Risks involved when investing in real-estate.

When an investor is considering taking up a project, he/she, with the help of a professional draws out a plan which contains the costs they estimate to incur and also the benefits they expect to earn from the project. This is crucial because no investor should dive into a project without knowing what they expect in return. Most professionals will draw out a detailed plan from A-Z of all costs, benefits and even factor in potential contingencies. However, no analysis can ever perfectly predict future events, especially those not in the investors control. For example, the market could respond well to a specific product at present date, but the prediction of the market behavior remaining constant over a span of years can never be totally accurate.

Risk is the possibility of an aspect of an investment not turning out as earlier anticipated, it’s an inherent characteristic of any given investment venture. Risk often has negative implications on an investment because it produces results that deviate from the expected ones. If the deviation is so significant, an investment project originally expected to be highly profitable might turn out to be less viable or even a total loss instead. As an investor considering investing in the real-estate sector, here are seven risks you are likely to encounter.

1. Market risk: The relative success or failure of any investment occasionally boils down to the final consumer; the market. If the demand for the resultant property outweighs the supply, at a favorable price, then the property is likely to be profitable and the investment a success, however if supply outweighs demand and the market price lower than expected, the project will turn out either less profitable or worse; a loss. Owing to this, investors usually use analysts to study the market behavior and study which property is most demanded for and at what price. However, most real-estate development projects take years from conceptualization to completion, hence the analyst is tasked to predict the market behavior over a number of years. Timing is critical for any investment; It’s in the investor’s best interest to bring the product into the market at the time of highest demand and highest prices. The analysis can at best, predict future market behavior using market trends. The risk however is to the extent that the predictions could be wrong and results unexpected.

2. Location risk: The location of your property determines its relative attractiveness to the market and ultimately its value. You ought to consider aspects like crime rates, pollution among others. Basically the surrounding of the location plays a part in its attractiveness. An office building will probably lose value if located near a noisy factory or a residential house located right next to a night club. Any type of property will lose value if located in an area with high crime rates. Much as the location may be ideal at present day in regards to those aspects, there’s no telling what the future holds; a previously safe neighborhood may witness a high rise in crime rates in the future, hence the property devalued.

3. Approval risk: Before putting up property in a given area, the investor ought to consult first the local authorities of the area for among other things, permission. Without this permission, the local authorities have the right to reject a proposed project. Aside from rejection, local authorities might choose to give an investor approval but with conditions. Most conditions involve spending even more money which may even threaten viability of project. Such conditions may include; adherence to specific design requirements or contributions towards development of amenities like roads or street lighting.

4. Construction risk: Aside from the budgeted construction expenses, there’s a risk of unexpected expenditures that may be as a result of unforeseeable occurrences like accidents at work, or halt of operations due to bad weather. For example; excavators are usually hired on a time basis (per hour) whether in operation or not. In the event of bad weather and a halt of construction, extra costs are incurred during the idle time.

5. Completion time: Like earlier mentioned, the time in which a property is put in the market is critical. One of the factors that determine this is the time it takes to complete a project. Originally, this time is often estimated and known, however, it can be extended due to factors like; Bad weather during construction, unexpected shortages and delayed deliveries.

6. Financial risk: Before an investor takes on a project, he/she asses how much they expect to spend on the entire project. Usually developers finance real-estate projects using either their own money, or loans from the bank, or even both. In this case, the risk is an unexpected increase in the cost of capital. In case you opt to use your own money, there’s a risk of loss of value of currency due to inflation; cement prices and prices of other building materials go up and you end up having to spend more than expected. If you opt to use a bank loan, there’s a risk of lending rates rising which may mean you’d have to payback more when servicing the loan.

7. Development concept design: During the development process, the design of the project is drawn out. The proposed property can either be a specialized building for specific functions like; an office building or an arcade, or the building can be a mixed used building that has offices, retail shops, apartments among others. There’s a risk however that the finished property may not fare well in the market due to its design. Specialized building would probably command higher returns relative to a mixed use building, however it’s riskier because in the event that it’s a failure in the market, it can’t easily be modified to suit other purposes, much less sold off to cut the losses. In contrast, a mixed use building, might command lower returns but it’s less risky because it can be modified to suit other uses or even sold off later.

That said, risks cannot be entirely dealt away with, but can be reduced using various methods. Market risk can be reduced by investing in thorough market research, location risk by investing more in security or even taking up insurance covers; Approval risk by carrying out thorough initial research in regards to legal aspects and approvals; late competition by introducing rules like penalties to contractors for late competitions. All these methods however require some additional funds to off-set the risks which may in turn bite into the developer’s profit.

For risks that can’t be reduced, an analyst can alternatively check for its impact on an investors profit in the event that it produces unexpected results. This is called a sensitivity analysis. For example; an analyst can calculate the impact of a percentage increase in construction costs to your overall profit and tell you how vulnerable the profitability of the project is to a risk in increased construction costs. Overall it’s important to an investor to weigh how risky a project is before committing to it.

Reference;

Property development A F Millington.