Real Estate Investing Risks You Need to Watch Out For
Manage Risk. If you don’t read any further, just remember those two words throughout your investing endeavors, and you’ll have a leg up on negative outcomes.
Real estate investors are first and foremost investors. As an investor, regardless of asset class, if you only do one thing well it should be managing risk. The reason many investors discuss risk-adjusted returns, or segment real estate return targets (e.g., cash-on-cash, IRR, equity multiple, etc.) by category (e.g. class A or class B, this market or that market, etc.) is that there are certain elements of an investment opportunity that increase or decrease perceived risk. A prudent investor will adjust their required returns to account for the likelihood of a permanent loss or expected gain of capital. Return consists of two parts:
Return of investment: full recovery of the capital invested.
Return on investment: distributed capital in excess of return of investment.
As you may conclude, return on investment is one of the rewards investors seek for their assumption of risk, time, effort, skill and other resources or circumstantial fortune that relate to the project.
All investments carry some degree risk. An investor that decides to sell all of their investments and/or buy none, while keeping their cash in the bank is taking inflation risk. An owner with a property that is free and clear is taking market risk. Even if an owner owns a property and paid nothing for it, there is litigation risk—there are stories where vacant buildings have uninvited guests who get hurt and owners are sued. There’s no way to avoid risk altogether, so the next best option is managing it.
So How Do You Manage Risk?
The first step is knowing what risks are out there, then doing your best to learn as much as you can about each one. Once you know what there is to know, or at least understand the basics of what to watch out for, you’ll be in better shape than most.
Investors often review lists like the one you’ll see below and then store it, in whole or in part, somewhere deep in their memories for convenient retrieval when the time is right. In practice, investors will not recall many of these items when making related decisions, and often they will be reminded of them by way of unpleasant circumstances. Try to get ahead of the curve by learning and memorizing the below list, or saving it somewhere accessible so you can easily return to it whenever you’re making an investment decision.
Important Risks to Remember and Manage
- Market risk: There are two types of market risk.
Space market risk indicates how changes in supply and demand of rentable space impact rental rates and leasing timeframes, which impact net operating income.
Capital market risk recognizes how changes in interest rates, investor yield requirements, or future value expectations impact values and capital cost and availability.
- Inflation (purchasing power) risk: Changes in the purchasing power of the dollar (in US markets and globally), which impact value of cash flow (interim and reversion) in real dollar terms (nominal, adjusted for inflation)
- Physical property risk: Physical characteristics and/or property condition impact costs of ownership
- Legislative risk: Lawsuits, changes in legislation and tax code/law, permit/city approval, zoning, city planning, etc. impact costs of ownership and options with current and future use
- Personnel risk: There are two types of personnel risk.
Internal team personnel risk, applying to people like W-2 employees and partners, recognizes how competency, loyalty/confidentiality, costs or profit sharing, lawsuits, quitting, underperformance, overhead, health issues, personal issues, and human nature impact overall performance and bottom line.
External team personnel risk, applying to contracted third-party professionals like lenders, property managers, legal/tax professionals, and contracts/subs, identifies how costs, competency, confidentiality, bankruptcy, overhead, and lack of proper incentive impact overall performance and bottom line.
- Underwriting/analysis risk: Errors, omissions, and using inaccurate or incorrect models result in an increased likelihood that actual outcomes do not meet participant expectations
- Financial risk: The use of debt and/or equity (amount and terms) impact cash flow, personal exposure, and the ability to respond to (and sometimes survive) changes in market conditions
- Liquidity risk: The inability to quickly convert real estate equity or debt instruments to cash.
- Environmental risk: The local environment exposes property owners to perceived health hazards, possible remediation costs, changes in asset value, partial or total loss due to natural disasters.
- Management risk: There are two types of management risk.
Asset management risk: Ability and actions of ownership entity and/or dedicated asset manager impact value maximization and stability through operations; decisions around capital improvements, renovations, and major repairs; financing; disposition; negotiations, etc.
Property management risk: Ability and actions of property management impact day-to-day operations including rent collections, bookkeeping, budget preparation, marketing and leasing, repairs and maintenance, data collection, tenant communications, property upkeep, tenant retention, etc.
- Personal risk: Changes in your behavior, impulses, poor decision-making, susceptibility to biases, propensity for proactive and unwarranted fear or unlikely outcomes, and all other human flaws. Know thyself!
Quick Tips for Managing Risk
- Limit deal size relative to portfolio. Be careful with the temptation to continually pursue larger deals if each subsequent deal requires you/your team putting most or all of your available capital at risk. If and when the market turns sour, some percentage of invested capital and equity will decrease; having available capital will help reduce the likelihood of foreclosure, allow proper upkeep of properties in the portfolio, and possibly help you take advantage of depressed prices.
- Ensure an adequate margin of safety. Buy at the right price to protect yourself from the permanent loss of capital if market conditions worsen and/or unexpected circumstances negatively impact operations at the property.
- Plan ahead to limit the impact of possible, unexpected high cost items. By definition, unexpected problems will be a surprise. Plan for surprises with adequate reserves and conservative, yet reasonable, assumptions about what could go wrong and what a remedy might cost.
- Consider money now vs. money later. Always focus on the timing of cash flows, in addition to the amounts. Keep in mind the power of reinvestment, compounding, and the time value of money.
- Be aware of changes in personal circumstances. You are relying on yourself, your partners, contractors, and many others to make smart decisions and follow through on the work. Have a backup plan if someone can’t or won’t continue to perform in a manner that gets you closer to your goals.
- Watch out for dishonesty. Trust, but verify.
It might be worth printing this list and keeping it taped to your wall and periodically scanning it to see if you’re missing anything—whether it be before a purchase is made, during the execution of a hold-period strategy, refinancing, selling, partnering, and so on. Ignorance to these risks is not bliss!