The Risks, Rewards and Challenges of Buying Real Estate

Investing in Real Estate for Beginners

Property values are rising in smaller cities, renting remains popular in first-tier cities, and many Millennials are entering the housing market for the first time. There are plenty of opportunities for buying investment real estate, whether you’re looking to rent a property out yourself or make passive investments through professionally managed private placements or real estate investment trusts (REITs).

Real estate is a smart way to add diversity to your portfolio with a risk profile and time horizon that best suits your needs. Understanding the benefits and challenges of owning real estate, as well as the factors that contribute to investment risk, is an important first step to get started.

Advantages of Investing in Real Estate

Cash Flow Plus Upside

Real estate can provide current cash flow (if it is leased to third parties), as well as an opportunity for appreciation if the value of the underlying property increases during your period of ownership. As a consequence, investors can achieve substantial benefits by leasing for more than what the property costs to own and operate. Even better, some real estate investments are structured to pass through depreciation and other tax deductions to owner-investors, thereby sheltering a portion of the distributable cash flow. You may also generate returns on your investment (capital gains) if you are able to sell the property for more than what you paid for it.

Low Volatility

Real estate values do not fluctuate as often or as dramatically in the short-term as many other popular types of investments. Changes in value that happen quickly are often attributable to a “value-add” strategy – the owner’s investment in capital improvements or changes in property management practices intended to make a significant and immediate impact on property values and/or rental rates. For this reason, owning real estate adds diversity to your portfolio with less exposure to market volatility.

Leverage Options

Real estate investors can use loans to buy real estate with a smaller outlay of initial capital, as well as to improve cash flow. The loan will create a mortgage secured by the property. If net income generated from operating the property (meaning proceeds available after all property expenses are paid, including real estate taxes and insurance) exceeds the cost of the loan (i.e., the amount of mortgage interest paid during the loan term), you can generate cash flow from dollars you borrow in addition to income from the equity you invest. The cost of the loan and the benefit it will generate for you depend on factors such as the size and type of the property, the amount of leverage you require (i.e., the size of the loan in comparison to the cost of the property), the credit of your tenants, and your experience in operating similar investments. In the meantime, using a loan allows you to put your own capital toward other uses. A loan or equity line of credit can also be used to improve a property and make it more profitable, especially while interest rates are comparatively low.

Active Management or Passive Investment

While many people invest in real estate by purchasing a property directly, you can also invest passively in a real estate project managed by others. These options include investments in real estate private placements (as through syndications or crowdfunding) and purchasing shares in real estate investment trusts (REITS).

These types of investments are typically managed professionally by individuals and firms with expertise in the applicable market and asset class. Opportunities may include a single property or a fund with multiple assets. Investors must conduct their own due diligence on the manager or sponsor of the investment, and familiarize themselves with the underlying real estate and/or investment strategy since the day-to-day operations, as well as matters relating to acquisition, disposition, leasing and financing (including property-level due diligence) are typically handled by professionals. If you do manage your own real estate, you can profit from your own labors and make decisions about how the property will be operated. You can also decide how long you want to hold your investment and take charge of your own exit strategy when you are ready to sell.

Tax Benefits

In addition to cash flow and profits from appreciation at the time of sale, a real estate investment can provide tax benefits. These may include annual deductions for depreciation or interest expenses. Furthermore, there are provisions in the federal tax code to enable you to defer payment of capital gains when you reinvest real estate sale proceeds into another property (i.e., 1031 exchange or a Qualified Opportunity Fund), or to receive a dollar-for-dollar tax credit for investing in certain kinds of low-income rental housing (LIHTC). Note that these tax benefits do not flow through to investors in REITS, which are treated like securities for certain tax purposes, but they may be applicable to private placements and direct (self-managed) investments.

There are also state and local programs that provide owners or developers with real estate tax incentives for projects that spur economic growth in the neighborhood, reduce automobile traffic, or provide other benefits to the community. These types of benefits help owners of real estate to operate more competitively and achieve greater profits while minimizing the risk of development in a less desirable location.

Broad Range of Risk Profiles

While buying real estate involves some degree of risk, real estate offers a broad spectrum of risk profiles to suit your particular tolerance. A successful real estate investment can line your pockets generously, while a failed one can set you back or potentially lose your entire principal. A ground-up development, for example, will have a greater degree of risk than the same property will have once it is fully constructed and leased. A “value add” opportunity, where an existing property is upgraded or repositioned in some way, should have a risk profile somewhere in between. A single-user property may provide secure cash flow if you have a financially strong tenant, but it is an all-or-nothing proposition. A multi-tenant property, in contrast, may generate more variable levels of income as rental rates fluctuate over time, and turnover costs for shorter-term leases can add up.

