Understanding risk management in real estate is crucial to building a lasting real estate portfolio. There will always be inherent risks to consider, prepare for, and mitigate against in real estate investing, regardless if you're buying commercial real estate or residential property. Being proactive and educating yourself as to where risks lie can save you a lot of time, money, and headaches in the long run. To help you stay ahead of the curve, here are some of the most common real estate risks a real estate investor may face and ways to diminish those risks before they become an issue.
Dealing with risk in real estate
To a degree, real estate risk is inevitable. Some risks can be avoided altogether, while others can be reduced by transferring risk or controlling it on an ongoing basis. While there are many creative risk reduction solutions, they fall under three main categories:
- Risk avoidance: Avoiding a clearly defined risk is one of the best ways to eliminate it. For example, if you want to avoid potential unintentional drowning lawsuits, don't buy properties with pools or hot tubs.
- Risk control: Not every risk can be avoided, which is why risk control is the most common mitigation strategy. Maintaining a property before problems occur or having the proper precautions in place, such as a gate or lock around the pool or hot tub, are examples of risk control.
- Risk transfer: Transferring certain risks is another way to protect yourself and is often used in addition to other mitigation strategies. An example is having the proper property insurance with coverage against potential unintentional drowning lawsuits that cover properties will pools, which transfers the risk from you as the property owner to the insurance provider.
The real estate market is constantly changing. Economic circumstances and financial conditions, as well as supply and demand, will all impact the profitability and success of a real estate investment at a given time. The real estate market is cyclical, meaning it's not a matter of whether market conditions will change, but when.
Ways to mitigate
Real estate is extremely localized, so diversification is one of the best ways to mitigate risk. Owning a variety of asset classes in different sectors or owning in different markets reduces your risk exposure.
Right now, several cities in the Rust Belt and Southwest are benefiting from an increase in rental demand, high occupancy, and stable rental rates, while major metro markets in the Northwest and Northeast are suffering from a decline in demand, lowered rental rates, and high vacancy rates. Having assets in multiple markets reduces risk from market downturns in one centralized market.
The same goes for owning a variety of asset classes. Industrial real estate has fared rather well during the global pandemic, while retail, hotels, and office space have had a super tough time.
Another way to control risk is by making sure your real estate portfolio isn't overleveraged and substantial reserves are maintained. That way, when a market downturn occurs, you have enough liquidity to maintain the real estate investment until the market recovers.
Keeping an eye on market conditions is also helpful in controlling risk. If the market is high, it could be beneficial to sell that asset, recapitalizing the business or moving into a newer asset to help avoid obsolescence over time.
Litigation is another big risk real estate investors face. It's important to have the proper protections in place to help cover the cost if someone gets injured on your property or files a suit against you for wrongful eviction, breach of contract, failure to disclose a defect, or other litigious matter.
Ways to mitigate
All three risk mitigation strategies come into play when it comes to legal risk. Some risk can be avoided altogether, but only to a point. It's crucial investors are knowledgeable of and stay informed of current local, state, and national laws regarding real estate and remain compliant with these laws. Make sure contracts, leases, loan documents, or other underwriting measures are drafted and reviewed by an experienced attorney.
Despite following the rules, tenants, borrowers, and other real estate professionals can always dispute an eviction or foreclosure or take other legal action against you as the landlord, property owner, or lender, even if you've done everything right. That's where risk transfer comes into play.
Purchasing general liability insurance can help cover property damage claims, medical costs if someone is injured on the property, and legal fees or settlement claims regarding suits. Errors and omissions insurance is another form of liability insurance that covers issues relating to employee relations with clients. This can be particularly helpful if an employee goes rogue and a suit is filed against the employee or real estate firm.
It's always a good idea to have proper (organized) records of all financial transactions and borrower, tenant, and investor communications, and make sure you are operating legally. In the event of a lawsuit, you can use this information to validate your position. However, if you do keep files or communicate digitally, make sure this data is protected. Cybersecurity claims are becoming more prevalent. Work with operating systems that explain their data security protocols and procedures, and make sure systems are in place to protect sensitive data.
Hurricanes, tornadoes, earthquakes, fires, wind damage, hail, or other environmental factors can cause damage to your property.
Ways to mitigate
One way to prevent environmental risk is by avoiding purchasing real estate in high-risk areas like Florida, the Northwest, or Gulf Coast. But as environmental activity increases across the country, finding property in an area with no exposure to environmental risk is rather difficult. Instead, investors can transfer their risk exposure by having property insurance. Property insurance covers costs related to property damage from most environmental situations but may require additional policies or coverage like flood insurance or hurricane riders to cover named storms.
Property damage isn't just limited to environmental factors. People can also cause damage to your property. Stolen equipment from a construction site, someone breaking in and stealing copper wires, tenants trashing their place on the way out, dealing with squatters in a vacant property as you foreclose, or accidental damages from construction on-site are all risks investors face.
Property deterioration is also a concern. Real estate needs to be maintained and improved upon over time to prevent potential hazards from those visiting or occupying the property.
Ways to mitigate
Property insurance will also provide protection for property damage made by tenants or other third parties. However, communicate with your insurance provider if the property is vacant or occupied, and make sure the policy provides adequate coverage. Lenders foreclosing on a property in which the borrower has let their property insurance lapse or if there's no proof of insurance can purchase force placed insurance, which protects the lender's position if the property is damaged.
Transferring risk through property insurance will only take you so far. Investors also have to control risk by maintaining the property. Keeping up with repairs and updating certain property features to comply with current code and safety requirements will help reduce potential hazards tenants or others may face.
Being proactive about this before an issue is reported is ideal. Install proper lighting, security cameras, gates, fences, or other safety measures like smoke detectors and fire exits. Give particular attention to things that could be seen as potential slip-and-fall or other hazards, like rusty or slippery stairwells, broken windows, or cracked cement or flooring.
Address risk before it happens
The risks above aren't all investment risks but are some of the most common. General liability insurance and property insurance are two of the best ways to mitigate real estate-related risks, but being educated and informed on additional risks and the best ways to prevent, avoid, or transfer that risk is by far the best thing investors can do.
Speak with experienced professionals like an attorney and accountant to ensure your assets and business are adequately protected. Conduct or hire a company to conduct a risk assessment, which looks at your business structure, business procedures, real estate portfolio, property, legal documents, and communication systems to identify areas of weakness or risk. This can help you address potential issues before there's a problem.