Many know that they need to manage risk and diversify when investing in stocks but forget that those same principles apply to real estate.
Certain markets and property types will carry different risks, so it’s essential to evaluate the risk of a potential investment so you can fully understand how it will impact your portfolio. In this article, we will examine the highest and lowest-risk ways to invest in real estate to help you make the right decision for your portfolio.
Why Invest in Real Estate
Real estate offers many benefits to savvy investors looking to diversify their portfolios beyond stocks and bonds.
While we published an article on the benefits of investing in real estate, the top benefits worth mentioning here are:
- Potential for cash flow: Through consistent rental payments, real estate offers the potential for cash flow, making it an income-generating asset while you own it/invest in it.
- Tax deductions: Through depreciation and other deductions, real estate offers many benefits during tax season in April.
- Potential for appreciation: Thanks to targeted improvements in a property, you can improve your chances of earning a greater return once you are ready to sell it.
- Diversification: The S&P went up over 20% in 2024, and while those were extraordinary gains, they are not guaranteed every year. While there is no sure thing in real estate, returns have a lower correlation with other asset classes like stocks, making real estate a great way to diversify a portfolio.
There are many ways to invest in real estate, though, so we’ll explore those next.
How to Invest in Real Estate
Many benefits come with investing in real estate, but you must ensure you invest in a way that matches your risk tolerance and time commitment. The following are popular ways to invest:
- Purchase a property: One of the most straightforward ways to invest in real estate is to purchase and manage a property yourself. Be warned, while you’ll get 100% of the upside, this also requires the most capital upfront and puts you in the position to assume all the risk.
- Invest in a REIT (Real Estate Investment Trust): A REIT is a diversified portfolio of properties. REITs can be traded like a mutual fund and often have much lower barriers to entry compared to other ways of investing.
- Invest with a firm (a real estate syndication/private investment firm): If you want the benefits of owning real estate while remaining 100% passive, investing with a real estate syndication/private real estate firm may be the best option.
Between these three, we’d recommend investing with a firm.
Purchasing a property can take up much of your time, and while a REIT may offer more diversification, it also limits your upside. Colony Hills Capital is a multifamily investment firm that purchases, manages, and sells Class B to A- multifamily real estate and invites accredited investors to invest passively while reaping all the benefits of owning a piece of real estate.
Real estate syndications bring in investments from two roles:
- General Partners (GPs) who source and manage the deal
- Limited Partners (LPs) who invest passively
Due to the work involved, General Partners earn an increasing share of the return as the deal hits new milestones. This is done to reward the GPs for their effort, align their interests with the passive investors, and incentivize them. Unlike other firms, Colony Hills Capital invites passive investors to invest as Co-GPs.
This means that you get an increasing share of the return while investing passively.
The Highest-Risk Real Estate Investments
Many investors understand that higher risks can come with higher rewards, but they forget that higher-risk investments also come with a wider set of possible outcomes.
As you’ll see in this list, high-risk real estate investments aren’t risky because they require significant capital to invest. High-risk real estate investments are often investments in unproven markets, making them a less desirable bet for those seeking stability as they diversify their portfolios.
Some of the highest-risk real estate investments are:
- Land development
- Speculative development
- Distressed properties
- Commercial real estate
Land Development
Land development may be the riskiest way to invest in real estate.
This involves purchasing undeveloped land with plans to build from scratch. Due to zoning challenges, environmental issues, infrastructure costs, and market changes, numerous risks can arise that are hard to predict. What’s more, raw land won’t generate income during the development phase, resulting in negative cash flow.
Speculative Development
Speculative development covers large real estate projects in up-and-coming neighborhoods. Think about the last time you saw a luxury apartment building going up in a developing neighborhood in/just outside your city. While these projects can be lucrative if they pay off, they are risky bets in unproven markets.
Distressed Properties
This involves purchasing troubled assets at a discount with plans for significant upgrades to sell them for a profit. While the purchase price might be attractive, these properties often have hidden problems, complicated legal issues, or require extensive capital improvements that can exceed initial estimates.
Commercial Properties
With many companies still taking a hybrid approach, the evolving way we work has transformed the market for commercial real estate – many would say it’s for the worse. In Q3 2023, office vacancies hit 19.3%, and commercial property sales volume dropped 51%. As the future of work remains uncertain, we’d suggest that commercial real estate continues to be a risky bet.
The Lowest Risk Real Estate Investments
Low-risk real estate investments check the boxes that high-risk investments miss: they are diversified, in high demand, and in stable markets.
