Real estate investing is about balancing risk and reward. How an investor balances these two values depends on his risk tolerance, market conditions, and certain economic factors. Let’s talk about these.
Low Risk-Low Reward
Often called Core investments, in this category, the investor is not concerned about big gains. Therefore, the investments are safer and yield lower returns. These investments often rely on buy-and-hold strategies in the best neighborhoods with properties that require very little in the way of upgrades. They typically provide an ongoing passive income where tenants have stellar credit. Apartment buildings and commercial rental properties make good Core investments.
Low Risk-Moderate Reward
This category of investment is often called Core-Plus. While involving buy-and-hold strategies, these investments aren’t quite as solid. Core-Plus focuses on lower quality properties in okay neighborhoods, and the creditworthiness of tenants is less than prime. In some situations, there could be vacancies.
Moderate Risk-Moderate Reward
In this investment category, the real estate investor seeks to add value to the property. Maybe the landlord seeks to improve the property, or a house flipper may renovate a property before selling it. The risk is higher because the investor is putting money up beyond the cost of acquisition. There may also be a loan involved in such projects, which also increases risk. The reward is usually deferred to the back end of the project when the landlord can increase rents or the house flipper sells the property for a nice short-term return.
High Risk-High Reward
This strategy involves a high upfront investment with the potential for high returns but there is often a long period when no returns are expected while there are ongoing costs. Ground-up developments, for instance, could go for years before a return is realized, but that return could be as much as 50%.
Risk Factors to Leverage Higher Real Estate Investment Returns
The above risk factors are more about the actual property investment and less about a real estate investor’s risk tolerance, which is still important. Investors with a large investment pool available may be willing to risk more of it for a higher return. On the other hand, if an investor has to borrow money for an investment, they may think twice before taking on that risk, especially if they have a low-risk tolerance.
Savvy investors don’t just look at the investment opportunity. They also consider their own risk tolerance and consider current and expected future market conditions.
If housing prices are trending upward, people may be more reluctant to buy. In that case, rental properties may be more popular, and that presents a good opportunity for real estate investors to consider rentals over ground-up developments and flips. On the other hand, if housing prices are in decline—and it very often happens that housing prices may trend upward in one geographical area while trending downward in another—then more people could be in the market for buying a home. That will increase demand for fix-and-flips and ground-up residential units.
Balancing Risk With Potential Rewards
There are two other considerations a real estate investor should consider before entering any type of investment. The first of these is the downside. Every investment has a downside. Even those with multiple very good upsides often have at least one downside. Be sure to keep the downside in mind when investing in real estate.
The second consideration is the investor’s exit strategy. How do you intend to get out of the investment once you’ve realized a gain, or in the unlikely event that you experience a loss? If you don’t consider your exit before you get into an investment, you may find yourself stuck and taking larger losses as a result.
Successful real estate investors learn to balance all risk factors with potential rewards. Remember, don’t invest more than you can afford to lose.