Real Estate Investments: As Safe as Houses?
Investors usually refer to an extremely safe investment with the phrase As Safe as Houses. This shows the traditional mentality that real estate is one of the safest investment options.
The old school chain of thought believes that real estate investing is largely risk-free and provides the best hedge against inflation.
However, the world has recently discovered after multiple real estate crashes that the houses arent as safe as they were considered to be.
This article enumerates the various risks that an investor has to face while investing in real estate properties. Some of the common risks are as follows:
Risk #1: Risk of Bad Tenants
A lot of people that invest in real estate usually invest for the sake of cash flows that are received from real estate. These cash flows are received in the form of steadily rising rental payments. The assumption behind these cash flows is that investors will always be able to find good tenants. Good tenants pay up on time, do not destroy property and create no other legal hassles.
However, research has shown that there is statistically a good chance that investors may not always find a good tenant. Bad tenants are rated as the number one risk by most seasoned real estate investors.
Although only a very small percentage of investors will face bad tenants, there is a good chance that you may end up with significant legal costs if one comes your way. Hence, real estate investing is also a peoples business. This is the reason why landlords want to look at credit scores and police records before they lease out their property. The idea is to mitigate these risks.
Risk #2: Liquidity Risks
Real estate investments are probably the most illiquid as compared to all other investments. This is because the amount of money required for real estate investments is huge and it takes a huge commitment from the personal finances of any investor.
Therefore, in case you are a real estate investor and want to exit a property, there is no ready market which will provide minute to minute quotes regarding your property. Also, the buyers who are willing to enter into such a huge transaction are few and far between.
Hence stocks, bonds and gold can be liquidated in a few minutes if an investor has to. However, real estate takes a very long time to liquidate. This illiquidity needs to be priced into the real estate investment to ensure that investors are not making a bad bet.
Risk #3: Leverage Risks
In the above point, we stated that real estate investments usually require a significant commitment of capital. Most people that buy real estate do not have that kind of spare capital to invest in a given property. Hence, over two-thirds of real estate that is bought and sold in any market have leverage attached to it.
People usually buy a home with a mortgage. The mortgage stretches over an extended period lets say 30 years or so. Therefore the interest that is due on the mortgage is several times the original amount borrowed!
To add to that, the first few monthly payments that are made towards mortgage comprise almost exclusively of interest. Hence, over the first 4 years or so, one hardly pays back any principal!
Since real estate is leveraged so highly, it almost exclusively relies on the property prices rising continuously. The property prices do not need to fall down. A mere stagnation would make the interest costs unsustainable and would take the investment in the red!
Therefore, real estate investments are subject to some serious financing risks contrary to what is commonly believed by people.
Risk #4: Counterparty Risks
A lot of individuals that buy real estate usually buy unfinished units. Unfinished units are generally cheaper, and developers are willing to provide more favorable financing. However, buying under construction units also carries some serious risks.
The investors become vulnerable to default by the developers. Also, many times the developers are unable to get the required permissions from the local authorities. As such the project gets delayed. As a result of this delay, buyers end up losing a portion of their investment as they have to continue to pay rent.
Thus, real estate investment projects are prone to counterparty risks. Investors need to be diligent and have a plan to mitigate such risks.
Risk #5: Information Risks
The real estate market is extremely opaque when compared to other markets. There is up to date and accurate information available in markets like stocks, bonds and bullion. One can use the data to gauge the trends in the asset class and make informed decisions.
However, when it comes to real estate, the only data that is available is from local brokers. These brokers have vested interests and therefore have no reason to provide reliable, actionable information. Data related to the ongoing rental and capital values is therefore largely a guess!
Buyers, therefore, need to have multiple sources of information so that they can corroborate the validity of the data they receive. This risk has also been largely mitigated with the advent of online real estate portals and direct transactions between buyers and sellers. However, the price discovery mechanism remains largely opaque.
Investing in real estate is a very sophisticated business that requires a lot of expertise to mitigate the risks that are mentioned above.
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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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