Financial Risk in Real Estate – Types of Risks Discussed
Real estate investing requires a balance of risk & reward! Higher financial risk in real estate usually relates to the potential for higher profits. For making informed decisions, investors should quantify these risks of real estate investing. For example, most investors use sophisticated models with an experienced acquisition team to evaluate potential profits in different markets before taking any real estate investment risk.
Types of Risk in Real Estate Investing
What are the risks of real estate investment? Let us discuss some of them:
● General Market Risk: This type of risk is affected by broader economic trends, interest rates, & inflation. While market shocks can’t be removed, investors can mitigate some of these risks by expanding their portfolios. Fathoming general market conditions can help you develop strategies to hedge against economic variations.
- Investment-Level Risk: Risk varies by asset class. For example, multifamily properties usually have low risk due to their stable demand, while hotels are at higher risk due to their heavy reliance on tourism & business travel. Office buildings fall somewhere in between, being less sensitive to consumer demand but still subject to wider economic factors.
- Idiosyncratic Risk: This risk is specific to each individual property. For example, construction projects face risks such as delays, cost overruns, & potential environmental issues. Location also plays a key role, as properties in certain areas might face some specific challenges & benefits. Understanding these particular risks is essential to accurately assess potential returns.
- Liquidity Risk: Liquidity risk depends on the depth of the market and the ease with which an investor can exit their investment. A more liquid market provides easier entry & exit opportunities, while a less liquid market can make it harder to find a buyer and therefore harder to exit an investment.
- Credit Risk: This relates to the stability of rental income. Properties leased to long-term, creditworthy tenants are generally considered to be safer investments. However, even high-profile tenants can run into financial difficulties, as has been seen in the past. To assess credit risk, it is important to evaluate the track record of the tenant.
- Replacement Cost Risk: Replacement cost risk generates when new construction in an area makes existing properties less competitive. Newer buildings offer better facilities at similar rents, while older buildings may have difficulty maintaining occupancy & rental levels. To figure out this risk, it is crucial to evaluate whether current rent levels justify building a new building.
- ● Structural Risk: This refers to the financial structure of the investment and the rights granted to the participants. For example, senior secured loans tend to have priority over mezzanine & subordinated loans in repayment, thus reducing the lender’s risk. In joint ventures, it is important to recognise the alignment of interests between management & investors to avoid disputes and guarantee a fair distribution of profits.
- Leverage Risk: High debt soars the risk along with the potential for return. Excessive leverage can cause significant losses if property income can’t cover interest payments. To minimize such a risk, investors keep leverage below seventy percent and avoid the use of mezzanine or preferred capital. A key investment principle is to derive returns largely from property performance, rather than extreme leverage.
Fathoming & assessing the financial risk in real estate is vital to making safe & informed investment decisions. Mitigating risks in real estate investment is also important! Transparent communication about potential risks allows investors to ensure their decisions are aligned with their goals & risk tolerance. You can reach out to Innovativ Developers to make the best investment decision in Bangalore