Real Estate Investing Risks

By Amanda Cruise

 

Risk. The most exciting investing topic! Ok, ok. Not so much. It’s important though. I’ll do my best to give information that helps you understand the risks of investing in real estate without putting you to sleep. Fair enough?  I’ll start with the obligatory statement that I am not a lawyer and this is not legal advice. It’s educational material. Alright – let’s get to it.

How Does Real Estate Risk Compare to Other Investments?

Bank Account

For the most part, money in your bank account is very safe meaning no one is going to take it and it’s not going to $0. While we all know some money should be kept in bank accounts, the interest made on those accounts is very low, which means inflation is eating away at the money sitting there.

Government Bonds

There are relatively safe investments such as government bonds. These bonds pay more than your savings account and are backed by the U.S. government. These bonds are generally considered a very low risk investment. The returns for these investments aren’t very exciting though. Even in the high 2023 interest rate environment, they topped out around 5%.

Stock Market

There is the stock market, which has ups and downs though over time, tends to go up at say 7 or 8% annually. The stock market has risk, as your money can go to $0.

Businesses

Investing in businesses tends to provide the highest return, 25% annual returns or even higher, but also the highest risk. There is no physical asset to back your investment, so the entire investment can truly go to $0 like the stock market.

Real Estate

Real estate tends to return higher than the stock market and while it has higher risk than savings accounts or government bonds, there is a physical asset such as land, building, etc that is always worth something. From a risk-adjusted perspective, which just means weighing your potential returns with potential risks, real estate tends to be a great option.

Let’s dive into the risks that do exist with real estate investing and how to mitigate those.

 

Contingency Plan

Not all deals go well.  A major tenant can leave a commercial building,  rents could go down, and a flip can lose money.

Before you invest your money, make sure the person you are investing with knows the risks of the project plan and also has plans for things that might go wrong.

Ask what the 1st exit strategy is, how you will get your money back, and what the backup plan is in case the 1st strategy doesn’t work out.

Risk To Your Investment Capital

Risk With A Debt Investment

With a debt-structured investment, you loan money to the active investor doing the work. You are owed a specific interest rate on the principal you loan. No matter how the property performs, even if the project loses money, you are owed your principal + interest. Your rate of return is not tied to the property’s performance. This is one of the top features of a debt investment. How do you get your money back?

1. If you invested with the right active investor, no matter how the property performs you will get your principal + interest payments. Even if the property itself is underperforming, that investor will pay you back through other money of theirs, through selling different assets they own, etc.
2. While investing with the right person is critical, legal security is also important. The way you secure a debt investment is through a lien. When you loan money through a debt investment, make sure you have a 1st, or sometimes a 2nd position, lien on the property depending on whether a bank is also involved. This lien should be recorded with the local city or county. This way if the investor you loaned money to gets hit by a bus, your interest in the property is recorded, which means the property could be sold and the proceeds would go to the debt holders in their respective positions.

Risk With An Equity Investment

If you’ve passively invested in a group investment, often called a syndication, you own a portion of the asset purchased. This is of course different than a debt structure. In the worst-case scenario, if the asset value significantly diminishes and the property has a bank loan requiring a sale or a refinance, the investor principal could go all the way to $0.

It’s critical to ensure you trust the person you are investing with and understand their track record. Ask what difficulties they’ve run into and how they’ve overcome them. Ask about the risks they see in the investment opportunity you are evaluating and their plans to mitigate those risks.

Do your research, and understand the investment you are making. And never ever invest with money you can’t lose.

Risk To Other Personal Assets

The person who signs for the loans (either bank loans or otherwise) is financially liable to repay them. Generally, the active investor, who also could be called the general partner, puts their personal assets on the line to secure a property.

There are times an otherwise passive investor is the one to sign for the loan. In that case, the arrangement is worked out in advance, and that investor is compensated for the specific risk they are taking signing for the loan.

If you are not signing for the loan, your capital invested is the most exposure you have. Your personal assets (houses, cars, retirement accounts, etc) are not at risk.

Legal Liability

The active investor or company making the investment decisions is the one with legal risks.  It’s critical they follow all laws such as fair housing, SEC, etc.

While you wouldn’t personally have legal consequences as a passive investor if the investment runs into legal issues, those  legal issues such as a class action lawsuits could bring financial costs that could impact the financial performance of an investment.

Bottom Line

As a passive investor, your risk in a real estate investment is the principal you are putting in. You need to understand what can happen with each specific investment, whether a bank is involved, and how that might impact the financial outcome of your investment.