Sep 12, 2023

How to Determine the Risks in Real Estate Investments

Jacob Blackett
How to Determine the Risks in Real Estate Investments

Real estate is an investment class that has stood the test of time. Through wars, economic crashes, and global crises, real estate has proven to be resilient and reliable. Like any investment, there are risks when it comes to real estate. Every real estate syndicator must understand the real estate risks associated with their real estate investments in order to account for them and protect themselves and their investors. If you're looking to raise real estate capital, you need to understand these real estate risks.

The Market

Every real estate market experiences fluctuations as it moves through its economic cycle. Booms and busts are inevitable. Real estate markets are impacted by the economy, inflation, and interest rates.

If you want to mitigate the risk of a potential economic downturn, it’s important to understand the market you are investing in.

  • What major employers are there?
  • What is the unemployment rate?
  • What economic anchors are there (universities, colleges, etc.)?
  • What is the population growth rate?

Knowing the answers to questions like these will give you an idea of the economic health of the market. A hospital or a prominent college are two anchors that provide jobs and bring people to a given area. They are also resilient during economic downturns. Understanding the market you are investing in is a critical part of determining the risk in a real estate investment.

The Operator

The team in charge of your real estate deals plays a major role in its success. Experienced real estate investors know how to oversee a property management company’s performance, how to negotiate with lenders, and what to do in case of a market crash.

For many investors who don’t have the experience or track record, finding a team that does is essential. Asset management, project management, and real estate investor relations can all be challenging, especially for someone who lacks prior experience in these roles. Not everyone wants to raise investment capital, and not everyone needs to manage real estate projects.

If you’re a syndicator looking to mitigate the risks associated with an operating team, make sure to find business partners who have experience and credibility in areas you don’t. If you have a construction background, and project management, but have never operated a real estate property before, it’s a good idea to find someone who does. You could either offer a business partner equity in the deal or bring them on as an employee at the property.

Either way, identifying your own weaknesses and leveraging the strengths of others is a great way to mitigate risk in a real estate investment.

Government Policy

Government policies are a risk factor you need to be aware of as a real estate syndicator. State and local governments may pass legislation that impacts real estate in more ways than one.

If your real estate deal is Section 8 Housing, that means the government will be covering part of the rental income through subsidies. If Section 8 housing legislation changes, this could impact your cash flow.

Whether or not a state is landlord friendly is also a factor to take into account as a real estate syndicator. If your property is in a state where the tenant is favored, it can be more challenging for you to evict a non-performing tenant.

Many investors avoid states that use rent control. If a state uses rent control, then your ability to force appreciation of a property through higher rental premiums will be limited. The government could also change property taxes, which would impact your cash flow.

These are all factors involving policy and legislation that can create additional risks for a real estate syndicator. Understanding what these are in a given market or for a particular property can help you navigate or avoid them.

The Asset Class

The real estate asset class you invest in can also determine how much risk you’re facing as a real estate investor. Commercial properties like malls aren’t as essential as housing and heavily rely on consumer demand. Hotels rely on work travel and tourism. Therefore, they both are riskier investments than apartments, for example.

The way to mitigate risk associated with the real estate class you invest in is to make sure there is enough demand for the property in a given area. Investing in a property that offers an essential service is a great way to mitigate risk. Housing is something people will always need, and that's why many investors prefer to invest in multifamily real estate.

The Leverage

The amount of leverage you have on your real estate deals also determines how much risk is involved. The more leverage you have, the more risk. The more leverage you have, the more capital you can use to speed up a project and generate returns for yourself and your investors.

However, being “over-leveraged” on your real estate deals is dangerous, because if your returns aren’t enough to cover your interest payments, you can find yourself in a tough position. There isn’t an exact percentage of leverage that is considered safe. Some commercial real estate investors are comfortable with 70%, while other investors use less or more.

At the end of the day, it’s up to you as a real estate investor to make sure you don’t end up in an over-leveraged investment.

Many savvy real estate investors also emphasize the importance of having cash reserves on hand. In case an economic downturn occurs during the hold period of your asset, cash reserves will help you cover operational expenses if revenue decreases significantly. Think of this as saving for a rainy day.

The Property

The property itself is also a potential source of risk for real estate investors. The current condition of the property will determine how much capital and time is needed to make it align with the desired rental rates the real estate investor would like to be at.

Other investors might assume a property is in better condition than it is in, you may end up spending hundreds or even thousands of dollars over your estimated budget. This can eat into your profits and eliminate returns.

To mitigate this risk, make sure you conduct thorough due diligence. Make the time and financial investment to review financials, rent rolls, inspect the units at the property, and more.

It’s essential to have an in-depth understanding of where the property currently stands. This way, you can anticipate the work it will take to get it to where you need it to be to meet your desired returns.

The Investment Strategy

The investment strategy you plan to use during your business plan can also add to the risk you’ll face. Value-add investing involves forcing the appreciation of a particular property by improving the condition, increasing rent, decreasing operational costs, and/or improving operational efficiency. Value-add investing gives the investor more control over the value of the property, and therefore, allows them to have more control over the risk they face.

Real estate investors who find distressed properties that need major renovations are bearing more risk. These heavy lift projects require more capital, time, and resources. Therefore, there is more opportunity for the investor to both lose and make money. By taking a distressed property and drastically improving its condition, the return on investment is greater than if the property only needed moderate renovations.

Another strategy, known as turnkey investing, involves buying a property that requires little to no renovations. It is bought for cash flow because there isn’t much room to force appreciation. Although it yields fewer returns than the other two investment strategies, it also typically involves the least amount of risk.

Experienced investors make an effort to grasp the risks associated with the investment strategy of their choosing. To mitigate your risk in a real estate investment, make sure you have an in-depth understanding of the investing strategy you intend to use. There are no right or wrong strategies. What matters is that real estate investors understand the pros and cons of the one they choose.

Educate yourself and perform proper due diligence

The first step in mitigating risk in real estate is education. Reading this article was a great start! Now, it’s time to do your own research, and make sure you understand these factors as they relate to your specific real estate investment.

There’s no need to be afraid of risk. You simply need to understand what the risks are so you know how to manage them. This will not only protect your track record, but it will also help you sophisticated and accredited investors who you raised capital from.

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