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

Investing for Beginners

Many people are reassessing their financial portfolios to make them more resilient. Owning real estate is a time-tested strategy to diversify your investments and protect from volatility in the stock market. This asset class can even provide some tax advantages.

But how do you get started?

There are plenty of real estate investment options, whether you’re looking to rent out a property yourself or make passive investments through a professionally managed product. Like the stock market, real estate can have a range of risk profiles, and property can be held for a time horizon that best suits your needs.

Before pursuing real estate ownership it is important to make sure you understand the benefits, challenges, and risks as well as all options available.

Advantages of Investing in Real Estate

Cash Flow Plus Upside

Real estate can provide current cash flow if it is leased, as well as an opportunity for appreciation if the value of the underlying property increases during your ownership. As a consequence, investors can achieve substantial benefits by leasing to others for more than what the property costs to own and operate.

Some commercial properties have ‘net leases’ where the tenants are responsible for payment of all operating expenses, insurance costs, and taxes, making it easier for owners to predict their potential cash flow. 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 if you can sell the property for more than what you paid.

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 more quickly are often attributable to a ‘value-add’ strategy, the owner’s investment in capital improvements, or changes in property management practices, all of which are intended to make a significant and immediate impact on property values and or rental rates. These types of changes are intentional, allowing you to predict their likely impact on cash flow and ultimate property value. In this way, 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 commitment of initial capital and often as a way to improve cash flow. For example, the loan creates a mortgage secured by the property. If the net income generated from operating the property exceeds the cost of that loan, cash flow can be realized both from the initial capital borrowed as well as the income from the equity invested. The loan, an equity line of credit, or net operating income generated can also be used to improve a property and make it more profitable, especially when interest rates are comparatively low.

The cost of the loan will depend on several factors, including the size and type of the property, the interest rate, and the amount of leverage required, i.e., the size of the loan in comparison to the cost of the property. Note that as interest rates are comparatively high, it is important to understand the cost of borrowing before you take on a mortgage. As discussed below, your lender may also require you to personally guarantee the loan. The ultimate benefit you will derive from leverage will depend on the factors above, as well as the credit of your tenants and your experience in operating similar investments.

If you manage your own real estate, you can profit from your own labor 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 exit strategy when you are ready to sell. However, directly managing a real estate investment can come with challenges, so it is often a good idea to enlist professional help if issues arise that are beyond your personal expertise to solve, even though these costs may eat into your ultimate profit.

Passive Investment

While many people invest in real estate by purchasing a property directly, you can also invest passively in a project managed by others.

Options for passive investment include real estate private placements through syndications or crowdfunding, and real estate investment trusts (REITs). Opportunities within these passive investment categories 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, the tenants, especially if they are businesses, and the investment strategy.

Passive investments are typically managed by professionals and firms with expertise in the applicable market and asset class. These professionals will manage the day-to-day operations, as well as matters relating to acquisition, disposition, leasing, and financing, including property-level due diligence.

Passive investments often require less initial capital than the outright purchase of a property and can provide you with an opportunity to see how people with real estate expertise operate their businesses. Depending on the investment, they can also provide regular cash flow distributions and/or upside potential.

Tax Benefits

In addition to cash flow and profits from appreciation at the time of sale, a real estate investment can provide several tax benefits, including annual deductions for depreciation or interest expenses.

There are provisions in the federal tax code to enable you to defer payment of capital gains and depreciation recapture when you sell real estate and reinvest the proceeds into another property. Examples include the 1031 exchange, UPREIT or 721 contributions, and Qualified Opportunity Funds. Note that these tax benefits do not flow through to investors in REITs, which are treated like securities for income tax purposes, or to investments made with funds in a retirement account as these are already tax-advantaged. These tax benefits may apply to private placements, some real estate funds, and direct (self-managed) investments.

There are also federal, 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, create affordable or low-income housing, and provide other benefits to the community. These types of benefits help owners operate more competitively and achieve greater profits while minimizing the risk of development in a potentially less desirable location.

Risk Profiles

While buying real estate involves some degree of risk, this asset class offers a broad spectrum of risk profiles sure to appeal to many investors.

Many of the risks are tied to the general investment strategy or structure:

• A ground-up development 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 ground-up development and a fully constructed and leased property.
• 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 may generate more variable levels of income as rental rates fluctuate over time, and turnover costs for shorter-term leases add up.
• Disagreements with partners and other difficulties with management can also impact the success of an investment.

Risk Factors

In addition to the risks inherent in the various profiles mentioned above, there are several risk factors that can make a real estate investment more or less risky.

Asset Class

Some real estate is inherently riskier than others, with all other factors, like location, being equal. For example, hotels, parking facilities, and self-storage, where operating revenues can vary based on occupancy rates, have a more volatile cash flow compared to commercial property, which brings long-term leases and tenants with strong credit. It is helpful to think of these types of properties as both real estate projects and an investment in an operating business.

Retail Properties

Some people believe that retail properties have been risky over the past decade due to inflation, the ‘Amazon effect,’ and the decline of enclosed malls, while essential retail such as groceries and pharmacies have been competing with their own online pickup and delivery services. 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, i.e., enclosed mall, strip mall, outlot, or ’Main Street’ storefront.

Office Properties

Risks specific to office properties include recent trends to reduce or even eliminate the overall office footprint, including the transition to remote and hybrid arrangements and paperwork reduction. Tenant appetites for property features like private offices, open floor plans, natural light, outdoor space, improved HVAC, and shared workspaces are also causing some disruption in this market.

