Techniques to Manage Risk When Investing in Real Estate
Any form of investment has a certain level of risk associated with it. Real estate investing, like any other speculative undertaking, entails a number of risks. Among these risks, some risks can be systematically estimated and avoided whereas some are not within as investor’s control. For example, investors can avoid the risk of losing all their money in a single investment by diversifying. However, risks associated with demographics and unexpected events are beyond the control of any investor. In any case, it’s smart to recognize the level of risk that an investor is comfortable taking and also find ways to manage the said risk, to benefit more from their investments.
Risk management is the method of determining which risks are present in a given investment and then coping with them. Risk management is critical because it can help investors and portfolio managers mitigate risk based on their financial objectives. In this article we will discuss the various risks involved in real estate investing and how to mitigate these risks to earn attractive returns on your real estate investments.
Ways to Mitigate Risk While Investing
- Risk Avoidance : This refers to dealing with risk factors by avoiding them altogether. This means that while making investment decisions, you must ask if the amount of risk associated with the investment is bearable and does not outweigh the potential profits. For example, if you are considering buying a property in a locality that has seen disputes in the past among existing residents and the builder; then you can avoid the risk by looking for other options.
- Risk Control : As already mentioned, an investor cannot foresee every type of risk. Therefore, it becomes essential to know how to deal with uncertain and unexpected risks through risk control or mitigation. One of the ways could be to monitor your property from time to time and carry out all necessary repairs.
- Risk Transfer : As an addition to mitigation measures, investors can also look for ways in which they can lessen the burden borne by certain risks by transferring them. For example, having property insurance with coverage against all the anticipated risks attached with the property could transfer the risk from you to your insurer.
Real estate does not have a widely accepted metric of calculating investment risk, unlike stocks that have beta, which measures expected risk and bonds that have ratings. This is often because each property has its own set of characteristics that make it difficult to implement “standard” methodologies. Therefore, investors may not be able to quantify all forms of risk associated with their real estate investments, but they can surely identify them. The following are the various types of risks associated with real estate investing.
Diversify your Portfolio to Mitigate Market Risk
The ups and downs of the real estate industry due to the economy, inflation and interest rates that cause an imbalance of the supply and demand in the market are well-known. The reality of any market is that it is constantly changing and this is bound to impact the profitability and the success of the real estate investment at a given time. Market shocks can’t be avoided, but investors can protect themselves with a diversified portfolio and keep an eye on the market conditions. Your risk exposure is minimised by buying a number of asset classes in various industries or in different markets.
Follow a Systematic Legal Procedure to Manage Legal Risks
Another significant danger that real estate investors face is litigation. It’s important to have the right insurance in place to help cover the costs if someone is injured on your property or files a lawsuit against you for wrongful eviction, breach of contract, failure to report a defect, or some other type of legal action.
To protect yourself from legal risks, it is important that you are aware of the current local, state and national laws pertaining to real estate. It is also a basic requisite to follow a systematic legal procedure while purchasing, selling or transferring your real estate assets. Make sure an experienced attorney drafts and reviews contracts, leases, loan papers, and other underwriting steps.
Consider Fractional Ownership to Reduce Liquidity Risk
Real estate is mostly regarded as an illiquid asset because it is not often easily liquidated. If the economy is experiencing a downturn, there may not be a good number of potential buyers available. In such cases, you may have to hold on to the property or under-sell the asset. However, the best way to avoid any major losses due to under-selling is by including fractional ownership that allows you to own a certain percentage of an asset that allows you to realize your profits by simply selling them. Fractional ownership would ensure that there is no net loss altogether and there are other sources for you to meet your immediate financial needs, if any.
Buy Adequate Property Insurance to Guard You From Environment Risks
Damage to property due to extreme weather conditions is among the environmental risks involved in real estate. It also includes property deterioration due to unexpected and unaccounted factors such as earthquakes, heavy rainfall, fires and other natural calamities.
The best way to mitigate against environmental risk is to be a smart buyer and educate yourself about the geographical aspects and anticipate risks according to the past track record of natural disasters in that specific area. However, these risks can be avoided only to a certain extent as they are unpredictable, hence it is also important that you have adequate property insurance that covers against losses caused by natural factors.
Periodically Monitor Your Property to Control Property Risk
Environmental conditions aren’t the only cause of property loss. Harm to your property can also be caused by others. Trespassers in a vacant property, stolen construction equipment, risk of someone breaking in, tenants trashing their place on the way out, or unintended losses from on-site construction are all threats that investors face.
You can hire experienced property managers to control your risk by monitoring your properties regularly and catering to repairs on time. In addition to this under these circumstances, transfer of risk is one option.Therefore, buying adequate property insurance that protects your position and assets in cases where the property is damaged by tenants, trespassers or builders, etc.
Conduct A Thorough Research to Gauge Replacement Cost Risk
As the market’s appetite for space pushes lease rates higher in older properties, it’ll only be a matter of time before those lease rates justify new development, raising supply risk. What if a better facility with equivalent rentals emerges, rendering your investment property obsolete? Rents may not be able to be raised, and occupancy rates may be low.
To mitigate this type of risk, it is important to estimate the competition in that locality with respect to the rates and amenities offered, to anticipate any sort of competition that could threaten your position in the rental market. Another way to counter this risk is to invest in relevant upgrades for your property to match the level and quality of amenities offered by other living spaces in your area to attract customers and tenants.
Risk management is an essential requisite while investing in real estate that will ensure that you earn your projected profits. Following the techniques for risk management can help you deal with the anticipated risks in an appropriate manner and help you make better investment decisions. Therefore, it is prudent that you conduct your due diligence by increasing your knowledge of the asset class and market to better be able to gauge the various risks involved and how to manage them as per your personal risk tolerance.
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Frequently Asked Questions on Risk Management in Real Estate:
Risk management refers to a tool for deciding which risks exist in a given investment and then dealing with them. It entails conducting due diligence from the investor’s part to account for both predictable and unpredictable risks associated with real estate investing and follow certain techniques to manage and control the said risks.
Real Estate risk can be managed in three ways:
- Avoid the risk- You can avoid a certain type of predictable risk by either considering less riskier options. This would require you to conduct a thorough market research, understand the locality and the asset class before making any investment decisions.
- Control the risk- You can control your risks to a certain point to make it less burdening. To control your said risks you must monitor your property, invest in suitable upgrades, provide periodic maintenance and all the legal procedures thoroughly.
- Transfer the risk- To further safeguard your interests and properties from unexpected risks, it is better to transfer your risk to your insurer. Therefore, purchase adequate insurance that guards you from all the anticipated risks.
Amongst the various predictable and unpredictable risks associated with real estate, the most common one is the market risk. It arises from the changes in inflation, interest rates and the economy. Depending on the market scenario, your property could either be appreciated or devalued.
Secondly, there are many risks pertaining to property which could be different for different properties. This type of risk involves longer periods of vacancies, damage due to trespassers, and other unpredictable risks too.
Thirdly, environment risks have a role to play as well. This type of risk is often difficult to anticipate. Environment risks often include damage due to natural disasters such as earthquakes, hurricanes, floods, etc.
When it comes to real estate investment, risk management is a must if you want to make your expected money. Risk management awareness will assist you in dealing appropriately with anticipated risks and making better investment decisions. As a result, it’s a good idea to do your due diligence by learning more about the asset class and industry so you can properly assess the different risks and how to handle them according to your personal risk tolerance.