Investing is a balance between risk and returns. Knowing which real estate risk factors are important improves the investment process and ultimately results in making better investments. Risk comes hand in hand with returns and unavoidable in any investment.
Like our commercial real estate 101, this article covers the top 10 key risks of investing in real estate. Knowing the risk is the first step to manage it and mitigate it in the business plan.
Real estate market risk is the primary risk all investors take when buying real estate. Market changes can impact capital values and future cashflows of the property and ultimately returns overtime. The market risk can fluctuate from changes to supply and demand or other general shifts in the market cycle.
Market risk is one of the critical drivers of value for long-term property appreciation. As the old saying goes, time in the market is just as important as the point of time buying an investment.
However, a good deal is either from buying below market prices or at cyclical lows, so the long term returns include a catch up to the long term trend and benefiting from the tailwind of the population growth or improvement in the market for the property.
Real estate risks can come in many forms. The location of the asset is a key contributor to the market risk of the asset. If the area improves relatively better than other competing locations, real estate value will have a tailwind.
Real estate values can likewise be affected by external economic forces such as increased unemployment rates or consumer spending. These all play a factor in setting the overall market risk influencing the real estate value.
Housing and Apartment Supply Risk
Supply and demand have a more acute impact on real estate than other assets because you cannot move property from one market to another. Instead, people migrate between various markets in reaction to prices as a result of supply and demand.
Like any market, a significant increase in supply can pose a risk to current property values either directly when the increase in supply is near the investment or indirectly where the additional units or houses have to be absorbed by the market before value growth can restart.
We can see an inverse example from the San Francisco market. San Francisco has always experienced strong demand for residential housing due to its proximity to technology employment opportunities. The consistent growth in demand resulted in elevated property prices relative to other major markets. A particularly strong strain of NIMBYISM has prevented the market property from reacting to higher prices through new supply. As investors, this combination of population growth and limited future supply presents an ideal solution to any future supply risk and tailwind if we invest in that market.
Rental Income Risk
Many people invest in real estate because of the consistent income it provides. But there is always a degree of risk in that income stream where the landlord is taking on the tenant credit risk, which could lead to gaps in cashflows from unforeseen downtime or vacancy.
Rental income risk can be a large factor in real estate risks which can affect income.
Leasing Downtime Risk
Leasing risk refers to how the change in the underlying tenant demand and specific aspects of the property can affect the building lease-up, tenant retention, and overall vacancy.
The Building lease-up period refers to the time it takes to fill the property. Market conditions can play a significant role in the lease-up timeframe. Still, the quality of the real estate and location is just as important.
Another way of looking at this is to evaluate the investment from the tenant’s perspective. Only because a property is cheap relative to other options does not mean that it is a good investment. The discount could reflect the limited sunlight, noise, or location in the building for the apartment.
Only because a property trades are a premium does not mean it is expensive. The premium could reflect better characteristics such as closer to better schools and transport links. A premium is only a cost if, overtime it disappears relative to the other comparable products. If the premium reflects the right reasons, then it can justify the higher prices.
Exit Liquidity Risk
Real estate is an illiquid asset class, unlike REIT ETFs, which can be bought or sold immediately when the market is open. It takes time for real estate transactions to consummate. An excellent timeframe to have in mind is at least 2 or 3 months for a sale process to happen. This timeframe is shorter in good markets and longer in downturns. That is if there are even buyers for the property.
The transaction process consists of three stages.
- Getting the property ready for a listing.
- Allowing a period to be on the market to maximize exposure
- Closing process
Each of the steps above can easily take a couple of weeks, and usually, if something can go wrong, it will. So it is always good to have some buffer to limit the risk of showing urgency in the sale. Any sign of urgency is a sign of weakness and will result in less favorable terms or price.
Financing risk refers to both the property’s bankability from the lender perspective and the borrowing capacity of the investor. Any weird or uncommon characteristics can limit the financing options available. Similarly, if the investor stretched themselves during an auction process and paid more than what they can borrow, it makes the loan’s sourcing more complicated than otherwise.
Financing risk also refers to the risk that you thought you could initially borrow is lower in reality. Knowing the borrowing capacity is critical at the start to avoid any financing shortfall once the commitment is made.
The landlord is always taking on the risk of tenant default and resulting damages.
Building Condition Risk
Real estate is a physical asset, and over time the wear and tear on the property internally or externally can pose a risk to the investment. The older the property, the more potential issues there could be.
Changes in the building condition overtime could affect future cashflows as the cost of repairs and maintenance adds up and may be required to ensure the product is competitive to peers in the market.
Interest Rate Change Risk
Leverage plays an essential role in investing in real estate, and loan servicing cost is the single largest cost landlords have to bear. Interest rate changes will have multiple impacts on the investment, from the property’s value to the level of net cashflows after interest.
Investors can partially hedge interest rate risks with fixed-term longs.
Investors should always be aware of the property’s interest serviceability and can be managed by building a cash balance or pay down debt ahead of time.
Tax Change Risk
Investors face a multitude of taxes for owning real estate. The range of taxes includes capital gains tax, income tax, and property tax, just to name a few.
The different taxes means the greater one of the taxes will change during the investment period. The experience is always taxes going up than down.
For example, property taxes could always change during the term of the investment, which can result in negative outcomes. Investors should be aware of the tax code changes and budget accordingly.
Main Real Estate Risks Factor
Most investors should know the critical real estate investment risk factors, but it is always good to have a refresher and maybe thinking of the risk from a different perspective allows it to be managed easier.
It is essential for the real estate investment strategy to address the main risk relevant to the specific investment.