The housing market is very strong post-pandemic. Rates are low, the economy is rebounding, and people are spending more time at home. People seem to be going nuts over housing. Therefore, I thought it would be prudent to highlight the main risks in real estate investing to be aware of.
I’ve been a real estate investor in Honolulu, San Francisco, Lake Tahoe, and the heartland since 2003. During this time, I’ve made a tremendous amount of money in real estate.
Each property purchased was leveraged up with a 80% loan-to-value ratio after I put 20% down. Three properties turned out great, one property ended up being a dud due to poor market timing.
If you want to get wealthy, you must understand your risk tolerance and your upside reward. The people who go broke risk too much for not enough reward. You must properly asset your net worth in risk-appropriate assets with risk-appropriate weightings.
Let’s discuss the various types of real estate risk every investor should know. I’m in the process of buying a new single family home during the coronavirus pandemic and shelter-in-place ordinance in San Francisco.
Main Risks In Real Estate Investing
All investments can be said to involve certain basic risks; that is, the possibility of suffering adverse consequences. Experts can categorize these risks in various ways, but this article will divide some primary types of real estate investment risk along the following lines:
- Inflation / Systemic
- Variance / Sensitivity
Let’s go through the main risks of real estate investing one by one.
Business risk reflects the possible unsuccessful operation of a project. It is determined by the project type, 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 shopping center fully rented under long-term leases to top-credit tenants has a lower business risk than a raw land investment anticipating some future construction of a motel.
Generally, business risks are especially concentrated in management and the market. Management must keep the space leased and maintained to preserve the value of the investment, and management must innovate, respond to competitive conditions, and operate the property efficiently.
These key factors in project’s success speak to why sponsor due diligence is very important. Market changes constitute another key risk, but one over which an operator sometimes has little control. New competition, changes in local demographics, and slow regional growth would all affect a project’s business risk.
When investing on a real estate crowdfunding platform like CrowdStreet, it is preferable that the sponsor has done multiple deals on the platform and has a long history of operation. If you invest in a deal with CrowdStreet, you actually end up investing directly with the sponsor. Therefore, there is no CrowdStreet platform risk.
CrowdStreet is my favorite real estate crowdfunding for accredited investors. It focuses on individual deals in 18-hour cities. 18-hour cities are secondary cities with cheaper valuations and higher cap rates.
Financial risk primarily reflects uncertainty about the residual equity return when debt financing is used. Debt increases the variability of the investment return to the property owner; increased leverage can mean increased returns, but since debt service must always be paid before the equity holder, it might also mean lessened or even negative returns.
Financial risk also includes interest rate risk; larger-than-expected increases in interest rates with a variable-rate or short-term loan will increase a property’s debt service and thus decrease the rate of return to equity investors. Increased interest rates may also lower the price that subsequent buyers are willing to pay. Yield rates that investors require for real estate tend to move with interest rates generally.
It is important to thoroughly assess a project’s anticipated net operating income, because it is this amount that will be required to cover the debt service. The risk of a shortfall is increased when there is more debt on a property.
Inflation / Systemic Risk
Inflation / systemic risk arises when universal risks are higher than anticipated. In the case of inflation, it may be at a higher rate than was anticipated in the discounted cash flow analysis or IRR calculations. If this occurs, an investor’s purchasing power of the dollars later returned by the investment will be reduced. Other systemic risks include war and political changes that influence the whole economy. These risks affects all investors equally (at least within one country’s economy) and don’t really vary by project.
On the flip side, inflation risk can be great for real estate. Real estate is a primary end product people buy with the cash they earn. If inflation is going up, real estate tends to go up as well because real estate is a part of inflation. Inflation also whittles down the real cost of debt.
If you want to build real wealth, you must own assets that appreciate with or preferably faster than inflation. Investing in real estate, stocks, and alternative assets is key.
