The Real Estate Investor’s Quick Guide to Risk Mitigation
There is no investment in the world that does not come with some level of risk. If you invest in anything, you are accepting some level of risk, and that is certainly true with real estate investing.
So, how do you manage the unknown and prevent uncertainty with your real estate investments? While it is impossible to totally eliminate real estate investment risks, familiarizing yourself with common risks and preparing for them builds a solid defense against poor outcomes.
Common Types of Risk Exposure for Real Estate Investors
Property-Specific Risk
Individual properties themselves carry risks. Thankfully, many property-specific risks are easily managed because they are easier to control and influence. Property-specific risks may include elements such as:
- Unexpected maintenance and repair
- Destructive residents
- Turnover and vacancies
- Eviction proceedings
- Pools and hot tubs (due to accidents)
- Squatters
- Theft
- Hazards from deterioration
Attentive property management and maintenance can reduce most of these risks as they screen tenants, prevent and fix property damages, and otherwise preserve your investment.
Leverage Risk
Investors risk overleveraging when they A) overpay for a property and B) scale their portfolio too quickly. A high debt-to-income ratio can not only strain your financial resources should you need to tighten your purse strings, but it can also prevent you from obtaining lending in the future and hinder your ability to acquire favorable interest rates.
Liquidity Risk
Investments come in varying degrees of liquidity, and investors must consider the difficulty they may face in employing an exit strategy. For example, stocks are highly liquid investments that can be bought and traded in the blink of an eye. Real estate is less liquid. It can take time to sell a property, particularly if that property is more niche than the average residential home.
Your property’s location can also impact liquidity. For example, you may experience more liquidity in a suburban or urban market than in a rural market simply because there is a greater volume of market participants and, therefore, greater demand.
Environmental Risk
Because real estate is a tangible asset, it is exposed to environmental risks. These risks can damage the property physically or financially. Risks of flooding, natural disasters and manmade hazards, like pollution and soil contamination, can be difficult to manage.
When buying a property, beware of how its unique location impacts risk exposure. Even if you are not in Tornado Alley, proximity to busy highways, rail lines or industrial plants can potentially harm the value of your property.
General Market Risk
The real estate market is inherently tied to the economy on a global, national and local level. You might be most familiar with market risk when it comes to stock investing. A shift in the market, a public relations problem, or other unforeseen circumstances can tank the value of a stock. While real estate investments are not typically affected by a PR glitch or poor earnings like a stock, they are still affected by market conditions.
Structural Risk
Structural risk does not have to do with the actual property, but rather the risk associated with the structure of your business. You are exposed to different levels of risk in joint ventures as a majority or minority shareholder, within an LLC, S Corp and other various business structures. Your tax and legal obligations also vary between these structures. Investors should consult a professional beforehand to choose and set up the best structure for their real estate investing ventures.
Asset-Class Risk
Asset-class risk includes risks that are associated with your specific type of real estate investing. For example, multifamily and single-family rental properties are generally considered lower risk and more stable than retail, office and hospitality/vacation homes. That has been demonstrated throughout the pandemic as demand for commercial real estate plummeted where residential demand reached new heights.
Legal Risk
None of us want to find ourselves in the middle of litigation, but it is a real risk real estate investors face. You could be sued for wrongful eviction, failure to disclose, breach of contract and more.
Key Risk Management Strategies
Portfolio Diversification
Portfolio diversification is the best avenue for both risk management and wealth growth. When you buy multiple properties, sometimes across multiple markets, you can capitalize on their unique qualities and conditions while protecting them from risks other properties may be exposed to.
With diversification, if you have a property that is underperforming or “out of commission,” your other investments will sustain your cash flow so that you are not stuck in the red for months at a time. It also increases your risk tolerance and your equity.
Market Selection
Choose your markets carefully. You want to focus on markets with a proven record of growth, health and diversity, allowing for a softer blow from economic downturns. Investing in target markets that are more affordable than the one you live in allows you to grow your portfolio more quickly without overleveraging. Population growth and an abundance of job opportunities mean great demand for buying and renting real estate.
Financial Safeguards
Create a financial cushion. You never know when an unexpected event in your life will hinder your finances. Do not get caught unprepared. A special emergency savings account can relieve the stress of financial loss that can come from the unexpected, whether it is related to real estate investing or not.
Legal Counsel
To avoid lawsuits and trouble with Uncle Sam, make sure you get trusted legal counsel and a top-notch accountant familiar with real estate investment. Familiarize yourself with local laws, your lease agreements, and both tenant and landlord rights, and have your attorneys evaluate your leases and any other legal agreements.
A pair of expert eyes will help you avoid legal troubles, detrimental loopholes and legal ambiguities.
Thorough Systems
Due diligenceis the name of the game in real estate investment. Do you have systems in place that meticulously analyze and vet your investments? Does your property management team have their job down to a fine art? Your systems should encompass:
- Recordkeeping
- Number-crunching
- Accounting
- Portfolio Analysis
- Property Acquisitions
- Property Management & Maintenance
- Property and Market Assessment
Stay organized. Figure out exactly what you want out of your investments and how you intend to get there. The more intentional you are, the stronger your systems will be.
Attention to Detail
Do not settle for “good enough.” Not every opportunity that comes your way is going to be a fit for you. While cost is the most glaring factor that can make a property decidedly “not worth it,” other attributes can prevent a property from being right for your strategy and your portfolio. You can afford to wait. Pay attention to the details and keep your goals at the forefront of your mind.
Attention to detail also reduces your legal liability because it means you notice and rectify potential safety hazards: uneven, cracked sidewalks, slippery concrete, security lights, tree trimming, and broken doors and windows.
Insurance Coverage
A well-insured investor is a safe investor. You can do everything right, but it will not eliminate risk entirely. This is what insurance is for. General liability insurance can protect you from paying out-of-pocket for legal action taken against you. Property insurance, flood insurance, hazard and fire, landlord insurance, rent guarantee coverage, pet coverage, loss of income coverage, and more can save your financial bacon in a bad situation.
The Bottom Line
Real estate investors cannot avoid risk – it comes with the territory. A proactive approach, however, can minimize your troubles. Before you invest in anything,evaluate your individual risk tolerance. Do not feel bad if you are less willing to take risks than the next guy.
What is important is that as a real estate investor, you do not over-extend your resources. Build up wisely, over time.
And remember: Never invest more than you are prepared to lose!
