All investments have risk! Even a CD at your bank carries risk as inflation could erode returns, and if inflation surpasses your interest rate, you will be losing buying power. Understanding risks in investing is essential to making smart investment decisions. The real estate game carries some unique risks that could bite you but are manageable once you are aware of them. Here are seven risks in real estate to understand to keep your money safe!
1. Let’s Start WIth General Market Risk
Market risk in real estate can mean a few different things. Obviously, there is market risk with what your investment is worth. Back in 2008, when the financial world was falling apart, housing values were tumbling. Investors quickly became underwater, meaning they owed more than the house would sell for, making it next to impossible to protect themselves. If you combine that with a higher monthly payment than you can get in rent, you would be staring directly into the storm. Speaking of rent, that is the second piece to market risk. If you are holding real estate as an investment, you are likely leasing it out to produce income. Rental rates and vacancy numbers go up and down. Knowing that you may be forced to lower rents is essential when analyzing your potential downside.
Interest Rate Risk
Interest rate risk occurs when rates move up or down. If you have a fixed-rate loan, you shift that risk to the lender. However, if you have an adjustable-rate loan, you can be at risk of rising interest rates. In that environment, your payments could go up, reducing or eliminating cash flow.
Manage It Through Portfolio Diversification
There are several ways to manage market risk. Getting fixed-rate loans and buying for cash flow instead of speculating on appreciation are great starts. It is also a great idea to diversify in different product types and different locations. I am not a huge fan of investing all over the county, but different neighborhoods within a city can create enough diversification to reduce risk. I also like the idea of owning some single-family homes, some condos or townhomes, and some multi-unit properties. I would say it could further diversify into commercial real estate, but I say that with some caution. Sometimes buying assets you don’t understand creates more risk than the benefit of diversifying.
2. Liquidity Risk
The risk of the lack of liquidity is the number one reason businesses of any kind go out of business. This risk is especially true for real estate investors. Real estate, for the most part, is not a liquid asset. Meaning it is not easily converted to cash.
Learn The Market And Choose Wisely
About ten years ago, I was buying property in Memphis. I would pay somewhere between $25,000 and $30,000 for 3-bedroom, 2-bathroom houses that would rent for about $600 per month. Because I saw such a great return on my money, I kept buying until eventually, I bought the wrong house. The house was on Ford St and went vacant shortly after I purchased it. The property management company could not rent it out, even after dropping the rent. The problem was the location. Gang members were living next door, and apparently, they did not need a job because they were often out on the front porch drinking from a bottle in a brown paper bag during showings. I later learned that this specific neighborhood was in an extremely tough part of town, and the city had condemned and even demolished houses in the area. The area was so bad that property owners could not give homes away. No one wanted them.
I was the lucky one (if you can call it that) because I was able to sell my property for $14,000. After commissions and fees, my loss was over $20,000. I learned the hard way there is a lot more to picking a property than the rent you think you can get. Even at higher price points, properties in good areas are more liquid because they are easier to sell. Pick a market that has appeal, and you can limit your liquidity risk.
3. Risk At The Asset Level
Not every property is considered equal. Some assets perform better than others, and some need a specific type of management. An example of this is temporary housing. I know of some real estate investors that decided to convert some of their rentals into halfway homes. They did this because they can rent the house out by the room and get significantly more cash flow. The problem is the asset’s best use was not a halfway home. They started getting complaints from neighbors and had high turnover. They quickly learned that short-term rentals are a lot of work. It is more of a business and less an investment, so they converted the homes back after their failed experiment.
Know Your Asset Better
One of the biggest mistakes I made in my career was buying an extended stay hotel and thinking I would convert it to an apartment building. Many of the rooms had full kitchens and the ones that didn’t were easily converted. Unfortunately, I did not understand that the city would not allow me to convert the building to an apartment, so I was stuck running a hotel in Missouri from my office in Colorado. The property manager I hired stole cash, vacancies were through the roof, and the hotels’ taxes far exceeded my pro forma as an apartment. I had no idea what I was doing. I ended up selling to someone local that could keep a closer eye on it. The last I heard, he was making money, but I lost six figures.