Some of the lowest-risk real estate investments are:
- Multifamily real estate
- Government leased properties
- Storage facilities
Multifamily Real Estate
Multifamily real estate in established markets provides relatively low risk due to the fundamental need for housing and the diversity of the tenant base. By selecting the right class (more on this later), you can safeguard against swings in the economy, providing further stability for your portfolio.
Government leased properties
When the tenant is a government agency with a long-term lease, the risk of default is generally minimal. These properties typically provide very predictable income streams, though returns might be lower than other, more lucrative real estate investments.
Storage facilities
Storage facilities (and other similar utilitarian properties) require minimal maintenance, have low operating costs, and tend to perform well even during economic downturns. Month-to-month leases allow for quick adjustment to market conditions, and the diversity of tenants helps maintain stable cash flow.
Between these three, we recommend multifamily real estate as an investment choice. Multifamily real estate offers stability and tax benefits, along with the potential for passive income and appreciation. This is why Colony Hills Capital has specialized in the acquisition, management, and sale of multifamily real estate since 2008.
Read on as we break down strategies to manage the risk in your real estate portfolio.
How to Manage Risk in Your Real Estate Portfolio
When investing in multifamily real estate, there are a few tactics at your disposal to manage the risk you add to your portfolio. These are:
- Choose the right property
- Choose the right market
- Choose the right asset class
- Choose the right leverage
- Choose the right firm
We’ll explore each of these in depth.
Choose the Right Type of Property
This involves selecting properties that align with your investment strategy and risk tolerance.
For example, single-family homes may seem easier to manage, but they can be risky. With one tenant at a time, you open yourself up to stressful months if you cannot keep the property occupied. By investing in multifamily real estate, you lessen this risk by having a larger tenant base. Consider factors like property age, condition, and potential maintenance costs when evaluating property types before investing. Explore other benefits of investing in multifamily real estate over single-family in our guide.
Choose the Right Market
Market selection is crucial for long-term success.
Look for markets with strong economic fundamentals like:
- Population growth
- Job diversity
- High income levels
- Infrastructure development
Consider both primary markets (major metropolitan areas) and secondary markets (smaller cities with growth potential). Each market type offers different risk-reward profiles. Check out our guide to the top markets in the United States for multifamily investors.
Choose the Right Asset Class
As discussed earlier, speculative and distressed properties can be risky bets for your portfolio. You can manage risk by selecting the right class of real estate to invest in. There are four primary multifamily asset classes you will encounter:
- Class A: These are typically newly constructed or recently renovated buildings (usually less than 10 years old) and are located in prime urban or affluent suburban areas. Class A properties boast high-end finishes and cutting-edge amenities like smart home technology and rooftop lounges.
- Class B: Class B properties offer decent amenities but aren't as luxurious as their Class A counterparts. Class B attracts middle-income tenants and appeals to investors seeking a balance of cash flow and appreciation potential. While no investment is “recession-proof,” Class B real estate offers some extra security. In “boom times,” people often upgrade by moving into Class B properties, and in recessions, many downgrade into them as well.
- Class C: Class C properties are usually older buildings (20-30 years old), often located in less desirable areas, and need repairs or renovations. They offer basic amenities, if any, and cater to lower to middle-income tenants.
- Class D: These are the oldest multifamily buildings (often over 30 years old) and are located in economically challenged areas. They typically require significant repairs or renovations and offer minimal to no amenities.
Learn more about the different classes of multifamily real estate.
Choose the Right Leverage
Leverage is just as problematic when investing through a private firm as when you own and manage a property yourself.
While higher leverage can amplify returns, it also makes an investment riskier. If a firm plans to borrow 80% of the cost of the property plus improvements, that’s a lot of risk you take on. However, if a firm plans to borrow 65%, has a longer term period, and has a fixed interest rate, that lowers the risk.
Choose the Right Firm
Working with experienced professionals - property managers, real estate agents, lawyers, and accountants - is crucial for risk management. We recommend investing with a firm that has the following:
- A strong track record and history of returns
- A sound strategy for selecting and exiting properties
- Strong communication with investors
Check out our guide to selecting the right real estate investment firm for more guidance.
Download Our Free Guide to Investing in Multifamily Real Estate
Understanding risk is just one piece of understanding the potential of a multifamily opportunity. There are many other ways you can evaluate a deal’s potential and build confidence in the decisions you make for your portfolio.
If you’re looking to invest in multifamily real estate but are not sure where to start, we recommend downloading our free multifamily investing guide. We wrote it to show you the ins and outs of investing in multifamily real estate. Fill out the form below to get your free guide. In it, you’ll learn:
- The tax benefits of investing in multifamily real estate.
- Definitions of key terms.
- How to choose a firm.
- The best markets to invest in.
And more!
