There is no such thing as a “risk-free” real estate investment. With any return, there is risk.
Successful real estate investors typically know and understand two essential things:
- The financial objective or why they are investing in real estate, .i.e., is it for future cash flow, preserve equity, generate growth, etc.
- The risks associated with achieving their objective and how best to mitigate those risks.
There are five potential risk categories to mitigate when investing in real estate:
- Financing Risk
The loan type and structure of the financing can pose a risk depending on the financial objective. We cannot control interest rates, but we can control how we structure the debt. Also, the more financial leverage on a property, the more risk.
For example, if our objective is to hold the property for a long time, we want to reduce interest rate risk by fixing the rate in proportion to how long we anticipate owning the property. If our goal is to generate more cash flow, we will reduce the debt structure with a lower LTV ratio. If our financial objective is to shelter our personal assets, we can limit this risk by getting non-recourse debt.
- Market Risk
The economy and market conditions will always ebb and flow. We can’t eliminate market surprises, but we can anticipate and hedge our risk with different asset classes and locations.
For example, if our financial objective is to preserve equity, we would consider the different market conditions that could occur with a strategy of diversifying our portfolio in various property types and geographical locations to limit market risk.
- Liquidity Risk
The supply and demand for real estate fluctuate, causing liquidity risk. It’s all a matter of timing. You may or may not be able to sell a property and liquidate your investment quickly. Usually, immediate liquidity comes at a cost.
For example, if our financial objective is to easily access the equity in the real estate either through refinancing or selling the property, we would reduce the liquidity risk by structuring a loan with no prepayment penalty and invest in an asset class like entry-level single-family homes in a robust market where they can be sold quickly.
- Physical & Geographical Risk
There are entitlement and construction risks when developing real estate. They include the uncertainty of government approval for permits, the risk of completing a construction project on budget, and the loss of income throughout the construction period.
For example, if our financial objective is to invest in properties that require little maintenance with no near-term additional investment, the age, condition, and replacement cost of the improvements are essential factors to consider.
Location is another risk factor. For example, an investment in a property with a strategic location, limited supply, and strong demand can significantly improve the property value and return on investment.
- Specific Property Type Risk
Certain asset classes and tenants are better than others in generating income and providing security.
For example, if our financial objective were to have consistent, reliable cash flow from a property, we would invest in properties where the tenants are financially stable and the property type is not a special-purpose building. A credit tenant like Amazon offers less risk than a mom-and-pop retail business. And entry-level residential housing has less risk than a special-purpose building like an indoor ice rink where the use is limited and unique.
Real estate is an excellent investment and a hedge against inflation. However, it comes with risks that need to be considered based on an investor’s expertise, tolerance for risk, and overall financial objective.
Are you mitigating the right risks according to your financial objective? and if so how?