This article analysis a few risks that are associated with real estate investments.
Lack of Solid Market
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 people’s 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.
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 let’s 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.
Lack of Proper Information Channels
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.