Real estate is known as a low-risk investment. But that doesn’t mean it’s risk-free. No investment is risk-free. In fact, choosing not to invest comes with even bigger risks, particularly as inflation impacts your savings!
It’s worth understanding the risks of real estate investing and how to minimize them so you can make smart investment decisions with confidence.
Of course, the specific risks you may encounter as a real estate investor will depend on your chosen real estate investment strategies. For example, different risks come from buy-and-hold rentals than flipping properties.
But, whatever your strategy, we have identified 10 potential risks of real estate investing to explore:
- Market Risk
- Location Risk
- Property-Specific Risk
- Liquidity Risk
- Financing Risk
- Tenant Risk
- Management Risk
- Legal and Regulatory Risk
- Environmental Risk
- Tax Risk
We’ll break down each of these 10 risks and show you how to mitigate each of them as you build your real estate portfolio.
1. Market Risk
Market risk, also known as economic risk, is the possibility that property values or rental rates can decline as a result of changes in the local market or global economy.
Example of Market Risk
During the first month of the unprecedented COVID pandemic, real estate sales came to a standstill as economic uncertainty caused many people to pause any plans. Those who were selling during this period may have accepted less than market value for fear that another buyer wouldn’t come along for some time.
How to Mitigate Market Risk in Real Estate Investing
- Diversify investments to spread the risk across a wider section of the market.
- Invest in rental properties with strong tenant demand to provide steady income during market downturns.
- Consider investing in properties that cater to essential needs, such as affordable housing through the Section 8 program.
2. Location Risk
Location, location, location. This trope is well-earned as the value of any property is heavily influenced by its location. Changes in the neighborhood can impact property values.
Example of Location Risk
While a new Metro line can increase property values around the new stations, rental rates can decline during the building of the stations since renters don’t want to deal with the nearby construction.
How to Mitigate Location Risk in Real Estate Investing
- Choose properties in hot markets. Hint: you may need to invest out-of-state to find the best deals.
- Get professional opinions of potential neighborhoods from local real estate experts.
- Stay updated on local zoning laws and upcoming development projects.
3. Property-Specific Risk
Issues unique to the property, such as structural problems, poor construction, or outdated systems, can lead to unexpected costs.
Example of Property-Specific Risk
An investor underestimates the renovation costs of investing in a distressed property. This miscalculation causes the project to go over budget and eats into the profits.
How to Mitigate Property-Specific Risk in Real Estate Investing
- Conduct extensive due diligence checks, including having licensed home inspectors evaluate the condition of the property.
- Purchase properties with warranties or guarantees.
- Budget for potential repairs and maintenance.
4. Liquidity Risk
Liquidity refers to the ease of converting assets to cash. Traditional real estate investments are considered low liquidity because it takes time to find a buyer for a property and transfer ownership.
Example of Liquidity Risk
A rental property owner suddenly needs cash to take advantage of a limited-time investment opportunity. They would like to sell the rental property to get the cash for the new opportunity, but it takes months to find a qualified buyer, close the deal, and collect the proceeds.
How to Mitigate Liquidity Risk in Real Estate Investing
- Choose modern real estate investments with higher liquidity.
- Understand your options for converting home equity into cash (like home equity loans or HELOCS).
5. Financing Risk
Changes in interest rates, or the inability to secure favorable financing, can impact the profitability of an investment property.
Example of Financing Risk
When the Federal Reserve raised interest rates to fight inflation in 2022 and 2023, many investors paused new acquisitions because the cost of property ownership had gotten too expensive. The higher interest expense cut into profit margins for investors nationwide.
How to Mitigate Financing Risk in Real Estate Investing
- Lock in fixed-rate mortgages for stable interest expenses. You can likely refinance if rates drop later.
- Maintain a good credit score to secure favorable loan terms.
- Avoid over-leveraging by maintaining a healthy debt-to-equity ratio.
6. Tenant Risk
Difficult tenants can cause problems like property damage, missed rental payments, unexpected vacancies, and even legal issues.
Example of Tenant Risk
A renter breaks the lease without warning, leaving an unpaid rent balance and a messy unit. The property owner needs to turn the unit, find a new tenant, and initiate collections against the former tenant.
How to Mitigate Tenant Risk in Real Estate Investing
- Screen tenants thoroughly with background and credit checks (as allowable by law in your area).
