Seven Ways to Reduce Property Investment Risk

reduce property investment risk

Pursuing venues to reduce property investment risk is a wise strategy when investing in real estate since the income earned by a property, and particularly its Net Operating Income (NOI) and its resale price, are influenced by many factors that are out of the control of the investor. Of course, the acquisition of a commercial building fully-leased to strong credit tenants with long-term leases reduces significantly the risk of the income component of the investor’s return, but not the risk of considerable value declines. That is the case because at the time of liquidation the value of the property will depend to a large extent on the market rent that the particular property will command, even if there are existing leases with above-market rental rates. In any case, careful selection of property, location and lease/tenant characteristics can help reduce the risk of a property investment.

How to Reduce Property Investment Risk

Here are some strategies that real estate investors can follow, in order to reduce property investment risk and limit undesirable fluctuations in the property’s income-earning capacity and/or value:

(1) When investing in a specific market, the most important perhaps consideration from a risk point of view is to know what the more likely prospects of that market are. Although, the future can never be predicted with certainty (unless you have invented a time machine that can indeed travel to the future), thorough analysis and understanding of the historical behavior of a market, as well as econometric forecasts by experts about what lies ahead, can help better assess the future prospects of a market and a particular property type. It goes without saying of course that you should not invest in markets that based on reasonable and thoroughly analyzed forecasts, are expected to go downhill or just remain stagnant (unless you managed to close a terrific deal due to special circumstances pertaining to a particular property). Invest in property markets that have solid real estate demand-supply fundamentals and are expected to be growing.  This strategy will reduce (not eliminate) property investment risk from unexpected negative economic influences because even if a downturn hits due to the broader macroeconomic environment, your investment will probably do a lot better (or get hit less) than an investment in a real estate market that was predicted to decline or stay stagnant.

(2) Investing in the strongest locations (the ones that are in high demand because they have the strongest locational advantages) for the property type you are interested in, should also reduce property investment risk; strongest locations for office investments will likely be different from strongest locations for retail, industrial or apartments. Furthermore, you will want to assess whether there will be any developments (such as big transportation, infrastructure or other urban development projects) within the time horizon of your investment that will make other locations in the market considerably more competitive than the location you are considering. In the case of a portfolio of real estate investments, location diversification (still targeting strong locations but at different metropolitan markets) can also help minimize risk, as an economic downturn in one market will affect more the portion of the property portfolio in that market, and less or at all property investments in other metropolitan markets (assuming that they have been properly selected to provide diversification benefits).

(3) Invest in modern, high-tech, energy-conserving buildings. This strategy is likely to reduce risk because such buildings are more likely to stay in demand by good strong-credit tenants, even in the case of a demand downturn.

(4) Invest in multi-tenant as opposed to single-tenant buildings so that the loss of a tenant will result in a small loss of property income; on the contrary in the case of a single-tenant building, the inability to collect rent from that tenant or loss of the tenant will leave you with no income from that property.

(5) Tenant-mix is especially important for retail investments, as it is a crucial factor in maintaining a shopping center’s attractiveness even in bad times; in the case of office investments, a diverse tenant mix, composed companies that are active in different sectors of the economy, can also help reduce property investment risk. For example, having tenants that are all in the same industry is clearly riskier because if that industry goes downhill, the impact on the building’s NOI could be quite negative.  Avoid tenants that are active in a declining industry, if you can find tenants active in a stable or growing economic sector, even at somewhat lower rent.  These tenant-mix principles apply also within a property portfolio context.

(6) Invest in commercial properties with long-term leases and high-credit-score tenants. Long-term leases shield the property’s income from market rent fluctuations to a significant extent; have in mind though that as the expiration of these leases approaches this protection expires too since building income will have to adjust to market rents.  If these are considerably lower than the expiring lease contract rates, property income and value will decline significantly.  That is why having a mix of leases that expire at distinctly different time periods can also help minimize risk.

(7) Minimize property income fluctuations and losses by investing in triple-net leases that have the tenant pay for all operating expenses takes and insurance, which fluctuate from year-to-year; also if you can obtain rent guarantees from the seller for units or space that is vacant you could potentially avoid loss of income while trying to find tenants.


Completely FREE 48-page e-book Real Estate Math for our visitors. Download it from this page of our site. No email address or anything else will be asked of you.


Bibliography

Kolbe, P. T., & Greer, G. E. (Author), Gaylon E. Greer.  (2012). Investment Analysis for Real Estate Decisions, 8th  Edition. Dearborn Real Estate Education.

Sivitanides, P.  2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.

Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P.  (2013). Commercial Real Estate Analysis and Investments (with CD-ROM). Oncourse Learning

Clauretie, T. M., & Sirmans, G.S.  (2009). Real Estate Finance: Theory and Practice 6th EditionOncourse Learning.

Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

6 thoughts on “Seven Ways to Reduce Property Investment Risk

  1. Pingback: Property Return Standard Deviation - Smart Property Investment
  2. Pingback: Property Investment Diversification - Smart Property Investment
  3. Pingback: Property Return Formula: A Tool for Strategizing -
  4. Pingback: How to Calculate Property Risk - SMART PROPERTY INVESTMENT
  5. Pingback: Real Estate Risk is key to Evaluating a Property Investment
  6. Pingback: Cap rate spread: Find out why it is a useful metric for real estate investors

Comments are closed.