Updated: Aug 19
Risk & Real Estate
One of the most critical pieces of advice that the investment industry preaches is to invest according to one's risk tolerance. Why? Because undue risk-taking can inflict substantial financial ruin. For example, individual stocks can bust, and bonds can go into default. However, risk-taking is an integral feature of all investments. After all, that is why there is a reward.
When discussing risk, we often think of stocks and bonds. But, since we have been focusing on real estate as part of our ongoing series, we will focus on the risks real estate investors accept when utilizing this unique asset class.
Investing in real estate carries risks
The Great Recession was a wake-up call for many that real estate could go down in value. The perfect storm of events that conspired in 2007/2008 caused many homeowners to lose their properties and valuations to suffer for several years to come. Fortunately, many reforms have occurred since then.
While real estate values can and will fluctuate with future economic cycles, a repeat of 2007/2008 remains unlikely.
Besides the risk of real estate going down in value during recessions, real estate possesses unique qualities that present other forms of risk that investors must know. These include interest rate sensitivity, capital expenditures, litigation, vacancy, and leverage.
Interest rate sensitivity
When interest rates rise, like in our present economic environment, physical real estate valuations generally go down (even if we aren't in a recession). The reasoning behind a decrease in property prices during rising rate periods stems from the lower demand buyers exhibit since financing costs increase.
Therefore, even if the economy is growing, real estate prices are directly influenced by the Federal Reserve's rate changes.
When you invest in a stock or bond, you don't have to put any additional funds into these securities in hopes of gains. Instead, you passively put money into them and continue your life. With physical real estate, such scenarios are unlikely.
Property owners are responsible for maintaining their rentals, regardless of the source of the damage (tenants, strangers, or nature). If landlords fail to maintain a property, it can decrease in value and stop providing rental income.
Resultantly, property owners must anticipate recurring capital expenditures to keep their portfolios in tip-top shape.
When one owns a property, they become responsible for many things, including civil claims.
When injuries occur on a property by tenants or strangers, the landlord can be held responsible for paying out medical claims and more. Further, if a landlord fails to provide tenants with contractually obligated features, the tenant may have civil recourse.
Therefore, it is essential to maintain rental properties and have sufficient insurance coverage for freak events.
When investing in stocks, shareholders don't have to worry about generating revenue and income. Instead, that burden falls on management.
With real estate, the burden of finding tenants to generate income falls on the owner. Many landlords utilize property managers to find tenants and maintain the tenant relationship. Still, during periods of economic turmoil, there is the risk an owner may go months or longer without a renter.
Be sure to have ample funds if you buy a property with leverage, as debt payments from a mortgage can quickly add up during vacancies.
Leverage is the use of debt to finance the acquisition of an investment. Most homeowners utilize leverage when buying a home with a mortgage.
While leverage is standard in real estate, it is uncommon elsewhere in the investment world. Still, lenders remain willing to make these loans since real estate (generally) maintains its value better than other assets and can quickly be repossessed and sold.
Real estate investors enjoy leverage because it amplifies returns. Here is why:
If a property is purchased with 20% down for $100,000 and rises in value by 20%, the investor makes a 100% ROI. However, if they invested only the down payment and experienced the same 20% value increase, they would make substantially less ($16,000, to be precise).
While leverage can be a great way to build wealth, it goes both ways and can amplify losses. Using the example above, a 20% decrease in property value would cause the investor to lose 100% of their money instead of only $4,000.
So, invest wisely and know that leverage can be dangerous.
Real estate remains a good investment
Despite these unique qualities that pose particular risks to real estate investors, real estate is still a great investment opportunity. If you are wondering how real estate could fit into your portfolio, please get in touch with us at Lundeen Abrams Advisors today. We are here to help in our happy to look into your specific situation to find what will work best.