Monday, April 27, 2020

What are the various kinds of risks involved in real estate investment? And what should you as an investor do to minimize those risks?

Author: Sachin Gupta | Find me on Twitter

Any kind of investment whether in Gold, property, stocks, bonds, etc. is subjected to certain risks. While Government securities are considered risk free, there is still some amount of risk involved in those. What if the government defaults as has happened in some of the EU nations? Consciously or unconsciously people do their risk analysis before making any investment. In this post, we will analyze the risks that are involved in real estate investment. Whether one is investing a small amount or substantial amount, going through this risk analysis will help you in foreseeing the potential risks that can creep in your real estate investments.


  • Business risk:

Property investors suffer due to fluctuations in economic activities that affect the variability of rental income generated by the property. Changes in economic conditions prevailing in the country often affect some properties more than others depending on the type of property, its location, and any existing leases. For commercial properties, particularly office space buildings, a property with a well diversified tenant mix is likely to be less subject to business investment risk. Lease deeds that provide the owner with protection against unexpected changes in expenses (e.g., with expense stops in the lease, or leases indexed to WPI, etc.) would have less business risk. Changes in the economic conditions also affect the residential property investors who are primarily looking for capital appreciation gains on the property. With economy slowing down, the capital yields goes drastically down as can be seen in the latest housing price index across many cities in India.


  • Financial risk:

The use of debt (financial leverage) magnifies the investment risk. Financial risk is directly proportional to the amount of debt taken to finance the purchase of property. Based on the prevailing interest rates, the financing costs may go up and eat into the income generated by the property. Financial risks affect both commercial and residential property investor due to the financial leverage. The cost of financing goes up or down depending on the economic situation and prevailing interest rates.


  • Liquidity risk:

This risk occurs when a continuous market with many buyers and sellers and frequent transactions is not available. The more difficult it becomes to sell a property, the greater the likelihood that owner will have to under-sell the property in order to dispose of the investment quickly. Sometimes, it can take from six months to a year or more to sell real estate income properties especially during period of weak demand. We have seen many cases in recent past when investors were forced to undersell because of slow property transactions across the country.


  • Inflation risk:

Unexpected inflation can reduce an investor’s rate of return if the income from the investment does not increase sufficiently to offset the impact of inflation. To overcome this risk, use of leases that allow the Net Operating Income to adjust with unexpected changes in inflation is applied. Higher inflation also eats into the capital gains that are sought by many housing investors.


  • Management risk:

The risk is based on the capability of the management and its ability to negotiate leases, respond to economic conditions, and operate/maintain the property efficiently. Even in case of residential properties, with outdated tenant laws across India, we have seen how difficult it gets for the manager or owner to get hold of their property. Therefore, as is the case in commercial properties, property owners must go for registered leases for residential properties as well.


  • Interest rate risk:

Real estate tends to be highly leveraged and thus the rate of return earned by equity investors can be affected by changes in interest rates. Most mortgages are of floating interest rates in India and therefore any monetary policy changes by RBI is keenly watched by the real estate investors. Even if an existing investor has a fixed interest rate loan or no loan at all, the change in the monetary policy by RBI by increasing the level of interest rates may also lower the capital value of a property that a new buyer is willing to pay.


  • Legislative risk:

Regulations such as tenant laws, taxes, registration procedures, stamp duty, restricted use of property, zoning, and other restrictions imposed by the state bodies or municipalities are categorized as legislative risk and must be factored in by the investors.


  • Environmental risk:

Environmental risks such as constructing or buying property in areas where the land use policy is under jurisdiction and therefore have the possibilities of adversely affecting the returns on investment.


Having gone through the above risks, a property investor should do his/her due-diligence before investing in a property:

  • Review of title/deed documents
  • Property survey
  • Government compliance
  • Areas of review/locality
  • Physical inspection
  • Tax matters
  • Insurance policies
  • Pending dues
  • Market studies including the demand for the similar property
  • Review of rent agreements or lease deeds in case the property is already rented.




Have any Questions?

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