Thankfully, some of the upheaval precipitated by the pandemic is beginning to settle as companies determine what works best for their employees and their productivity. At a minimum, office investors should ensure that they set aside sufficient reserves to address tenant improvement requests as they arise.

Industrial Properties

For industrial properties, the tenant may require substantial improvement allowances to adopt new technology and reconfigure equipment in the building. The need for warehouse space in general is changing as more goods are ordered online and stored in ‘last mile’ distribution centers.

Residential

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, the appetite for tenant amenities is always evolving, and remote work has allowed some people to live far from traditional urban centers. Owners must be prepared to invest in unit and common area upgrades, including space for home offices, to attract and retain tenants. Options like ‘micro-apartments’, rental homes, and adult co-living are also competing with traditional apartment-style living.

Medical Facilities

Medical facilities remain 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 the next tenant.

Tenants

The nature and number of tenants at the property and the duration of their lease terms will also impact investment risk. The success of single-tenant properties will depend on the economic viability of that tenant. The terms of the tenant’s lease and the costs of retaining or replacing that tenant when their lease 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 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, for better or for worse.

Geographic Location

Factors such as local government, population density, diversity of employers, job growth, access to highways, parking, public transit, household income, and local amenities can help or harm a prospective investment. Other general geographical risks include the potential for damaging storms, fires, or extreme temperatures; this risk may sometimes be mitigated with insurance.

Disadvantages of Investing in Real Estate

While a successful real estate investment can line your pockets generously, an unsuccessful one can set you back or potentially deplete your entire principal.

As we’ve shown 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. Thorough due diligence can help you mitigate some of these risks. Below we’ll walk through some of the major disadvantages to owning 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 fails.

There is no federal insurance program that covers funds invested in real estate projects, such as FDIC insurance for bank accounts, or that protects you from the failure or malfeasance of an investment sponsor, such as SIPC protection for securities brokerage accounts.

Despite 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, 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 the debt service on the loan and all operating expenses must first be satisfied before any net cash flow can be realized. Debt service includes interest expenses, which may be at a fixed or variable rate, as well as ongoing fees charged by your lender. Upon disposition, the outstanding loan balance must be satisfied before the owner can receive sale proceeds. These concerns are heightened if you have personally guaranteed the loan.

Most loan agreements have covenants that allow the lender to sweep or impound cash flow if things go wrong, i.e., unanticipated vacancy, key tenant insolvency, decreases in rental rates, or delays in lease renewal, even if the problem is caused entirely by tenants or other third-parties. If your loan is maturing under its terms, you will need to either refinance or pay off the outstanding mortgage balance.  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 your investment must 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 assets unrelated to the real estate.

The risks associated with personal recourse 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, either with amortizing debt or a loan where 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 tenants. 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. This is true even if your property is located in a robust seller’s market.

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, structural, and environmental status of the property, obtain any necessary financing, and close. However, obtaining a buyer at a favorable price is not always possible, especially if the real estate market or interest rates change during your ownership.

If you have a commercial loan on your property, there are frequently penalties to paying off the debt early, such as defeasance or swap breakage or fees to assign the loan to your buyer, assuming the lender consents to an assignment. Even if you do not have a mortgage loan yourself, your potential buyer may need one. If your investment is a fractional interest in a larger deal, such as a private placement or partnership, there are not always secondary markets to sell your interest to a third party when you wish to exit, and the investment documents may limit or preclude you from transferring your interests.

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 individual income over $200,000 ($300,000 jointly with a spouse). Depending on the investment, you may be required to provide proof that you satisfy these requirements. This generally comes in the form of financial records or certification from a financial professional.

If you are purchasing real estate with a mortgage, the lender will require you to have income or assets to support the loan, especially 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 closing timely at the agreed-upon sale price.

Partners & Sponsors

If you are investing in real estate with partners or a third-party sponsor,  it is critical that you take the time to do your homework on all parties involved and have a firm understanding of everyone’s goals and experience at the onset. The written agreement among the parties should make everyone’s expectations clear before an investment is made. Be sure to carefully review your agreements with any partners or sponsors, particularly around liability and termination. There should be clear provisions about how decisions about operations will be made and how disagreements among parties will be resolved.

This particular element of the due diligence process can be even more important than the location of the real estate investment itself. If your partners are family or friends, don’t let your personal relationships prevent you from protecting yourself by conducting the proper due diligence.

Mitigating Financial Risks

Beyond doing your due diligence and selecting an investment with the most favorable risk profile, there are a variety of steps you can take to help mitigate your financial exposure in a real estate project:

• Buy property on an all-cash basis if possible.
• Keep any leverage at a lower loan-to-value ratio to reduce risk and exposure from a loan default.
• Obtain adequate insurance coverage.
• Implement good security measures at your property to provide peace of mind, as well as practical assistance if a problem should occur.
• Obtain lease guarantees and/or substantial security deposits from tenants.
• Maintain operating capital and additional reserves to reduce the impact of changing tenant tastes, a tenant default, or unexpected property damage.
• Enlist experienced, full-time real estate professionals, especially for aspects of the project where you lack expertise.

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

We think you’ll also like:

1. Real Estate Terminology Every Investor Should Know
2. 3 Real Estate Investment Types and Cash Flow Potential
3. The Complexity of Real Estate Investment Partnerships

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Real Estate Investing 101: Commercial Leases, Their Provisions and Pitfalls to Avoid
2. Real Estate Investing 101: Investing in Commercial Property
3. Real Estate Investing 101: Investing in Residential & Multi-Family Real Estate

This is an updated version of an article originally published on June 19, 2018 and updated January 27, 2020.]

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