Financial Poise
The Risks, Rewards and Challenges of Investing in Real Estate

The Risks, Rewards and Challenges of Investing in Real Estate

Get Started Investing in Real Estate

If you want to invest your savings prudently, there are plenty of alternatives available. Investing in real estate, savings accounts, stocks and mutual funds, hedge funds, precious metals, oil and gas and cryptocurrencies all each have distinct advantages, drawbacks, risks and rewards.

Real estate is an easy way to add diversity to your portfolio with a risk profile that best suits your needs. Understanding the benefits and challenges of owning real estate 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, it is possible to achieve substantial short-term and long-term returns on your investment.
  • Low volatility: While capital improvements can potentially make a significant and immediate impact on property values and/or rental rates, real estate values do not fluctuate as often or as dramatically in the short-term as many other popular types of investments, such as securities. Investing in real estate, therefore, can add diversity to your portfolio without exposing you to significant market volatility.
  • Leverage options: Real estate investors can use a loan to acquire 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) exceeds the cost of the loan (i.e., the amount of mortgage interest paid during the loan term), you can receive cash flow generated from dollars you borrow in addition to income from the equity you personally invest. In the meantime, the loan allows you to put your capital toward other uses. A loan or equity line of credit can also enable you to improve a property and make it more profitable, especially while interest rates are comparatively low.

Real estate investors can use a loan to acquire real estate with a smaller outlay of initial capital, as well as to improve cash flow.

  • 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 syndications (private placements) 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. While 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, the day-to-day operations, as well as matters relating to acquisition, disposition, leasing and financing (including property-level due diligence) are handled by the professionals. If you manage your own real estate, you can profit from your own labors and make decisions about how the property will be operated.

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  • Tax benefits: In addition to cash flow and profits from appreciation at the time of sale, a real estate investment can potentially 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 sale proceeds into another property (1031 exchange) or to receive a dollar-for-dollar tax credit for investing in certain kinds of low-income rental housing (LIHTC). 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 community. These types of benefits allow owners of real estate to operate more competitively and achieve greater profits.
  • Broad range of risk profiles: While investing in 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. 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. 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 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). 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. 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 investing in 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. Additionally, most loan agreements have covenants to allow the lender to sweep or impound cash flow if things go wrong (i.e., 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.
  • Potential personal recourse: The risk that a real estate investment will not perform as projected is heightened if you have personally guaranteed a mortgage loan for the property. 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. Avoid tenants who cannot perform their financial obligations, vacate the premises prematurely, interfere with other tenants or neighboring properties and require you to incur unusually high maintenance or improvement costs. To the extent possible, you should seek guarantees of payment and performance from a well-capitalized and credit-worthy guarantor.

Avoid tenants who cannot perform their financial obligations, vacate the premises prematurely, interfere with other tenants or neighboring properties and require you to incur unusually high maintenance or improvement costs.

  • 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. A third-party buyer will require some period of due diligence, in addition to the time needed to negotiate a purchase and sale agreement, to 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 syndication, there are not always secondary markets to sell your interest to a third party at any price. Plus, 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. 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.

Investing in Real Estate Comes With Certain Risk Factors

Geographic location can help or harm a prospective investment. Factors such as high population density, local job growth, access to highways, parking and public transit can help boost occupancy and reduce risk. Negative demographic trends, lack of support from local government or a poor local economy may adversely affect an investment. Other general geographical risks include the potential for damaging storms or extreme temperatures.

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

Negative demographic trends, lack of support from local government or a poor local economy may adversely affect an investment.

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, taking into account the goods or services they provide; the property’s location and proximity to potential customers; and the style of building (i.e., 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”, 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.

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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.

Sure, 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.

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

  • Obtaining lease guarantees and maintaining operating capital and additional reserves can reduce the impact of 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 if rental incomes decline.

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 of any given investment and to 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 a particular investment is a good fit for you.

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About Tracy Treger

Tracy is a Principal at Syndicated Equities where she helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas…

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