There are many factors that can affect the risk of an investment, so it is important to understand the particulars before you commit your funds to a project.

Disadvantages of Investing in Real Estate

No Hedge Against Downside

Unlike savings or money market accounts, where your original principal is effectively certain to remain intact, it is possible to lose your entire investment if a real estate project is unsuccessful. There is no federal insurance program that covers funds invested in real estate projects (such as FDIC insurance for bank accounts) or protects you from the failure or malfeasance of a sponsor of a real estate investment (such as SIPC protection for securities brokerage accounts). In spite of all parties’ good faith and best efforts, you may find yourself unable to sell a property for as much as you originally paid for it when you are ready to exit the investment. In some cases, such as during the Great Recession, you may not be able to sell your property at all. Or, you may be unable to find ways to generate sufficient income to cover your taxes, insurance and operating expenses.

Financing Risk

The primary risk of using leverage for buying real estate is that debt service on the loan must be paid before owners receive distributions of net cash flow (after payment of expenses). And, the outstanding loan balance must be satisfied before the owner can receive sale proceeds. These concerns are heightened if the loan has personal recourse to the borrower, as described below. Additionally, most loan agreements have covenants to allow the lender to sweep or impound cash flow if things go wrong (e.g., unanticipated vacancy, key tenant insolvency), even if the problem is caused entirely by tenants or other third parties. Failure to comply with the terms of a loan agreement can result in penalties or fees, loss of control over property operations and perhaps even foreclosure.

An additional type of financing risk is a loan with a prepayment penalty, or “defeasance,” which arises primarily in the context of a commercial loan. These provisions may make it very costly for you to sell the property earlier than originally anticipated.

Potential Personal Recourse

If you have personally guaranteed a mortgage loan for the property, then it is crucial for your investment to perform as projected. If you are not able to fully perform your loan obligations (regardless of who or what caused the problem), the lender may be able to foreclose and/or recover any deficiency from your personal assets unrelated to the real estate. This risk can be mitigated by (a) purchasing property on an all-cash basis; (b) obtaining a non-recourse loan if possible; (c) using a lower amount of leverage in comparison to the cost of the property (which lowers your risk of non-payment due to lack of cash flow and may permit you to have more lenient loan covenants); or (d) paying down your principal loan balance as quickly as possible, assuming prepayment is permitted.

Reliance on Tenants

If you lease your property for rental income, your success is dependent upon the existence and performance of your tenants. You must keep your property occupied at a profitable rental rate and minimize downtime between tenancies. You must make predictions about whether prospective tenants will be able to perform their financial obligations, holdover on their tenancies or vacate the premises prematurely, interfere with other tenants or neighboring properties, or require you to incur unusually high maintenance or improvement costs. Advance research of the financial wherewithal of your potential tenants, through credit checks, review of financial reports, or tenant interviews, is an important area of due diligence to complete before you sign a lease. To the extent possible, you should seek guarantees of payment and performance from a well-capitalized and credit-worthy guarantor for each tenant, or obtain security deposits to defray the cost of tenant non-performance.

Illiquidity

Real estate investments can be difficult to exit or liquidate on short notice, even at a loss. Because real estate is not directly traded on public exchanges, it may take considerable time and effort to find a buyer for your property at a price acceptable to you.

In addition to the time needed to negotiate a purchase and sale agreement, a third-party buyer will require some period of due diligence to inspect the property, review financials, verify the legal and environmental status of the property, obtain any necessary financing, and to close.

However, obtaining a buyer at a favorable price is not always possible. If you have a commercial loan on your property, there are frequently steep penalties to pay off the debt early (defeasance), or fees to assign the loan to your buyer (assuming the lender consents to an assignment). If your investment is a fractional interest in a larger deal, such as a private placement, there are not always secondary markets to sell your interest to a third party at any price, and the private placement documents may limit or preclude you from transferring your interests.

Most Opportunities Have Minimum Net Worth Requirements

While stocks, bonds and mutual funds are generally available to anyone with sufficient cash to cover the purchase price, investing in real estate requires a degree of financial wherewithal. Many private placements offered in compliance with federal securities laws are generally available only to “accredited investors” – individuals with a net worth (excluding their primary residence) of at least $1 million, or annual income in excess of $200,000. If you are purchasing real estate with a mortgage, the lender will require you to have income or assets to support your borrowing if you are guaranteeing the loan. Even in the case of an all-cash acquisition, sellers are more likely to choose a potential buyer with a strong balance sheet, as that party has a greater likelihood of actually closing at the agreed-upon sale price.

