Real estate investing has always been attractive to those looking to build wealth. In fact, in June 2023, investors snapped up 26% of all single-family homes sold. The draw of real estate lies in its potential for cash flow, tax benefits, and property appreciation over time. But just like any investment, it comes with its own set of risks that investors must be aware of and prepared to manage.
Many aspiring investors are drawn to the potential rewards of real estate investing but may not fully understand the challenges that come with it. From market variations and property issues to legislative changes and tenant problems, real estate investing presents a unique set of risks that can catch even seasoned investors off guard.
In this article, we'll cover the most significant risks of real estate investing that every real estate investor should be aware of. By understanding these potential pitfalls and learning strategies to mitigate them, you can increase your chances of success with your investments.
Types of real estate investment risks
If you're considering diving into investing, here are the real estate investment risk factors you should consider as part of your analysis:
General market risk
Economic conditions tie real estate investing to fluctuations that can affect property values and rental income. Economic cycles like recessions can cause major changes in the housing market. During an economic downturn, property values may drop due to decreased housing demand from job losses, reduced consumer confidence, and tighter lending standards. Rental demand may also decrease because people prioritize other expenses.
To mitigate this risk:
- Track economic indicators and the market cycle.
- Avoid taking on too much debt at market peaks.
- Keep cash reserves in case the market declines to avoid selling low.
- Diversify investments across markets and property types.
Location risk
The neighborhood and regional factors of your investment property's location influence its desirability and value. Considerations like crime rates, school quality, transportation access, and proximity to amenities greatly impact the appeal of an investment property. Regional factors like job growth, population trends, and infrastructure development also impact housing supply and demand.
To avoid this risk, research location dynamics like job opportunities and development plans. Visit in person to get a better sense of the locations where you're considering buying investment properties.
Legislative risk
Laws and regulations can change over time and directly affect the real estate market and your investments. Some examples include:
- Changes to tenant laws that make it harder to reject applicants or process evictions when necessary.
- Property tax increases could reduce your profits and negatively impact cash flow.
- Rent control laws can limit how much landlords can increase rent yearly to cover rising expenses.
- Changes to zoning rules might restrict certain property types or rentals, like banning the use of a property as a short-term rental.
To stay ahead of these changes, keep up with the latest news, get involved in industry groups, and diversify your investments to reduce the risk of local law changes.
Property risks
The physical condition of the property itself is a risk factor to consider. Properties may have hidden defects or require extensive renovations that can result in unexpected and possibly expensive costs.
Even if a property appears great on the surface, there could be underlying structural issues with the foundation, roof, plumbing, or electrical systems. If you don't address these problems, these issues can escalate and lead to even more expensive repairs later on.
Hiring a professional inspector before you buy a property can help reduce this risk. And, if you do find major structural problems, you can negotiate with the seller to fix them or back out of the deal.
Negative cash flow risk
One of the primary goals of real estate investing is to generate positive cash flow, where rental income exceeds the expenses related to owning and maintaining the property. The risk of negative cash flow happens when an investor overestimates the property's rental income or underestimates expenses like maintenance, property taxes, insurance, and unexpected repairs. This mismatch can lead to a financial shortfall, affecting the investment's profitability.
Make sure you calculate all of your expenses accurately before buying a property. Have a cash reserve in case your expenses are higher than expected, and consider raising the rent if you're not making enough.
Vacancy risk
Having an empty rental unit means zero income from that property while you still have to pay the mortgage, taxes, insurance, utilities, and maintenance costs.
Some vacancies between tenants are inevitable, but a high overall vacancy rate is a major risk that can hurt your investment profits.
To reduce vacancies, set your rent at competitive rates to attract quality tenants. Establish positive relationships with existing tenants to encourage lease renewals. And the moment you receive a move-out notice, start marketing for a new tenant to quickly fill the vacancy.
Tenant risk
Occupied properties can still pose risks, leading to increased stress and costs. These risks include tenants who might:
- Damage your property.
- Miss rent payments.
- Neglect reporting maintenance issues.
- Keep unauthorized occupants.
