Understanding the 5 Risks of Investing in Real Estate And How to Combat Them
In today’s tumultuous times, investing in real estate may very well be your best bet in protecting your future while at the same time creating new streams of income. On the other hand, real estate investments don’t come without risks and the unforeseen dangers of foreclosure and the loss of capital. Just as there are potential advantages and benefits associated with real estate, the perils of real estate are also real. Each real estate strategy has specific risks associated with the investment method. Every real estate entrepreneur should take the time to evaluate both the real estate itself as well as his or her investment temperament.
There are five major categories of risk associated with most real estate strategies. When you fully comprehend the dangers, you will be prepared to confront these risks and use real estate as a tool to create wealth and establish new streams of income.
Categories of Risk Associated with Real Estate
- Risk of Unpredictability. The future is unknown and you can’t determine in absolute terms what will happen to any specific property at a future date. Long-term historical data has shown that real estate has appreciated, but the rate of appreciation has varied and at times has even dramatically dropped in value. When you purchase a property, you control the asset without any ability to control outside factors which can determine the value of the property. Even when you purchase the property you may believe that you understand all the information about it, but experience has proven this to not always be the case. There are unexpected events or undisclosed facts that may appear. Naturally you try to minimize these factors, but it may not always be possible to do so.
- Economic Downturns. Recent history has shown that when the economy stumbles or even collapses, so do real estate values. Thousands of home owners found themselves owing more money on their homes than they were worth. When you are upside down like this, the value of your real estate can fall dramatically. Historically, the values have returned to their previous values and even appreciated, but if you weren’t prepared for this situation, you would have lost money. These economic downturns can happen on a nationwide basis, but far too often take place on a local or regional basis. If a major employer closes or moves to another location, there are naturally more properties that come on the market, which in turn can cause values to decrease. It’s all part of the supply and demand cycles. When demand exceeds supply values increase, and when the opposite happens, values can also decrease. Good real estate markets are best characterized for having strong occupancies and regular increasing rents. When a downturn occurs, occupancy rates fall and rents decrease, which in turn can lower real estate values.
- Interest Rate Fluctuations. The majority of real estate today is purchased using other people’s money through loans. These mortgages are secured by the properties themselves. These loans are based on interest rates that can change with major impacts on both cash flows and corresponding property values. When you purchase a property, through a bank or a private lender, it is imperative that you protect yourself from interest rate increases. Many real estate purchasers were unprepared for large balloon payments or the requirement to refinance the property under the original mortgage. When this situation occurs and you are unable to meet the terms of the mortgage agreement, you can face the condition where you are forced to sell the property at a reduced price. Whenever possible, you should lock in long-term stable interest rates on your loans. Failure to do so is disaster waiting to happen.
- Changing Demographics. With urban development comes change and the changing demographics associated with “Baby Boomers” and other age groups, real estate values can change unexpectantly. The demographics of a certain location may include the need for more rental housing while other demographics may suggest investing in other commercial ventures.
- Legal Entanglements. Because you control the asset, the real estate could become at risk through legal disputes that may occur against you. You can also be subject to risk associated with accidents that may take place on the property itself. Additionally, there may be zoning or similar issues that could create some form of cloud against your property. Finally, we seem to live in a litigious society where lawsuits are far too common. Fortunately, most of these types of issues can be combatted effectively when choosing the right professional and legal help.
- Risk of Negative Cash Flow. Negative cash flow can be the demise of the unwise and ill-prepared real estate investor. When cash out exceeds cash in, you have a situation that may be short-term, but can be the start of long-term financial headaches. There are many reasons for this condition to occur.
- Rental Property Negative Cash Flow. When you purchase rental property and the expenses; such as interest, maintenance, repairs, and management exceed your rental income, you face negative cash flow. In some cases, this situation is a short-term occurrence, while oftentimes the negative cash flow is ongoing. When this happens, you may face the problem of finding outside capital to finance the short-fall. Failure to prepare or to avoid this dangerous situation can ruin you. It’s critical to complete an accurate property analysis prior to purchase of the real estate. Once this is done, you need to evaluate your personal financial situation. Negative cash flow from rental property can be reduced or even avoided completely by using proven real estate strategies developed by professionals.
