7 Ways To Minimize Risk in A Real Estate Investment

Real estate is the largest asset class in many countries, with a higher share of people’s wealth going into it than into other assets. This is partly the result of the perceived simplicity of this asset: everyone lives in a home and has a sense of understanding of residential properties, and some high net-worth individuals (HNIs) also feel comfortable with commercial property investments.

While real estate seems to check all the right boxes, not all real estate investors are equally lucky in the results of their property investments- some are able to speak about their huge real estate profits, while others have less happy stories to tell. Here are seven ways in which a property investor can minimize the risk quotient of a real estate investment to ensure that it yields predictably good returns.

1. Learn About the Real Estate Market in Multiple Cities

Most of us invest in real estate quite differently from how we invest in anything else. If you were buying a stock, you would not look at buying the shares only of companies located in your city or your part of the city. Similarly, you would not open a bank account only in a bank headquartered in your city or buy insurance only from a local insurance company.

But when it comes to the biggest investment of all – real estate – we all tend to become highly parochial and prefer to invest close to where we live. In the past, this made sense as it was hard to access information about the real estate market in other cities, and a local investment was often the only one that the investor knew enough about to do prudently.

In today’s world of digital information, it only takes a little bit of extra effort to learn about other markets and cities and get a broad perspective of the overall market before investing in property. The reason this is important is that real estate is a highly cyclical industry where the right timing and location of one’s investments can significantly reduce risks and increase returns. A broad perspective will allow you to avoid errors both with respect to when to invest and where to invest.

2. Select the Right City to Invest In

In the long run, real estate prices tend to track median household incomes. As median household incomes rise, property prices also rise. However, like any other asset class, real estate is also subject to boom and bust cycles and there will be times when home prices overshoot their normal multiple of household income, and there will be times when they are quite a bit lower than they should be.

The best investments, of course, are in cities where incomes and population are rising and yet property prices are not too high as a multiple of current incomes. But a typical investor makes real estate investments in locations close to where he or she lives or grew up, or where one’s family lives, as most information on investment options are obtained through conversations with one’s friends, family, or colleagues.

The performance of such investments is a hit or a miss, as it doesn’t take into account the prospects for that location. If the city grows at a rate lower than the nominal GDP growth rate, then the investment may be an underperforming one. Similarly, if current prices are frothy, future returns will not be.

For your investment to predictably do well, you should invest in cities that are growing fast, have a lot of high-paying white-collar jobs, and have reasonable current property prices as a multiple of household income.

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3. Understand the Micro-market and its Trends

In addition to the city’s selection, the micro-market selection is also important to the asset’s performance. Locations that are on or are close to major arterial roads, or are well-connected to efficient public transportation are preferred by end-users as they make it easier to commute to other parts of the city.

Availability of good socio-cultural infrastructure such as schools, shopping, and hospitals are additional factors one needs to look at in micro-markets to make them less risky. Investors also need to keep in mind that well-established areas are less risky but may offer lower returns, while up-and-coming locations with planned new infrastructure can offer better returns but with more uncertainty over the timing of the realization of one’s profits.

A well-informed investor must ultimately make the decision of selecting a location, keeping in mind the above factors.

4. Select a Project Based on its Functional Attributes

Historically, Indian real estate had all the wrong attributes – uncertainty over regulatory matters, disputes over land title, etc. Due to these factors, buyers preferred buying from developers who had the resources to iron out these inefficiencies at the ground level. However, as this sector gradually becomes like the rest of the economy, there is an increasing importance given to the product being offered. Instead of focusing on a developer’s ability to handle regulatory uncertainty, one should focus on the developer’s ability to offer a high-quality product to buyers.

Once a project is completed, its market price depends on the quality of the product, its location, and its specifications, and it is this future market price that determines the profit of the investor. An unimpressive, cookie-cutter design may become irrelevant in a few years and not fetch a good resale value. So, an investor needs to look at the functional aspects of the design of each project he or she invests in to reduce the risk of the property becoming obsolete in the future.

Superior design, floor plans, specifications, and the number and density of amenities are important factors while selecting a property in the residential sector.

5. Select a Project at the Right Stage of Development

Real estate projects are, just as their name implies, projects that need to be executed. They take a lot of capital, have regulatory risks associated with them, and take many years to complete. And like most things in life, there are trade-offs between investing early and investing at a later stage of a project. If you invest early in a project, you can get higher returns but you will also face more uncertainty over regulatory and execution aspects.

On the other hand, if you invest towards the end of the project or after its completion, most of the profits would already have been made by earlier investors and you may end up with lower returns but with the benefit of less uncertainty over timelines.

Uncertainty in the time taken to receive all the necessary regulatory approvals is a factor one must take into account while looking at early-stage projects. Once the developer obtains the necessary regulatory approvals the duration of project construction and completion is much more under the control of the developer. So one must look at the stage of the project and the list of regulatory approvals pending at any given stage of the project prior to making the investment.

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If one is not willing to take these risks, it may be prudent to stick to the Real Estate Regulatory Authority (RERA) registered, under construction, or completed projects for making one’s investment.

Once the construction of a real estate project begins, it takes anywhere from three to five years to construct it depending on the magnitude of development. During this period, factors such as escalation in raw material costs, rising interest rates, and stoppage in construction due to local lockdowns increase the overall development cost of the project.

While these external factors cannot be eliminated in any market, an investor must shortlist projects that are well funded or are being developed by groups with sound financial backgrounds. This will ensure that irrespective of cost escalations the project will be completed.

6. Select the Right Type of Real Estate Asset

The various sub-asset classes in real estate do not have equivalent risk factors and may perform differently in the same location. For instance, in the commercial sector, Grade A offices in high-demand markets tend to be relatively lower-risk as compared to retail and hospitality sectors in the same location.

This is especially true in the short to medium term period. Corporate tenants typically have a long-term view of their plans and requirements and may not cancel their leases. However, seasonal consumer trends and occupancy in the retail and hospitality sectors have a direct impact on their revenues, thereby making it more difficult for investors to predict their outcomes.

The residential sector is perhaps an even safer place to invest, partly due to its lower ticket sizes, and partly also due to the lower potential vacancy periods in the event a tenant leaves. But then again, nothing comes free and the lower vacancy risk in residential is accompanied by lower rent yields as well.

7. Understand Your Own Financial Time Horizon

Real estate is a large ticket purchase and lacks the liquidity of typical financial assets such as mutual funds and bank accounts. Therefore, investors should understand their own personal financial situation and plan for a holding period that is comfortably longer than the expected project completion and exit timelines.

Finding the right price to sell at may take time especially keeping in mind the prevailing demand and supply in the location. In the current scenario, one must also factor the occurrence of unprecedented events such as a pandemic to allow the asset sufficient time to perform.

Bottom Line

Real estate is a massive asset class and its popularity with investors is well-deserved. An investor who exercises prudence and diligence prior to investing, as outlined above, can benefit from the safety, security, and low volatility of this asset class while avoiding undue risk.

While most investors aspire to own a real asset as a foundation of their investment portfolio, it is important to evaluate the underlying risks before making the investment. If you invest in real estate with the right knowledge and perspective and give your investment the time to perform that it deserves, it could be not only a fruitful investment but also an enjoyable journey combined with the pleasure of ownership of a hard, tangible asset that no other asset class can match.

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