Investing Activity - Risk Management in Real Estate Investments

Prepared by Jonathan Kappler

A significant part of the American Dream is the fact to own a house. Many Americans want to fulfill this desire and purchase real estate to get away from renting homes. Though investing in real estate does not only mean to use a house for living purposes, but also for rises in value and for retirement arrangements. Buyers should be aware that investment in real estate is not just a banking investment like a savings account. The economic background of real estate is dependent on numerous factors which also might lead to losses. The purchase of real estate is a long-term investment which includes many different types of risks which can occur during possession. However, there are ways to measure and mitigate some of these risks. In the following research paper several types of risks and ways of risk management for the investment in real estate will be demonstrated.

A factor which can influence an investor’s return when investing in real estate is capital market risk. Capital market risk is the daily volatility of prices on the international stock markets which consists of changes in interest rate, inflation rate, and exchange rates.[1] Every investor of real estate has to deal with this type of risk. It is almost impossible to predict the mentioned changes on the worldwide capital markets. However, a way to measure potential capital market risk is by monitoring the trend of international capital markets.[2] In case of conducting a real estate transaction it is very important to consider appropriate timing. If there is no pressure of time to make a good purchase, a way to mitigate capital market risk is to wait for low interest rates for example. Sometimes waiting for the right moment is not possible for many buyers; however, changes in market conditions cannot be positively influenced or completely mitigated. Another way how to manage market risk will be shown later on.

Many investors who use the investment in real estate for long-term retirement arrangements strive to gain rental incomes from tenants. However, the purchase of real estate also involves expenses such as covering debt services and to maintain the value of the property.[3] Many buyers tend to spend the monthly proceeds immediately which come from renters. It is hard to measure the shortfall of money because when most people realize they ran out of money, they cannot cover their expenses anymore.[4] For this reason, investors should be aware to create a reserve account to save their positive cash flows. With these savings debt services can be covered and money can be invested in the property to replace short-lived components which wear over time.[5] It is very important to keep the property attractive over time of possession for the purpose of reselling and value. The way how investors manage this type of risk is up to the individual because it can be influenced very easily.

Finally, for those people who choose real estate as a portfolio investment the most effective way to mitigate risk is diversification. By diversifying a portfolio, the invested capital will be spread in many different sectors. Possible sectors next to real estate would be the investments in stocks, bonds, and the money market.[6] Systematic and unsystematic risks can be distinguished in a portfolio.[7] For both risks, there exist ways to measure it. The risks can be measured by calculating beta-coefficients and other ratios.[8] The relation between both risks tells us if the assets are more influenced by the market development as mentioned above or by operational features. An appropriate and well-known phrase which can be mentioned referring to risk diversification is: “Don’t put all your eggs in one basket”.[9]

To sum up, it can be seen that several risks can occur and have to be considered when an investor purchases real estate. However, only a few types of risks have been demonstrated. There are many other risks that exist. Sometimes it is not easy to measure these risks, such as the occurrence of specific market trends. However, for some types of risk there is a way to manage and mitigate them. Thus, before deciding to make an investment in real estate, research of existing risks and timing can be very significant for the future possession of a property. Nevertheless, real estate investors will always confront risks but these cannot be fully eliminated. Thus, risk management can be a very valuable tool for investors when investing in real estate.

References:

[1] http://www.investopedia.com/terms/m/marketrisk.asp (online), retrieved 5/1/11.

[2] Martha S. Peyton, Ph.D. and Steven Bardzik, Ph.D. “What is Risk Management and How Does It Apply to Real Estate?”. 2008.

[3] http://www.corus-partner.de/immo_kriterien.php (online), retrieved 4/29/11.

[4] http://www.totalrealestatesolutions.com/articles/disp.cfm?aid=192&typeid=1 (online), retrieved 5/5/11.

[5] Hansz, Andrew J, and Julian Diaz III. “Real Estate Analysis: Environments and Activities”. Dubuque, Iowa: Kendall Hunt, 2010, p. 236.

[6] Hansz, Andrew J, and Julian Diaz III. “Real Estate Analysis: Environments and Activities”. Dubuque, Iowa: Kendall Hunt, 2010, pp. 243-244.

[7] http://www.investopedia.com/university/risk/risk2.asp (online), retrieved 5/6/11.

[8] http://www.marketoracle.co.uk/Article12274.html (online), retrieved 5/6/11.

[9] http://en.wiktionary.org/wiki/don't_put_all_your_eggs_in_one_basket (online), retrieved 5/6/11.