Evaluating the risks of investing in real estate requires understanding the cost of replacing a property in order to know if it is economically feasible for a new property to appear and take those tenants away. To calculate the replacement cost, consider the asset class, location, and submarket of a property in that location. This helps investors to understand if the rent can rise enough for the new construction to be viable. For example, if a 20-year-old apartment building can rent apartments at a price that justifies a new construction, there is a good chance that competition will arise in the form of new construction offers.
It may not be possible to increase rents or maintain occupancy in the old building. The housing market is very strong after the pandemic. Rates are low, the economy is recovering and people are spending more time at home. People seem to be going crazy about housing.
Therefore, it is important to understand the main risks of real estate investment to consider. Business risk reflects the possible failed operation of a project. It is determined by the type of project, its management and the market in which it is located. Each of these factors can affect the expected operating cash flows from a project.
A regional mall rented entirely through long-term leases to tenants with better credit has less business risk than an investment in unprocessed land that anticipates the future construction of a motel. These key factors in the project's success explain why due diligence with sponsors is so important. Changes in the market are another key risk, but a risk over which the trader sometimes has little control. New competition, changes in local demographics and slow regional growth would affect the business risk of a project.
When investing in a real estate crowdfunding platform such as CrowdStreet, it is preferred that the sponsor has made multiple transactions on the platform and has a long history of operations. If you invest in a deal with CrowdStreet, you actually end up investing directly with the sponsor. Therefore, there is no risk for the CrowdStreet platform. Financial risk mainly reflects uncertainty about the residual return on capital when debt financing is used.
Debt increases the variability of the return on investment for the owner; higher leverage can mean an increase in profitability, but since debt service must always be paid before the shareholder, it can also mean lower or even negative returns. Financial risk also includes interest rate risk; higher than expected interest rate increases with a variable-rate or short-term loan will increase the debt service of a property and, therefore, reduce the rate of return for equity investors. Rising interest rates can also reduce the price that subsequent buyers are willing to pay. The rates of return that investors demand for real estate tend to move with interest rates in general.
Liquidity risk refers to whether and when the investment can be “cashed out” in the future. Real estate is generally considered an illiquid asset; it cannot always be sold easily. Most real estate crowdfunding platforms set up individual LLCs for individual transactions to minimize platform risk. The real estate market is unpredictable.
While there are forecasts about the direction of the market, nothing is set in stone. Many factors affect market conditions, such as economic forces of demand and supply, changes in government policies, and unforeseen domestic or international events. Not all real estate investments are flawless. Sometimes, there can be hidden structural problems, such as foundation damage or mold.
This can cost you even more because you'll have to take care of unexpected maintenance and repairs. As a potential real estate investor, you've probably heard of the phrase “real estate is all about location, location, and location” at least once. True, the main attraction of real estate is its location. However, it can also be a risk.
Location is crucial for real estate, so you should thoroughly evaluate if the area is a good investment. Research crime rates, find out if the town or city is developing recently or is being gentrified, and check if the place is urban or suburban. The more you know about an area, the better. Real estate investments lack liquidity compared to other assets such as stocks or gold. This means that if you're in a desperate situation where you need instant cash, you won't be able to easily make money with your property. Negative cash flow is one of the most common risks for real estate investors.
If you don't do your studies and analyses of housing markets correctly, you could end up losing money instead of making it from your investments. Negative cash flow occurs when your real estate loan payments, taxes, and other associated expenses exceed your rental income. It would be useful to calculate possible costs and rental income before buying any property to avoid this risk. Rental real estate can carry risks related to tenants struggling to pay rent on time or not paying rent at all. Don't accept all tenants who request space; bad tenants are worse than no tenants because they can consume your time and expenses. Therefore, you should go through a thorough screening process with your applicants to ensure that these situations do not occur. In addition to difficult tenants, you also run risks related to having lots of vacancies for extended periods of time without any rental income coming in to pay financial obligations. You can mitigate this risk by offering competitive rental rates and promoting your property through social media or publishing it with trusted real estate experts. The opposite of property appreciation - property depreciation - means that your investments lose value over time. Not all properties are guaranteed to be appreciated so you should select your asset with care. Research lots of real estate statistics and analyze markets before studying location and economic growth potentials for your property to avoid buying real estate with potential for depreciation. Whether you're considering investing in residential or commercial properties or using crowdfunding platforms like CrowdStreet for investing in real estate - understanding these risks will help you make informed decisions.