Real estate investing is a great way to build wealth, but it also comes with certain risks. Evaluating the risks associated with a real estate investment requires understanding the cost of replacing a property and knowing if it is economically feasible for a new property to appear and take tenants away. To calculate the replacement cost, investors must consider the asset class, location, and submarket of a property in that location. This helps them to know 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. In these types of transactions, investors must know their rights in relation to their position in the LLC, which is a majority or minority stake. The risk of leasing can be mitigated by setting aside a reasonable amount of time and money as a reserve, which can be used if vacancies are not filled. However, it is important to understand the risks associated with the acquisition of such debt and the possible foreclosure that may arise as a result of overleverage, the risk of maturity of the debt, or both. Tenant risk also comes in the form of renewal risk, which refers to the risk that tenants will leave at the end of their lease without renewing or “extending” the lease agreement, or that no substitute tenants will be found, or even that the new lease agreements will be on less favorable terms than before for the landlord.
Owning a variety of property types, in different sectors and markets, would significantly help reduce exposure to risk. While it's impossible to eliminate the risk of having a problem tenant, investors can protect themselves by implementing a thorough tenant selection process. The cash flows from a real estate investment refer to the money that is left over after paying all expenses, taxes, insurance and mortgage payments. For example, if an investor is a managing partner in an operation that has an advantageous profit sharing with a manager and that manager has invested much less money in the operation, they are encouraged to take risks. Supply and demand, the economy, demographics, interest rates, government policies, and unforeseen events influence real estate trends, including prices and rental rates.
Real estate due diligence usually consists of analyzing the financial performance of the property, checking if there are any taxes on the underlying assets, performing a physical inspection and carrying out research work on the company's partners and market conditions. Real estate diversification is one of the most common ways to reduce exposed investment risk since it is a very localized investment. However, commercial real estate investment involves many risks that must be considered along with the expected value of the investment. Diversification is a risk management strategy that combines a variety of investments in one portfolio. Having frames of reference for investors to quantify risk helps ensure that the investment fits their needs, objectives and tolerance.
Construction will add risks to a project because it limits the ability to collect rent during this time. Tenants of income-generating investment properties can pose a certain degree of risk to investors in terms of quality of rental list and reinvestment risk. Investors should understand all these risks before investing in real estate.