Understanding the pitfalls of real estate investing is critical to building your real estate portfolio and longevity whether you are investing in residential or commercial real estate.
One of the best ways to protect yourself is to be proactive and educate yourself as to where the risks may lie and what you can do to either avoid said risk or at least minimize it. Being proactive will help you save a lot of headaches, heartburn, and money.
To some degree, real estate risk is inevitable no matter what asset class you invest in. Some risk can be completely avoided, while other risk can be reduced by transferring the risk or controlling it on an ongoing basis.
Risk Avoidance:
Defining a potential risk and having the ability to avoid it is one of the best ways to eliminate it. For example, if you want to avoid a non-paying tenant, then make sure you do a thorough background check and/or consider a subsidized tenant.
Risk Control:
Not every risk can be avoided, which is why risk control is the most common mitigation strategy. Maintaining a property before problems occur such as maintenance on an HVAC system makes that tenant more likely to want to stay and pay rent.
Risk Transfer:
Transferring certain risks is another way to protect yourself and many times is used in addition to other mitigation strategies. An example is having a home warranty whereby the tenant calls the home warranty company, and the repair cost is covered with a service call fee and transfers the risk from you as the property owner to the home warranty company. (Different warranty policies cover different items, so be sure to read the coverage.)
Now that you know in what ways you can mitigate risk, it’s important to understand the different types and causes of risks you might encounter.
Market Risk
The real estate market is constantly changing. The economy, interest rates, and supply and demand, will all impact how profitable and successful a real estate investment will be at any particular time. As most investors know, the real estate market is cyclical—it’s not a matter of whether market conditions will change, but when they will change.
Some of the best ways to mitigate risk is by diversifying your asset classes or diversifying in multiple markets. Not all asset classes and markets appreciate or depreciate in the same ways or at the same time. Diversifying will help offset the potential risks if one asset class or market tanks thereby reducing your risk.
As we have seen right now, several cities in the Southeast are benefiting from an increase in home sales, rental demand, high occupancy, and increasing rental rates, while major metro markets in the Northeast are suffering from a decline in demand, lowered rental rates, and high vacancy rates. Diversifying assets in multiple markets reduces risk from market downturns in one main market.
The same goes for owning a variety of asset classes. Residential real estate has fared rather well during the pandemic, while restaurant, retail, and office spaces have struggled with many small businesses being forced to close. It is also very important to make sure your real estate portfolio isn’t over leveraged and that you have enough reserves to make sure you can stay afloat should things go south until that market recovers.
Mother Nature Risk
Flooding, hurricanes, tornadoes, earthquakes, fires, wind damage, hail, or other environmental factors can cause major damage to your property through no one’s fault. One of the best ways to prevent or mitigate risk caused by Mother Nature is by avoiding purchasing real estate in some of these higher risk areas prone to flooding, hurricanes and earthquakes like Florida, the Northwest, or the Gulf Coast. Sometimes this can’t be avoided and whether you believe in global warming or not, buying in some of these areas may pose a risk as the environment changes. The best way to help transfer some of this risk exposure is by having the right property insurance even if that includes paying additional premiums for coverage such as flood or hurricane insurance.
Property Risk
As an investor, it is important to understand that people can also cause damage to your property. If you fix and flip, having equipment from a construction site stolen or having someone steal the copper piping from a property as well as tenants trashing your place on the way out, are a few of the other risks that investors face. It is important to have the proper property insurance in place.
Investing in anything always has some sort of risk. When trying to avoid or mitigate risk as a real estate investor, it is important to have experienced professionals like an attorney, an insurance agent, and a CPA on your team to make sure you have everything in place you need to help minimize or remove any kind of exposure you may encounter.
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