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Assessing Real Estate Investment Risk And How To Minimize It

Sarah Sharkey6-minute read

April 27, 2021

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As an investment, real estate is a popular choice. With the popularity of real estate investing, it isn’t surprising that many dive in without a clear understanding of the risks. And that’s where the danger lies.

If you are considering this investment opportunity, then you need to understand real estate investment risks. With the right information, you can manage your real estate risk and build a profitable portfolio or properties.

What Is Real Estate Investment Risk?

Any time you invest, there is some form of risk involved. Investing in real estate comes with a unique set of risks. With that, you shouldn’t dive in with the assumption that you will make a return on your investment. When you make an investment and put up the funds to finance it, there is a chance that you won’t get that money back.

However, on the flip side, holding onto money has its own set of risks because of the lost opportunity to make money. Plus, inflation can eat away at the money you let sit under your mattress or checking account.

You’ll need to weigh the potential rewards of investing your money at all with the security of keeping your funds locked up. A good way to start this process of introspection is to learn more about your risk tolerance. Once you understand your risk tolerance, you can start seeking out investments that fit the bill.

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What Are The Seven Risks Of Real Estate Investment?

Before you dive headfirst, it’s critical to understand real estate risk so you can develop strategies to manage that risk and make the most of your investment.

Real Estate Market Volatility

A major risk of real estate investing is the fact that the market can be extremely volatile. With unexpected swings in the market dramatically affecting your investment, you should be aware of this threat.

Even a well-managed and well-maintained real estate property will have its value affected by a downturn in the market. As a real estate investor, that could become a major issue if your investment is made at an inopportune time.

For example, well-managed commercial real estate buildings saw a dramatic drop in demand with the beginning of the COVID-19 pandemic.

Location, Location, Location

You’ve likely heard before that location matters in real estate. And it’s worth repeating! The location you choose to invest in will dramatically impact the risk you take on and the potential for rewards.

As you consider properties, you’ll need to thoroughly investigate areas to ensure that they meet your investment goals.

Bad Property

Even with a careful property inspection, you might not find out about some problems until after closing. For example, you might run into hidden environmental risks such as mold or lead that could lead to expensive remediation costs.

Any of the problems found within the property will cut into your bottom line. Plus, you’ll have to handle these problems yourself as an active real estate investor. This could lead to extra hours working on the property or seeking out the appropriate contractor for the job.

Bad Tenants (Or Worse, No Tenants)

A good tenant can make all of the difference. The perfect tenant will pay on time, respect the property, and make you aware of any issues that could turn into a nightmare.

But if you have a bad tenant in place, then you might run into a world full of issues. You might have tenants who don’t report small issues that fester into major problems. For example, a small and manageable leak might grow to cause thousands of dollars in property damage.

Another big problem is when a tenant is refusing to make on-time rent payments, which can cut into your expected income. However, no tenants at all is an even bigger problem. A high vacancy rate can place a burden on any rental property owner.

The best way to avoid these sticky situations is to screen any prospective tenant carefully. You want to make sure that the tenant is able and willing to make on-time rent payments and seems to be respectful of your property.

Liquidity

When you put your hard-earned money into a real estate investment, the funds are tied up for long periods of time. The equity you build in a property is often not immediately accessible.

Although real estate investments can offer long-term rewards, you need to be comfortable locking a large amount of cash away in the property’s value. With that, it’s a great idea to have an emergency fund in place that can fund short-term cash flow emergencies.

Debt

Many investors have to take on debt to build a real estate portfolio. In fact, most real estate investors cannot fund their real estate investments entirely in cash.

Any time you take out a loan, you’re putting your finances at risk. With the heavy debt loads that are often associated with real estate investments, you may be facing a perilous proposition.

A good way to minimize this risk is to set up an emergency fund to cover the expenses of your real estate debt in case things don’t go according to plan. For example, if a tenant refuses to pay rent, you want to cover the cost of the mortgage until you can sort out the situation.

Lawsuits

Unfortunately, you may have to deal with lawsuits in your real estate investing career. Here are some legal issues to watch out for.

Poor Business Practices

You should absolutely avoid poor business practices that could put you at risk for a lawsuit. It is good practice to set up systems that have been vetted by trusted investors that ensure you comply with the countless housing laws in place at the federal, state, and local levels.

Accidents

You can help prevent accidents on your property by providing proper maintenance. But even with spotless maintenance, the potential always for a lawsuit exists.

Consider securing insurance coverage to help you cover the costs of defending yourself in a lawsuit.

How Can I Protect Myself From Risk?

Real estate investing comes with risks. But that doesn’t mean you should forgo the opportunity it presents. Here’s how to protect yourself from risk.

Avoid

As a new investor, you should avoid getting in over your head. Instead, make your start by taking on a simple project in a location that you know very well.

Of course, the less risk involved in the investment, the less potential for rewards. But you can strike a balance that works for you. Don’t forget to adjust your risk tolerance as you become a more experienced real estate investor.

Control

As the owner of a property, you should take care to maintain it well. Proper maintenance can remove some of the risks involved. If you aren’t sure what steps you should take to minimize your risk at a property, then seek out the advice of a real estate attorney.

A competent attorney can help you set up systems to shield your personal assets from your investment risks.

Transfer

Instead of allowing all of the risks to fall on your shoulders, you should consider transferring some of the risks through the vehicle of an insurance policy. Although this will create another expense for your real estate investment, it can protect your interests for the long term.

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Is Real Estate A High Or Low Investment Risk?

Every single investment comes with risk. The type of real estate investment you choose will determine if you are working with high- or low-risk investment. Take some time to find the right balance of risk for your situation.

Not sure that you are ready for real estate investment on your own? Consider working for a property management company to learn the ins and outs of property management before diving in.

Don’t Forget The Rewards Of Real Estate When Considering The Risk

We’ve covered the risks of real estate investing, but what about the rewards? The good news is that there are many.

You have the potential to build an income stream, enjoy capital appreciation, and take advantage of specific tax breaks. The rewards can be enticing, so don’t let the risks scare you away from giving real estate investing a shot.

The Bottom Line: Understanding Your Risks Helps You Manage Them

It is not a secret that real estate investing comes with risk. But the rewards can outweigh the risks. Want to learn more about buying an investment property? Check out our Learning Center.

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Sarah Sharkey

Sarah Sharkey is a personal finance writer that enjoys helping readers learn more about their finances. She has an MS in Business Management from the University of Florida. You can connect with her on LinkedIn or Instagram @adventurousadulting.