- Require a large deposit to cover any damages or unpaid balances.
- Draft clear and comprehensive lease agreements.
7. Management Risk
Poor property management can increase vacancy losses, result in excessive maintenance costs, and ultimately, reduce the property value.
Example of Management Risk
A property owner neglected their rental property, resulting in deferred maintenance that devalued the asset.
How to Mitigate Management Risk in Real Estate Investing
- Regularly inspect and maintain your properties. Respond to tenant maintenance requests promptly.
- Implement efficient property management systems to stay organized.
- Consider hiring a property management company to handle day-to-day rental operations.
8. Legal and Regulatory Risk
Changes in laws and regulations (like zoning laws, rent control, and voter-approved bonded indebtedness), can affect the profitability of your real estate investments.
Example of Legal Risk
Airbnb owners in New Orleans were left in a difficult position when the city suddenly and severely restricted short-term vacation rentals.
How to Mitigate Legal Risk in Real Estate Investing
- Stay informed about local and national real estate laws.
- Consult with real estate attorneys as needed.
- Diversify investments to mitigate the impact of local regulatory changes.
9. Environmental Risk
Natural disasters, climate change, and other environmental issues can damage properties and reduce their value.
Example of Environmental Risk
Rising sea levels and an increasing number of seasonal hurricanes are threatening coastal properties in Florida.
How to Mitigate Environmental Risk in Real Estate Investing
- Invest in strong insurance coverage for your assets.
- Choose locations with a lower risk of natural disasters.
- Make your properties more resilient with high-quality construction materials and building methods.
10. Tax Risk
While there are multiple tax benefits of real estate investing, there is a risk that rising property taxes, changes in tax policies, or poor tax planning can affect the net return on your real estate investments.
Example of Tax Risk
When an investor built an ADU (accessory dwelling unit) on the grounds of an investment property, they failed to plan for the property tax increase that resulted from the increased property value. This led to an unexpectedly large tax payment, which created a short-term cash flow concern.
How to Mitigate Tax Risk in Real Estate Investing
- Stay updated on tax laws and potential changes.
- Take advantage of real estate tax benefits like depreciation deductions and 1031 exchanges.
- Consult with tax professionals to reduce tax liabilities.
One Key Strategy to Mitigate All Real Estate Investment Risk
There is one real estate investment strategy that automatically mitigates each of the 10 risks of real estate investing discussed in this article: real estate syndication.
Similar to real estate crowdfunding, syndication pools funds from multiple investors to finance a single real estate project, which a sponsor professionally manages. This modern investment model automatically reduces risk in the following ways:
- Market Risk. Since syndication pools funds from multiple investors, you can buy into a deal for a fraction of the cost of direct ownership. These low investment minimums allow you to spread your investment capital among multiple projects for an instantly diversified portfolio.
- Location Risk. Syndicate sponsors who specialize in a specific region know exactly which locations are providing the greatest opportunities at any given time.
- Property-Specific Risk. Syndication deals are scouted and vetted by a team of expert real estate analysts.
- Liquidity Risk. Short-term syndication projects, such as single-family home flips, allow investors to get in and out of a deal quickly.
- Financing Risk. The syndication sponsor will handle any debt financing. Because of the volume of deals a syndication company completes, they can typically secure favorable loan terms for their investors.
- Tenant Risk. Professional property managers handle tenant screenings, deposits, rent collection, and leases for syndicated multi-family rentals.
- Management Risk. Professional property management is overseen by the syndication sponsor, adding an extra layer of management protection.
- Legal and Regulatory Risk. Syndication companies have attorneys to assess potential legal changes that could impact projects and have exit strategies ready should the legal landscape change.
- Environmental Risk. Syndication sponsors use experienced contractors who know how to build for the local environment and handle the insurance policies that protect the development.
- Tax Risk. Syndication companies have tax accountants to assess and address any changing tax risks for syndicated projects.
Gatsby Investment is a real estate syndication company that specializes in the Los Angeles housing market. Trusted by over 15,000 investors, Gatsby has achieved average annualized returns of 23% to investors since 2017.
Leverage the experience, knowledge, and skill of the Gatsby team to mitigate your real estate investment risk today. Learn more about investing with Gatsby and choose your new investment project(s)!