered good investments, and an astute investor can enjoy excellent returns, diversification, advantages in interest rates, passive incomes, and the chance of building wealth. But just like other investments, investing in real estate can also be risky. We can minimize these risks, but it may not be possible to mitigate them completely.