Real Estate Investing: Smart Strategies for Managing Risk and Maximizing Value

To the untrained eye, investing in real estate may seem like a simple, hands-off way to build wealth.  

The promise of passive income, increasing property values and, in some cases, a “free” place to stay on vacation appears to be too good to turn down. 

If you have excess cash, purchasing alternative investments, like real estate, may feel safer than investing in the stock market (with its ups and downs) but it’s not without risk. 

Before diving in, it’s crucial to consider the liquidity challenges you may face by tying up capital in an illiquid asset, how you’ll manage the property, the liability risk you’ll assume and how buying a property will affect your ability to take advantage of other investment opportunities. 

Understanding Real Estate as an Investment 

Investing in real estate may seem like a sensible option for high-net-worth individuals who have amassed a substantial portfolio of securities and want to diversify outside of the stock market. 

All you have to do is purchase a property. Rent it out. Collect your monthly rent check. Watch the property appreciate and your return on investment grow over time.  

At least that’s the story many people tell themselves.  

But the reality of being a landlord is more nuanced than that. And it starts with understanding the different types of properties you can invest in and the risks and benefits associated with each. 

Different Types of Real Estate Investments 

Multi-Unit Rentals 

Residential properties with multiple units you can rent separately, such as duplexes or triplexes. Multi-unit rentals offer higher income potential and make onsite maintenance more efficient compared to single units, but they concentrate geographic risk and require managing multiple tenants at the same time. 

Vacation Homes with Rental Potential 

Offer a combination of income generation and personal enjoyment. Vacation rentals can generate significant income during peak seasons but may sit empty during the off-season. Wear and tear from short-term renting can increase maintenance costs and reduce profitability.  

Commercial Real Estate 

Includes office buildings, retail spaces and warehouses. Commercial properties pose the greatest risk to individual investors who often have to sign long leases, cover higher maintenance costs and pay increased taxes and insurance premiums. 

Potential Advantages of Investing in Real Estate 

Income Generation 

With proper planning and budgeting, real estate has the potential to generate steady income that can offset the cost of managing and maintaining the property and supplement your existing cash flow. But because the “income” you earn is net of expenses, interest charges, unexpected repairs, insurance payments and maintenance costs can eat into your profits.

Property Appreciation 

Investors often assume home values will increase over time. Historically, that’s generally been true over the long-term, but there are no guarantees it will continue. In any given year, property values may increase, decrease or remain flat. 

Tax Advantages 

You may be able to deduct mortgage interest, property taxes, depreciation, insurance and other operating expenses from your taxable income. Because tax laws are complex and change often, it’s a good idea to speak with a tax professional who can help you maximize potential tax benefits and avoid penalties. 

The Hidden Costs and Considerations 

Real estate may be a good investment option, but it depends on a few key details. A rental property that may seem attractive at first glance might not look so great after factoring in the costs and risks of owning it. 

Management and Maintenance 

Real estate is often touted as a “passive” investment, but it may not be as hands off as you think. When you become a landlord, you’re responsible for maintaining the property, making major repairs, managing tenant issues and staying compliant with local laws and regulations. 

Outsourcing these responsibilities to a property management firm can help lighten your workload, but it adds additional costs that eat into your profits.  

Management companies typically charge 8% to 12% of the rental income a property generates; pricing varies by location and the services the company provides.  

When you have renters in your property, the appliances are working, and the roof isn’t leaking, you can sit back, relax and collect your rent checks each month.  

But there will be times when the property sits vacant, you have no money coming in, and you still need to make your mortgage payments, cover the insurance premium and pay the tax bill.  

Vacancies can significantly impact cash flow, and without proper planning, they may create liquidity challenges that disrupt your broader financial strategy. 

Insurance and Liability 

Insurance is a must when investing in real estate. Without it, you’re at risk of suffering significant losses. 

Having adequate coverage can help pay for repairs, cover your liability if a tenant sues you and replace your rental income if you’re unable to rent the property because of a covered incident like a fire or natural disaster.  

Premiums vary by property type and location, and properties in areas that are prone to natural disasters usually require specialty coverage such as flood or earthquake insurance. 

Properly structuring your rental business by setting up an LLC can also help reduce your risk by separating your business assets from your personal assets. If someone files a claim against you, they can’t come after your personal assets.  

Opportunity Costs 

Investing in real estate typically requires you to dedicate a significant sum of cash to an illiquid asset, reducing your ability to take advantage of other investment opportunities that may come your way. 

To purchase an investment property, you need to be able to cover the down payment and closing costs. Once you own it, you need to have enough cash set aside to cover routine maintenance and major repairs. 

Market Risks and Liquidity 

Although some investors may see real estate as a safer option compared to the stock market, it has its own set of risks. 

Market Volatility 

If you look at historical real estate returns, you might assume that property values have enjoyed a slow and steady climb over the years.  

But if you dig a little deeper, you’ll see that real estate isn’t immune from market volatility, especially when mortgage and unemployment rates are high, economic growth is slow, and consumer sentiment is less than optimistic.  

The real estate market is cyclical and just like the stock market, it’s nearly impossible to time. Stagnating values and downturns can last for years. If you have to sell during those times, you could lock in losses.  

Liquidity Concerns 

You may not want to sell off stocks or bonds when the market is down, but you can, and within a day or two you’ll have the cash you need.  

Real estate sales often take months, and if you need to sell fast, you may have to accept a below-market offer, provide buyer concessions or lock in losses.  

Diversification 

Diversifying a portfolio of stocks and bonds is a relatively simple exercise. With real estate, it’s more difficult.  

Unless you buy properties in multiple different areas, you’re not diversified out of your local real estate market even if you buy more than one property.