Top 11 Risks in Real Estate Investing
A recent article published in the Journal of Property Investment & Finance by Gupta & Tiwari (2016) describes how important it is that you, as an investor, do not take any real estate valuation to heart without seriously considering the lurking risks that are assumed within that valuation or appraisal.
First, it is important to define the terms ‘risk’ and ‘uncertainty,’ because although they are used interchangeably, they are very different concepts.
Uncertainty is anything that is unknown about the outcome when you’re making the decision to buy or walk away. Whereas, Risk is “the measurement of a loss identified as a possible outcome of the decision” (Gupta & Tiwari, 2016, p.158). All investment properties, whatever the type, will have some degree of both risk and uncertainty. So it is important that you are aware and rational about your expectations and keep a critical eye on that appraisal amount for what underlying risks and uncertainties the appraiser took into consideration, or worst, did not.
According to the Royal Institution of Chartered Surveyors (RICS), “Unless a property is actually sold to determine market price, any estimate is uncertain,” so the role of the property assessment, appraisal or valuation is to produce a single judgment by “assessing current market conditions... from a “sea of uncertainty”” (Gupta & Tiwari, 2016, p. 158). In other words, appraisals or estimations of value are mere guesses because no one can truly quantify the unknown elements (uncertainty) or the potential losses (risks) that surround that particular piece of real estate no matter how fancy our calculations and formulas get.
You and Your Investing
For you as an investor, what does this matter? It matters greatly because it is important to identify the different areas you could potentially lose money on a deal; those risks that every single deal has like tax obligations and maintenance costs, and the special risks that are unique to that property like potentially tenant risk (good, stable tenants vs. ‘the crazies’) or occupier demand.
It is very important that every investor take time to identify their own risk perception capabilities. Your ability to identify risk efficiently and effectively depends on your unique investment philosophy and risk tolerance (Gupta & Tiwari, 2016).
Your ability to stomach different levels of risk depends upon (Gupta & Tiwari, 2016):
your return expectations
your source of funds
the duration you intend on being wrapped up in the investment
the perception you hold of general market
It also depends on whether you are an international investor or a domestic, local investor. That is because local citizens tend to have different rights legally than you would and they also have stronger, local relationships that allow them lower levels of risks than international investors might obtain. So always keep in mind the legal and local ramifications of deals and incorporate the “outsider” element into your risk calculations for any deals you are doing outside of your comfort zone or home country.
According to their research, Gupta and Tiwari found that there are three main categories of risk in investing: market specific, property specific, and lease specific. With markets, there are the macro and micro market factors like interest rates and cap rates that every investor must obviously recognize the potential loss associated with those fluctuating unexpectedly. The property itself always has some level of risk given the potential functional obsolescence or location. And of course, the different risks that tenants and a lease carry like the structure of the lease and the tax obligations that occur. For commercial properties, there could also be capital expenditure obligations that increase the risk of the deal as well when doing fit outs.
Top 11 Elements of Risk
It would be impossible to identify all the risks before moving forward with a deal given the boundless combinations of risks that each market, property and tenant can hold, so don’t even try. But, when you are first looking for a property, to keep it manageable, Gupta & Tiwari (2016) recommended that you focus your investigations on the different levels of risk within these 11 different elements:
(1) rent escalation terms
(2) tenant risk
(3) functional obsolescence
(4) lock-in duration
(5) security deposit
(6) lease duration
(7) resale of property
(8) occupier demand
(9) yield movement
(10) fit out by tenant
(11) interest rate movement
By using these 11 elements consistently, it can help both beginners and seasoned investors make sure they do not forget a critical risk to their estimated value of that shiny new deal and hopefully help you avoid a potentially dangerous investment. All in all, uncertainty and risk will never go away and is part of what makes real estate investing so exciting. Nevertheless, you will become a much smarter and safer investor by remembering to acknowledge as much of the risk you can rationally and critically before going too far into a deal. Apsley & Grand focuses on these things for our members when searching for their next investment opportunity, and it is important that you do the same.
Gupta, A. & Tiwari, P. 2016, "Investment risk scoring model for commercial properties in India",
Journal of Property Investment & Finance, vol. 34, no. 2, pp. 156-171.