Liquidity risk relates to whether, and when, the investment can be “cashed out” in the future. Real estate is generally considered to be an illiquid asset; it is not always readily salable.
If the economy is suffering through a downturn, financing sources may dry up to a significant extent, reducing the pool of potential buyers to those who don’t require conventional financing. It is thus sometimes difficult to sell a property quickly without substantially discounting the price below fair market value.
You always want to be selling real estate in an upward trending market instead of a downward trending market. I ended up selling my San Francisco single family rental in 2017 because demand was strong. Demand started to weaken the following year due to a glut of inventory and higher interest rates.
If you need to sell real estate during a downturn, you could really lose. Therefore, before you buy real estate, make sure you own for as long as possible. If you can buy your forever home, even better. You will minimize costly real estate selling costs.
If you decide to invest in real estate via a real estate crowdfunding platform, there is a chance the platform could shutdown for whatever operating reason. If the platform shuts down, your investments should be protected because investors of the platform don’t have a lien on your investments in your respective real estate deals. You are an investor in real estate deals, not the real estate crowdfunding company itself.
However, there may be some disruption as individual investments get transferred to a fund administrator, and coverage teams responsible for following up with sponsors get whittled down.
Most real estate crowdfunding platforms establish individual LLCs for individual deals to minimize platform risk.
Variance And Sensitivity Risk
Variance/sensitivity risk relates to all of the foregoing four types of risks, and refers to the degree of variability of each of those risks. The more variance an investor expects in the equity portion of the property’s return, the greater the risk associated with receiving that cash flow.
Risk and Return In Real Estate Investing
Risk and return are positively correlated because people are risk-averse. Increased risks require that an investor demand increased returns in compensation. The return needs to be sufficiently above the current risk-free rate of return (10-year bond yield) in order for someone to risk their capital.
In general, it’s good to require at least a 2X or 3X premium on the risk-free rate of return. In other words, if the risk-free rate is at 3%, you would require a return of at least 6% – 9%, otherwise, why bother?
Investors must always be aware of the various risks involved with an investment, both those related to the economy and real estate markets themselves and those that relate to a specific project.
Undergoing appropriate due diligence on a project, including on the project’s sponsor or (for loans) on the proposed loan-to-value ratio, is key to understanding whether the expected rates of return for a certain investment are commensurate with the project’s overall level of risk.
Invest On The Best Real Estate Platforms
With real estate crowdfunding, you don’t need to risk $100,000 or more to invest in commercial real estate. Instead, you can invest for much lower amounts such as $5,000, thereby lowering your risk exposure The best real estate crowdfunding platforms today are:
1) CrowdStreet: Portland-based CrowdStreet was founded in 2014 and focus their deals in 18-hour cities, secondary cities which are cheaper and may have higher growth potential. CrowdStreet is mainly for accredited investors who are looking for ways to tap the mid-market, heartland of America real estate opportunities.
2) Fundrise, founded in 2012 and available for accredited investors and non-accredited investors. I’ve worked with Fundrise since the beginning, and they’ve consistently impressed me with their innovation. They are pioneers of the eREIT product. Most recently, they were the first ones to launch an Opportunity Fund in the real estate crowdfunding space to take advantage of new tax laws.
Both of these platforms are the oldest and largest real estate crowdfunding platforms today. They have the best marketplaces and the strongest underwriting of deals. Investors should carefully consider their own investment objectives when assessing the gamut of real estate opportunities that are available. Remember, too, that real estate investments have many risk factors, so it is important to review the full offering materials for any investment that is being evaluated.
About the Author:
Sam started Financial Samurai in 2009 as a way to make sense of the financial crisis. He proceeded to spend the next 13 years after attending The College of William & Mary and UC Berkeley for b-school working at Goldman Sachs and Credit Suisse. He owns properties in San Francisco, Lake Tahoe, and Honolulu and has $810,000 invested in real estate crowdfunding. I
In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $220,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies and writing online to help others achieve financial freedom.