4. High-Vacancy Risk: Not Many Tenants
As mentioned above, vacancies can kill your real estate investment. My mistake was believing the property management company. Since I planned to change the building’s use, I could not rely on the seller’s past performance. I had to rely on the management company’s experience, but, in this case, they fudged the numbers to ensure I purchased the building. I estimated a 10% vacancy, and it ended up over 30%. Yikes!
Search For High-Demand Property
Some of the most successful investors I have had the pleasure of working with a focus on high-demand areas. There seems to be a lot more predictability, and because of the high demand, you can keep your rents high and vacancies low, even in a slower market.
5. The Idiosyncratic Risk
Whenever you are heavily focused on an asset class or, in real estate, a specific area, you are taking on idiosyncratic risk. This risk means that you are exposed to outside risks that impact a particular investment. For example, if you were heavily invested in San Francisco, you were likely more affected by COVID and the fires. Idiosyncratic risk is reduced through diversification.
Idiosyncratic Vs. Systemic Risks
The opposite of idiosyncratic risk is systemic risk. Systemic risk is an outside influence that impacts many assets. In real estate, the credit crash affected everyone. Interest rates are another great example.
Know Your Way Around Market Factors
Each location you decide to invest in will have some unique market risks. Hurricanes in Florida or earthquakes in Tennessee are great examples. These risks could be harder to identify, though. Some markets, like Detroit, are heavily reliant on a specific industry to create jobs. If that industry takes a hit, the housing market in that area is impacted. The best way to overcome these risks is to read business news to get an idea of the job market and anything relevant in politics. You will also want to join real estate investment associations where you want to invest if you can. They often will update their members about the market climate, and you will get to know other investors in the area that you can lean on for information.
6. Structural Risk
No investment is immune to structural risk. Structural risk is the same as systemic risk. These are outside market risks that will impact an entire industry. An eviction moratorium (like was had with COVID) is a structural risk in real estate investing because it affected all landlords. Most other types of risks you can control or minimize, but this one is much trickier!
Analyze The Structure You’re In
You will have structural risk with any investment. However, most real estate investors believe that structural risk has much less influence on real estate. I tend to agree. A single tweet will not create a massive valuation swing with real estate investments like it can in the stock market.
The best way to minimize your risk here is to set yourself up to get through it. Most importantly, buy good assets that will rent and have plenty of money in liquidity to ride out a storm. The only time you will really lose money in real estate is if you are forced to sell. If you have reserves in the bank, you will not be forced to sell.
7. Over-Leverage Risk
Over-leverage might single-handedly be the fastest way to bankruptcy. The good news is you have 100% control over it. In 2008 many investors had too much leverage on their real estate investments. They had more than a safe amount of debt against the property. A safe level is different for everyone, but a general rule would be never to have more debt against a property than can be paid off by selling the house fast. If you had to drop the price below its market value, can you sell it and pay off the loan? If not, you might be over-leveraged.
Use Leverage Sparingly
A general rule for investment real estate is to stay at 75% leverage or less. So if your rental home is worth $100,000, you should not borrow more than $75,000. This 25% equity should be enough equity to exit the property quickly if needed. In 2008, many investors were 95% to 100% leveraged. Even if they sold that house at full price, it would not have paid off the loan because of commissions and closing fees. As a result, they defaulted, and banks were forced to foreclose.
Real Estate Investment Success Relies Upon Being Able to Assess Risks
Although real estate is a fantastic investment that carries less risk than many alternatives, it is in no way free of risk. Go in with your eyes wide open and get advice on analyzing a project from other investors you trust. We are also here to bounce ideas off of if you get hung up on something. Working together helps us all stay safer.