Risk and Reward in Real Estate Investing

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Education & Training with So-Nicheless

Are you a risk-taker? Do you believe -- not unlike the infamous dance of a young, underwear-clad Tom Cruise -- real estate is Risky Business?

 

There's a definite non-negotiable element of risk involved in anything that includes the exchange of money and/or assets. Here's how the investment sector defines risk: “A probability or threat of damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities…”

 

Sounds rather daunting, right?

 

But, wait. There's a happy ending.

 

The definition goes on to say “...and that may be avoided through preemptive action.” Yes, the silver lining, the light at the end of the tunnel, the reason taking risks often results in big rewards.

 

So, let's talk about risk. What types of risks are involved in real estate investment? And how do we manage them, turning risks into reward?

 

As Helen Keller once said: “Security is mostly a superstition. Life is either a daring adventure or nothing.”

 

Risky Business

Dr. James DeLisle Ph.D., the Runstad Professor of Real Estate at Washington University, describes two overall types of risk associated with any type of real estate investment. He refers to internal risks and external risks.

 

Internal risks revolve around errors and information as well as inaccuracies in the analysis of that information. DeLisle groups these factors under the internal risk category:

  • Decision makers receive inaccurate data
  • Investors receive information that is incomplete or inadequate
  • The predictive models used are unreliable
  • A failure to fully understand the dynamic nature of real estate (the physical, plus impact others who are involved in the transaction may have or create)

Real estate is one of the most complex assets to deal with, especially in an investment way.

 

In addition to the internal elements of risk, the industry is very susceptible to external forces. DeLisle uses the term “unforeseen changes” and list several examples:

  • Changes in laws governing real estate
  • The development of new technologies
  • The effects of globalization
  • Natural disasters

For the purposes of this article let's focus on the second group of risks -- the external comment off and uncontrollable ones.

 

External Risks in Real Estate

Whether you're an agent or broker dealing in single-family residences, commercial real estate, property investment, or property development there's always a chance that the return on your investment ends in a loss. There are so many variables, so many uncertainties, we could go on and on listing them. For our purposes, let's discuss three broad categories of risk: market risk, geographical risk, and tenant risk.

Market Risk

Anyone living the real estate life for any amount of time is familiar with the concept of market risk. (Hello -- Great Recession of 2008, anyone?)

The real estate industry is characterized by cycles of strong markets and market downturns. The most common factors that trigger a down market are:

  • Overbuilding
  • Fluctuations and changes in interest rates
  • Political turmoil
  • Inflation
  • Foreign investors

Real estate brokers and investors rely heavily on the dynamics of the industry to help predict potential changes in the market. By understanding the external factors affecting market conditions the smart investor can at least compensate for the unexpected possibilities.

Geographic Risks

The three L's (location, location, location) have long been the mantra of the seasoned real estate guru. Locating areas for successful real estate Investments is the primary role of a knowledgeable real estate professional. The importance of this is no joke and it's for that reason that the geography is a risk factor to pay serious attention to.

  • Land availability
  • Overbuilding
  • Urban sprawl
  • Employment or unemployment
  • Secondary and tertiary market growth
  • Gentrification
  • Natural disaster areas

Every factor that contributes to geographical risk is an external, therefore uncontrollable, event. With due diligence and a risk management plan, the successful real estate investor can ease some of the threat of these risks.

Tenant Risks

For the investor trying to come up with an accurate calculation for how much profit they can make on a rental property, there are both behavioral and economic factors that should be taken into consideration. (For a more detailed discussion on determining profits from a rental property you can read more here.) The risk factors of tenancy include vacancy rates, unemployment rates in the area, growth from new developments, and the overall state of the economy.

Whether you're planning to invest in commercial real estate, apartment buildings, or single-family homes when it comes to renting a property dealing with another individual is Risky Business.

Once you've successfully identified the risks associated with your niche in real estate investing -- which, as you'll see below, is the first step in risk management -- you can begin implementing your risk management strategy.

 

Risk Management

Not many of the inherent risks associated with real estate can be eliminated completely. But they can be managed and compensated for in most cases.

 

But first, what is risk management?

 

In a stripped-down version, the goal of risk management is to improve decision-making. Risk management strategies use a systematic, logic-based approach.

 

The first step in successful risk management is to create a structured plan on how to deal with risk. Many companies are now building risk management departments or hiring a risk management specialist. A standard process has developed as this type of job has become more prevalent and more needed.

The 4 Phases of a Risk Management Strategy

Risk management strategies are especially helpful in real estate investment because they help eliminate much of the emotion that goes along with real estate.

Phase 1: Identify Risks

Identifying the specific risks that are inherent in your industry is the first step in managing those risks. If you go into a deal knowing the potential problems you may face, you can devise a series of options on how to deal with them should they come up. Which leads us to the next phase.

Phase 2: Analyze Risk

This is self-explanatory. Now that you’ve identified the risks, you need to evaluate each of them. It’s during this phase that you will assess risks and quantify the possible outcomes. This allows you to assign a low- or high-priority level to each risk, then deal with them accordingly.

Phase 3: Control Risk

Of course, as we’ve already discussed, there’s no way to completely control risk. But what you can do in this phase is to develop specific reactions to individual risks, so that when they do occur, you are prepared with an immediate response or counteraction.

Phase 4: Monitor Risk

Because of the dynamic nature of risk, especially in real estate, risks must be constantly monitored. Risk responses must be regularly reviewed, and response strategies must be altered when necessary.

 

The basic idea behind risk management is to minimize risk while maximizing opportunities.

 

Once you have a risk management process in place you can dive into the specific risks that are distinct to your industry. In an intelligent, informed and calculated manner.

 

As General George Patton once put it: “Take calculated risks. That is quite different from being rash.”

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risk management
market risk
geographic risk
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