Buying Real Estate Comes with Certain Risk Factors

As noted above, there are a number of factors that can make a real estate investment more or less risky. It is important to have a good understanding of your tolerance for these various types of risk before making an investment.

Geographic Location

Location can help or harm a prospective investment. Factors such as high population density, local employers and job growth, access to highways, parking and public transit, stable or growing average household income, and local amenities can help boost occupancy and reduce risk.

Negative demographic trends, lack of support from local government, a local economy that relies heavily on one or a small number of industries, or the closure of nearby businesses or amenities may adversely affect an investment. Other general geographical risks include the potential for damaging storms or extreme temperatures; this risk may sometimes be mitigated with insurance.

Asset Class

Some classes of assets are arguably riskier than others, with all other factors (like location) being equal.

For example, hotels—where operating revenues can vary based on occupancy and rates—have more volatile cash flow than a commercial property with long-term leases and tenants with strong credit. Some people believe that retail properties are especially risky at the moment due to the “Amazon effect.” Whether this is true for a specific investment depends, among other things, on the number and type of tenants, the goods or services they provide, the property’s location and proximity to potential customers, and the style of building (e.g., enclosed mall, strip mall, outlot or stand-alone storefront).

Risks specific to office properties include trends to reduce the overall office footprint, whether due to telecommuting, “hoteling”, co-working facilities, or eliminating paper file storage, as well as changing tenant appetites for open floor plans and collaborative space. At a minimum, office investors should ensure that they plan for sufficient reserves to address these types of tenant improvement requests as they arise.

For industrial properties, outsourcing manufacturing may impact the long-term viability of a plant, or the tenant may require substantial tenant improvement allowances to adopt new technology and lay out equipment in the building. The need for warehouse space in general is increasing as more goods are ordered online and stored in “last mile” distribution centers. Older facilities may have insufficient clear height or poor layouts to accommodate current tenant needs.

Apartments are currently a strong asset class, as many people are renters by choice, have credit that does not enable them to qualify for a loan, or simply cannot afford a down payment. However, as more apartments are constructed, especially in large urban centers, the appetite for tenant amenities is evolving. Owners must be prepared to invest in unit and common area upgrades to attract and retain tenants. Further, options like “micro-apartments” and adult co-living are competing with traditional apartment-style living.

Medical facilities are also highly desirable, especially if they are leased to a single user such as a hospital or large institution. Depending on the type of medical services provided and equipment on the premises, the tenant may have a difficult time relocating once it is in place. However, if tenants do leave, the configuration of the space may make the property difficult or costly to repurpose for another type of tenant.

Tenants

The nature and number of tenants at the property, and the duration of their lease terms, will also impact investment risk. If a property has a single tenant, the success of the investment depends on the economic viability of that tenant. The terms of the tenant’s lease and the costs of retaining or replacing that tenant when its term expires are also important factors.

A greater number of tenants can protect you from having an all-or-nothing income stream. But, you may spend more time and resources keeping the property fully leased, maintaining common areas, and ensuring that all of the tenants timely pay rent and perform their lease obligations. If rents fluctuate in the market, properties with greater tenant turnover will be impacted at their bottom line more quickly.

Financial Risks

There are also a variety of tools available to help mitigate financial exposure in a real estate project.

• Obtaining lease guarantees and/or substantial security deposits, and maintaining operating capital and additional reserves can reduce the impact of changing tenant tastes, a tenant default, or unexpected property damage.
• Using professional property managers or working with experienced, full-time real estate sponsors can help you avoid potential problems before they arise, and to promptly resolve issues before they escalate.
• Keeping any leverage at a lower loan-to-value ratio can help reduce your risk of a loan default if rental incomes decline.
• Obtaining adequate insurance coverage and implementing good security measures at your property can provide peace of mind, as well as practical assistance if a problem should occur.
• If you are investing with partners or a third-party sponsor, do your homework on the people involved and carefully draft and read your agreements with those parties. Understand who is responsible for what, and if you may be liable for future capital calls.

Real estate can be an important and lucrative addition to your investment portfolio. You must be certain to conduct your own due diligence in order to assess the risks and evaluate whether those risks are consistent with your financial objectives. It is always prudent to consult with your own financial advisors to help you determine whether buying real estate as an investment is a good fit for you.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Basics of Real Estate Syndication and Investing in Commercial Real Estate. This is an updated version of an article originally published on June 19, 2018.]

Read more: Real Estate Due Diligence: A Simple Guide for Investment Properties