You may have heard that real estate investments carry a lot of risk. While this can be true, there are plenty of ways in which the investor can control and avoid any major risks. In fact, if you’re actively taking steps to mitigate risk, real estate investing can be significantly less risky than other types of investments. Let’s take a look at how you, as an investor, can avoid common risks associated with real estate investments.
Different Types of Risk
1. Idiosyncratic Risk
These are the inherent risks associated with investing in a specific asset, or group of assets, and vary based on the investment. An example of this type of risk would be found with a construction project. Construction projects have more risks because you can't make money during the construction phase. Many risks come with investing in construction projects, including construction delays, budget risks, approval risks, etc.
2. Asset Level Risk
As previously stated, the amount of risk associated with your investment depends entirely on the asset you invest in. Certain assets carry more risk than others. Asset level risk addresses the risk involved in a specific property. For example, apartment investments are generally at low risk when their demand is high. Commercial real estate (i.e., hotels) relies on tourism and seasonal stays, which is not always consistent - this presents a higher risk.
3. Credit & Replacement Risk
Replacement risk comes with older buildings. As the buildings grow older and new buildings are built around them, investors must decide whether or not to replace the older buildings due to competition and the potential inability to raise rent or maintain occupancy changes.
Commercial real estate investments may pose a credit risk. Even trusted and successful companies with good credit can go out of business. So, while the returns in a commercial investment property seem high, be sure to consider the risk you’re taking on.
4. Market Risk
Whether good or less favorable, changes in the real estate market happen all the time, making risk management an essential part of real estate investing. With substantial risk management, you can identify and measure risks to ensure you make sound investment decisions. Smart real estate investing requires knowledge and understanding of the current and past trends in order to determine what can cause changes in the market.
Tips to Mitigate Risk
1. Do Your Research
Do research on markets in multiple locations. Some locations are less risky than others, so by understanding the real estate market in different cities you can potentially increase your returns and avoid risk.
2. Diversify Your Portfolio By Location
As we just pointed out, you can minimize risk and maximize returns by investing in certain areas. However, this does not mean you should put all of your eggs in one basket. By diversifying your real estate investment portfolio you can mitigate risk. For example, if all of your properties reside in an area where natural disasters or extreme market shifts are common, your entire portfolio would be wiped out at once. Explore different cities and states where investing makes sense.
3. Focus on Residential Real Estate
No matter what is happening in the market, people will always need a place to live. By focusing your investment efforts into residential properties you will almost ensure consistent occupancy. This is especially true in multifamily investment properties because even if one side of the duplex is vacant, you will still be cash flowing from the side that is occupied. Commercial properties, such as retail and office space, have a much higher risk of vacancy.
4. Obtain Good Insurance
This is a no brainer. You don’t want to risk poor insurance because things will inevitably happen that are outside of your control. You may also want to consider getting good umbrella insurance to cover anything that the main property insurance does not cover.
5. Put Properties Under LLC’s
Putting your properties under an LLC is also a way of protecting yourself and your property. This is important if you are planning on renting out your investment properties. By renting your properties you are assuming the risk of being sued by a tenant. Making sure your rentals are separate from each other and from your personal finances, acting as individual businesses will mitigate a lot of risk often associated with rental properties.
Understanding the underlying risks behind any investment is critical before taking the plunge. With the right tools, understanding, and patience, you can enjoy a great investment and reap substantial returns.