- Land Negative Cash Flow. Many real estate investors purchase land on the expectation of increased appreciation. This increase may happen through inflation or when urban development encroaches on the property or zoning laws are changed. Regardless of the reason for the appreciation in value, you may have interest or loan repayment obligations, along with other expenses such as taxes. In these cases, you can immediately experience negative cash flow without any income to offset the expense. Holding land for resale can be an effective real estate strategy, but you must be aware of and prepared for the potential negative cash flow.
- Risk of Liquidity. Real estate is often categorized as a hard asset, and as such it may be difficult to get needed cash from the property in a short period of time. Real estate loans and the sale of the property itself can provide the cash liquidity you desire, but there is always time required to complete these transactions. When purchasing or controlling real estate, make sure you are aware of your personal liquidity requirements as well as that of the property itself. It is important to prepare for needed cash infusions into the property as well as to insure that you can meet your personal financial obligations.
- Risk of Depreciation. This risk has nothing to do with depreciation schedules for taxes and accounting. Rather we are referring to the situation where the property actually decreases in real value. Even though this is a less frequent risk in a good economy, it can happen. Property values can decrease when interest rates are increasing dramatically, when there is damage done to the structures on the property, when zoning laws are adopted that decrease the uses of the property, or when the economy itself suffers. These risks can be minimized or reduced by wise purchases and through the use of professional help.
- Risk of Management Problems. Almost all real estate requires management of some kind. Rental properties require more management than holding land for resale. Even if you are just doing a “fix up” on a property there is management involved. Management of real estate can be done by the investor, property owner, or through professional management concerns. The potential problems associated with management of rental property generally involve tenant problems and repairs. As the real estate owner or controlling party, you will need to be prepared to meedd these management problems and expenses.
These risks are real and happen on a frequent basis, but there are proven strategies that can reduce these risks dramatically or even eliminate them altogether. Here are 5 proven strategies to avoid real estate risk.
Five Strategies to Avoid Real Estate Risk
- Complete a Property Analysis. As an investor in real estate you must start by completing a comprehensive and accurate property analysis. Regardless of the investing strategy you are using, you must start by accumulating accurate complete information about the property itself. You want to understand the history associated with the property and all expenses, past and present, that can impact the value of the property. Don’t rely on the previous owner’s representations. Take the time to consult tax records, property management records, and local zoning and urban information. Eliminate the unexpected by doing your ground work before purchase. Numbers don’t lie. Spend the time doing a complete analysis of the property using the investment strategy you have chosen. For example, if you are going to do a rehab on the property and then rent it out, you would want to get bids on repair work, consult records on comparable properties, and work with reliable realtors. Every property analysis must include the bad information along with the good factors.
- Control the Money. All real estate investments require capital of some kind. If you are going to involve financing, make sure you get the best rates and repayment schedule that meets with your personal financial situation. If you have the capital to invest, make sure you aren’t using funds that have to be replenished in a short period of time. Your ability to control the money and the financing in a way that meets your investment strategy will determine if you succeed or fail.
- Understand your Strategy. It can’t be over emphasized how important knowledge is to real estate success. There are a great many ways to profit from real estate strategies, and they are all different. When you decide which strategy you are going to implement, take the time to learn as much about the investment strategy as you do learning about the projected property. If you believe you lack information or expertise in adopting a specific strategy, find help in learning more about the real estate strategy.
- Get Proven Professional Help. The importance of finding professionals who can become part of your real estate team is paramount. Theodore Roosevelt once said, “Believe you can and you’re half way there.” The importance of his statement is as true today as it was last century. You may believe you understand the real estate strategy perfectly and you truly are half way there. Don’t be fooled into thinking you can go it all alone. Use professionals to build a team that works together. Find people who can do the things you can’t.
- Protect your Future. It all starts with protecting your real estate. Use insurance to protect real estate structures and insurance to protect your title to the property itself. You can also protect your future by insuring that you can meet your liquidity requirements. Don’t allow lack of capital to spell disaster.
Real estate can provide a second stream of income and help develop wealth. Yes, the risks are real, but the rewards and benefits are also real. Your ability to recognize the risks and to take the steps to avoid as many of them as possible will determine your overall success. It’s your discipline that will provide the key to your real estate future. Warren Buffett is regarded as one of the world’s best investors, and he summed it up well with his comment, “We don’t have to be smarter than the rest. We have to be more disciplined than the rest.” Use real estate as the vehicle to your future and success can be right around the corner.