Real estate investing is something that’s popular for a reason. Owning investment property can serve as a hedge against inflation and help with portfolio diversification. The benefits are real, but there are some risks involved as well. Understanding them is essential as you build your portfolio and set long-term financial goals.
Our Addition Financial members often talk to us about their investments as a way of understanding and managing their risk tolerance. With that in mind, here are eight real estate investing risks that you should be aware of before you add real estate to your portfolio.
Is investing in real estate safe?
One of the questions we are asked most frequently is whether it is safe to invest in real estate. The answer is not as simple as yes or no because there are many factors that can impact your risk.
That said, real estate is in many ways a less risky investment than some other options you might choose. Depending on which stocks you buy, for example, your risk in buying them might be significantly higher than what it would be if you invested in real estate instead.
As we mentioned above, you’ll need to understand your risk tolerance and keep it in mind as you build your portfolio. Some people are comfortable with playing the odds and buying high-risk investments while others may prefer slow and steady growth. As a rule, younger people can afford to take more risks with their money than people who are close to retirement age.
Real estate investments may fit into either category depending on how you choose to add them to your investment portfolio. You may want to balance low risk options with higher risk investments to even out your overall risk.
8 types of risk in real estate
To help you decide whether (and how) to invest in real estate, here are eight types of risk that you should be aware of as you evaluate your options.
#1: General market risk
The first risk is one you’re probably already aware of if you own a home or have been shopping for one. The real estate market itself can be quite volatile and that volatility can present a risk in the event you want to sell a property you own.
Everything from interest rates to housing supply and demand to the state of the economy can impact housing prices. You’ll need to keep in mind that while the overall trend of housing prices is up, downturns and recessions can still impact market conditions and your investment in it.
#2: Illiquidity
Liquidity can be important with any investment. If you want to be prepared if you need a quick infusion of cash, you’ll need to make sure that you have some investments that can be liquidated quickly to provide it. Real estate is not the best choice if liquidity is your goal.
Even in a seller’s market, it can take time to get a property ready to sell, find a buyer and close on the deal. There are real estate investment options that offer more liquidity than buying property outright, including REITs. That’s something we’ll talk more about in the next section.
#3: Structural risk
You might think that a structural risk in real estate involves the structure of a building, but in this case we’re talking about the financial structure of the investment. There are many options that will allow you to obtain the funds you need to buy property and some are riskier than others.
An example would be if you took out a secured bank loan to buy and renovate a property. If your estimates of the property’s after-repair value (ARV) is too high, then you could end up in a situation where your returns are lower than expected because the bank is in a senior position and must be repaid first. Make sure that you always read the fine print to understand how a deal is structured.
#4: Asset level risk
There are many asset classes within real estate and some carry more risk than others. Choosing a high risk real estate asset to buy will put you at risk of losing money. Focusing on assets that are always in demand will put you at less risk than buying those whose demand may be variable.
An example of a high-risk real estate investment would be a seasonal property such as a hotel or motel. In many locations, demand will depend upon the weather and other factors that are beyond your control, whereas something like a multi-family residence would always be in demand.
#5: Negative cash flow
If you plan to buy property to rent out, you should be aware that there’s a risk of negative cash flow that can impact you financially. You’ll have mortgage payments to make and if you can’t make them, you’ll be at risk of losing your investment to foreclosure.
For example, you might have vacancies that translate to insufficient cash flow to make your mortgage payments and pay your property management company. The result might be a need to dip into your savings or, as mentioned above, default on your loan.
#6: Location risk
Whenever you purchase real property, its location should be a consideration. For example, with residential properties two of the biggest concerns are the crime rate and the quality of the area’s schools. Families are likely to consider both before making an offer.
You might find a low-priced property that you think you can renovate and rent but if it’s in an area that’s not desirable to renters, you may find yourself with vacancies or you might be forced to charge rent that’s too low to meet your expenses.
#7: Tenant risk
Your rental properties need tenants to earn a return on your investment and there’s more than one way that your tenants could put you at risk. For example, a lack of tenants could result in negative cash flow that can impact your investment.
There’s also a risk that a tenant could end up being disruptive, unreliable or even destructive of your property. Any repairs you need to make will impact your profits and if a really serious problem arises, you might also end up with legal fees.
#8: Higher than expected costs
If you plan to use the Fix and Flip, Buy and Hold or BRRRR methods of real estate investing, all of which involve buying properties in need of repair and rehabilitating them, then one potential risk is that the cost of renovation may be higher than you expected.
Even with a good inspector helping you out, there’s still a chance that you could run into hidden problems that didn’t come out during the inspection. When that’s the case, you’ll be on the hook for higher-than-anticipated expenses that can cut into your profits and impede your cash flow.
Low-risk real estate investments to consider
Now that you understand some of the most common real estate investment risks, here are a few real estate investment options that carry low or manageable risk with them:
- REITs. A Real Estate Investment Trust, or REIT, represents an easy way to get involved in real estate investing. The trust either buys or finances property and you can buy shares in it. By law, REITs must pay out 90% of their profits as dividends, so they’re a good source of passive income. They also have the advantage of being far easier to liquidate than real property.
- REIGs. A Real Estate Investment Group or REIG carries slightly more risk than an REIT but is still a low risk option if you want to get your feet wet in real estate investing. The most important thing is to research the group to make sure that it’s well managed and that you’ll have a say in how your money is being used.
- Buy and Hold Rental Properties. A buy and hold strategy can be a low risk option if you choose your properties wisely. Apartment buildings and other multi-family homes are always in high demand. Make sure to buy properties in good locations and conduct background checks on your tenants to minimize your risk.
- House Hacking. House hacking is one of the lowest risk ways to get started as a real estate investor. All you need to do is buy a house to live in with a mortgage you can afford, and rent part of it to a tenant. The rental money should be used to make extra mortgage payments and build equity quickly. You can then use your equity to make a down payment on your next property.
Some high-risk real estate investments include seasonal properties and properties in need of extensive renovations, particularly if they’re in less-than-desirable locations. None of this means you can’t pursue some risky investments, but we do recommend balancing them with low-risk investments to manage your risk.
Get help with real estate investing
Investing in real estate can be a good way to diversify your investment portfolio and earn income. Understanding the 8 potential risks we’ve outlined here will help you balance your portfolio with an acceptable level of risk.
Do you need a hand with real estate investing? Addition Financial is here to help! Click here to learn about our MEMBERS Financial Services program and schedule an appointment with a Financial Professional today.
Posted on Jul 31, 2023
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