- Violate the lease agreement in other ways.
Safeguarding your investment begins with tenant screening. Determining a tenant's reliability through background and credit checks can prevent many issues before they happen. A strong lease agreement that outlines responsibilities and penalties for violations should also be part of your risk mitigation strategy.
Financial risks
Many real estate investors borrow money to finance their investments. While this debt leverage can help you increase returns, it also has risks. If the property doesn't generate enough income to cover the mortgage payments, this can result in financial losses or even foreclosure. Variations in interest rates can also impact the cost of your debt and your cash flow.
To manage this risk, only borrow as much as you can afford to pay back. Keep some cash for emergencies, and prepare yourself for changes in interest rates.
Liquidity risk
Investors consider real estate investments illiquid because they cannot easily convert them into cash. Selling a property can take months or even years, depending on market conditions. This lack of liquidity can be a problem if you need quick access to your capital or want to diversify your investments.
To protect yourself, keep cash reserves in easily accessible accounts and consider diversifying with other liquid investments like stocks.
Asset-level risk
Concentrating on a single property or a small number of properties can expose you to asset-level risk. If something goes wrong with that asset, such as a natural disaster or a significant tenant issue, it can affect your entire investment portfolio.
To prepare for this, set aside money for repairs and make sure you have insurance coverage. Buying newer properties can also help reduce major repairs, and diversifying across multiple properties and locations can help reduce risk.
Low-risk real estate investments to consider
There's no such thing as a completely risk-free option in real estate investing, but some strategies can be lower risk than others. If you want to reduce risk in your real estate investments, here are some areas to consider:
- Buy and hold rental properties: One of the most classic low-risk approaches is to purchase a property and hold it as a long-term rental. The idea is to find a property in a great location and then collect rental income from tenants. This will provide you with a consistent cash flow, and if you choose wisely, the property can appreciate in value over time.
- House hacking: This is a great strategy to get started with your first investment property. You purchase a small multifamily property, like a duplex or triplex, live in one of the units, and rent out the others. This helps you offset your living costs with rental income and also builds equity in the property.
- REITs: Real estate investment trusts (REITs) are companies that own and operate income-producing real estate. By investing in a REIT, you're buying shares of a portfolio of properties managed by professionals. REITs are a liquid source of real estate exposure, and many investors consider them a relatively low-risk option compared to direct property ownership.
- REIGs: A real estate investment group (REIG) pools investors' capital to acquire and manage a portfolio of rental properties. The difference is that a REIG is more hands-on, and investors can actively participate in deciding which properties the group purchases. This can provide more control and responsibility than a passive REIT investment.
Real estate risks
Real estate investing offers profitable opportunities, yet it comes with its set of risks. We've explored various challenges, from market fluctuations to specific property issues, highlighting the importance of developing a strategy to manage and mitigate these risks effectively.
Note that success in real estate isn't about avoiding risks but skillfully navigating them. This involves thorough due diligence, staying informed about market trends and legislative changes, and adopting a proactive approach to property management and tenant relations.
The most adept real estate investors view risks as opportunities for learning and growth, refining their strategies for long-term success. Adopting this mindset of continuous improvement will position you well in the real estate market.
Real estate investment risk FAQs
Is real estate a high-risk industry?
Real estate is generally considered a moderate to high-risk industry. While it offers the potential for returns, factors such as market dynamics, economic conditions, and changes in supply and demand can affect rental income and property values.
What is the biggest risk of real estate?
The biggest risk in real estate is the potential for financial losses due to variations in property values. A downturn in the housing market or an economic recession can negatively impact property values and leave investors with losses if they need to sell or refinance.
What is the riskiest type of real estate?
Investors consider speculative investments, such as undeveloped land or properties in emerging markets, the riskiest type of real estate. Factors like zoning changes, infrastructure development, and overall market conditions influence these investments with higher uncertainty.
Important Note: This post is for informational and educational purposes only. It should not be taken as legal, accounting, or tax advice, nor should it be used as a substitute for such services. Always consult your own legal, accounting, or tax counsel before taking any action based on this information.
