Real Estate Risk Management: The 4 Types of Investment Risks You Should Prepare For
You have to consider many risks when getting into real estate investing. Some of them you might already know, while some are less talked about in the industry—albeit still crucial in creating a long-term, profitable, successful real estate investment portfolio.
Here, we list the key types of risks that residential and commercial real estate investors have to consider, so proper strategies can be in place before the threats come along. The more familiar you are with these risks, the better you can actively prepare for the inevitable challenges ahead.
Risk #1: Physical Property Risk
All properties are prone to risks, whether that’s multimillion property or a tiny unit in a small apartment building. The main threat facing all of these homes is physical damage to the properties.
For example, the roof may start to leak, the paint job may start to flake, and cracks can appear in concerning areas on the ceiling. You can’t prevent these things completely; you can have management strategies to lessen the extent of your losses.
Here are the ways to handle physical property risks:
- Get insurance. Instead of using your money to repair damages, put that money towards insurance premiums instead. Once any property damage appears, the insurer should cater to the repairs, address any stolen items, and cover any other expenses required.
- Conduct inspections. Have a more preventive approach by identifying property damages in the early stages. Conduct regular inspections and even hire professional inspectors to look for any concerning problems, and deal with them before they leave long-lasting damages.
- Avoid high crime rates. The safer the neighborhood is, the fewer chances there are that the property may become a victim of vandalism, theft, or trespassing. Do your due diligence and invest in specific streets that have the lowest crime rates.
These strategies are the most effective ways to handle physical property risks. The good news is you don’t have to choose just one—you can have a combination of all these solutions for optimum protection.
Risk #2: Regulatory Risks
The legal landscape is dynamic, requiring you to stay updated with the new local, state, and federal laws that control the real estate market. If your current investments are all anchored on a specific type of legal framework, you might find your business model takes a big hit if the rules change for the worse.
For example, tax rules may change resulting in higher taxes. Since there are some rules that don’t allow you to transfer the cost to your tenants, you might end up with higher monthly expenses that eat into your cash flow and income stream if you’re not prepared.
The solution is to either avoid the risk entirely, control the risk to an extent, or transfer the risk to another entity. Our suggestion is to insure your property against legal changes, where your insurance company should offset any increase in your operational costs or any reduction in your rental income.
Here are a few tips:
- Diversify your real estate portfolio. You can diversify your investments via size, class, price, and location. Moreover, focus on areas that are showing positive growth and landlord-friendly regulations, so you lessen the risk of laws turning against you.
- Be involved in the community. Not only will being a good partner and asset to the local community be a good business practice, but it’s also a great way to stay on top of regulatory developments and allows you to get ahead of proposed changes and take appropriate action.
- Take your responsibility seriously. Treat every tenant with respect, understand that financial emergencies happen, and be more proactive with keeping your tenants satisfied. You’ll lessen the chances of tenants working against you, and have a smooth journey managing your investments.
Whatever solution you end up going with, ensure that you disclose it to all your partners, investors, clients, or tenants. The method must also be consistent and abide by state and federal laws, so see an attorney if you’re unsure how to create the loan documents, leases, and contracts.
Risk #3: Environmental Risk
We can’t control how mother earth works. Even though we’re all doing our role in lessening the negative effects of climate change, environmental factors like wind, tornadoes, floods, and hurricanes are still wreaking havoc across the nation, threatening your assets and income stream.
A mitigation strategy is essential, especially as these issues are inevitable. Here are a few tips:
- Stay away from extreme environmental changes. The easiest way to avoid environmental risk is by staying away from anywhere that is prone to natural disasters. For example, the New York metropolitan area experienced a devaluation of $6.7 billion due to flooding from sea-level rise. If you’re not prepared to handle floods, avoid investing in this area.
- Equip yourself with local climate knowledge. As part of your research, observe the current situation of the properties in the market you’re eyeing. See what maintenance works are usually done and what renovations have been conducted to handle environment-related issues. If you can do the same, you can probably be as successful as them.
- Have good property insurance. Global climate change will continue to drastically alter the landscape, so do yourself a favor and have property insurance that covers any environmental catastrophes. In the event that a disaster does come your way, at least you know that you won’t have to cover all of the repair costs.
Environmental risks will lead to higher capital expenditure, increased operational costs, and a decrease in your liquidity and value of properties and buildings. Therefore, we continue to suggest that you diversify your investments across multiple locations to have the widest range of risk transfer possible.
Risk #4: Real Estate Market Risk
Lastly, it’s just not possible for you to compartmentalize and ignore the ebb and flow of the real estate market. No matter how careful and picky you are with the market you invest in, there are inevitable market risks that require strategies to protect your profits and hard-earned assets.
Here are the important real estate market risks you should look out for:
General Market Risks
Every real estate market is tied to the economy, interest rates, inflation, and other similar trends. Since you can’t eliminate these risks, you can hedge your bets against them with a diversified portfolio and strategy based on the local market conditions.
These are the risks shared by every investment in the particular asset class. Some markets will have great demand for apartments, while some offer excellent returns for single-family homes. Commercial properties are less sensitive to consumer demand, but also have specific risks that residential homes aren’t affected by.
These are the risks that are only applicable to the property. For example, construction will limit the capacity for collecting rent immediately, and entitlement risk is the possibility that government agencies won’t issue the required approvals for project completion. These are the risks that are specific to your asset and its business plan.
Check the depth of the market and your potential exit strategy before buying, because you don’t want to get stuck with limited liquidity. The more difficult it is to get out of an investment, the higher the risk of having your money stuck in a property.
This refers to the length and stability of your property’s income stream, which directly drives its value. For example, a property leased to Google for 20 years will command a steeper price than a regular office building. You’ll want to invest in a property that investors are willing to pay big bucks for, as it behaves more like a bond with predictable income streams.
Replacement Cost Risk
Demand for space will drive lease rates higher for older properties until those lease rates justify new construction and increase supply risk. If a new property makes your investment property obsolete, you won’t be able to raise rents or have decent occupancy rates. You’ll have to know the property’s replacement cost to know if it’s economically feasible.
This risk relates to the investment’s financial structure and the rights it gives to participating individuals. For example, a senior secured loan will give you a structural advantage over subordinated debt, as senior debt is always the first to get paid—being #1 in the event of liquidation. Invest where you’re comfortable with your rights relative to your position.
The more debt there is on an investment, the riskier it is, and the more investors should demand. Leverage is a multiplier, which can hasten a project and increase returns if things are going well, but if the project’s loans are under stress, you may also lose quickly and a lot. It’s best that you don’t leverage more than 75%, and ensure that you receive a return commensurate with the risk.
The bottom line is to inquire about these risks and only accept straight answers so you’re more confident in your investment decisions. Stay away from any investment opportunities that aren’t too keen on indulging you with all the risks involved.
Prepare for the Inevitable, Prepare for the Opportunities
While we now have access to a myriad of information online, the real estate market is still extremely localized. In other words, events in one market won’t usually affect another market. Consequently, the best way to manage risks is by diversifying your portfolio and cherry-picking the markets that give you the least number of risks while being proactive in keeping them at bay.
Learn how to manage these risks and you can be confident in pursuing your investment goals—one wise and strategic investment at a time.
Our team has been operating as a property management company in Metro Detroit for more than two decades. Work with us to manage, mitigate, and navigate all the risks you’ll inevitably face in the lucrative yet confusing real estate landscape today.