Real Estate Investment: As Safe As Houses?
Usually, Investors use the term to refer to an extremely safe investment with the phrase ‘As Safe As Houses’. This shows the typical mentality that real estate is the safest option of investment. The old school chain of thought believes that real estate investing is largely risk-free and provides the best hedge against inflation.
However, the world has recently discovered after multiple real estate crashes that the houses aren’t as safe as they were considered to be. This article enumerates the various risks that an investor has to face while investing in real estate properties. Some of the common risks are as follows:
Risk of Bad Tenants
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.
Real estate investments are probably the most illiquid as compared to all other investments. This is because the amount of money required for real estate investments is huge and it takes a huge commitment from the personal finances of any investor.
Therefore, in case you are a real estate investor and want to exit a property, there is no ready market which will provide minute to minute quotes regarding your property. Also, the buyers who are willing to enter into such a huge transaction are few and far between.
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!
A lot of individuals that buy real estate usually buy unfinished units. Unfinished units are generally cheaper, and developers are willing to provide more favorable financing. However, buying under construction units also carries some serious risks.
The investors become vulnerable to default by the developers. Also, many times the developers are unable to get the required permissions from the local authorities. As such the project gets delayed. As a result of this delay, buyers end up losing a portion of their investment as they have to continue to pay rent.
Thus, real estate investment projects are prone to counterparty risks. Investors need to be diligent and have a plan to mitigate such risks.
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!