The Risks of Investing in Real Estate
Real estate is emerging as one of the most preferred areas of investment. It is boosted by the fact that the middle class is expanding and more people are moving their families into cities. In the recent past, capital markets have become a global market and investors are taking this along with their investment priorities with millions of money spent annually investing in real estates. With emerging economies in different continents across the world, international as well as national real estate investors are expressing unprecedented interest in providing housing to people who want to stay in gated communities or estates for the first time. Among the reasons for increased interest in real estate is the improving economic performance of many countries. Because of the high returns that real estate generates economically and the diversifications of benefits that an investor may get from investing in real estate, it is a highly promising area. However, just as an investor is sure to make returns on investment in real estate, this sector has potential risks as any other sector of investment.
The globalisation and economic convergence in terms of financial systems implies that cities where financial systems are integrated offer low diversification benefits to real estate investors than other sectors. This fact is increasingly evident as more cities become integrated in a global financial system. The risk is that real estate that was once independent from the risks of global pricing will soon be a part of the system and therefore will drive out tenants who cannot meet the demands of the landlords. In other words, the price of renting a house has been on the increase, which is fuelled by the tendency towards a steady growth in the number of middle class citizens in many countries. This perception of economic trends is risky to real estate investment. It is mainly because the investors will be forced to increase the price of real estate even where the tenants are not able to afford the money attached to such properties. As a result, international investors become unwilling to venture into volatile international markets where the prices in bond markets are high and reflect the booming economic performance and yet the citizens cannot afford the prices that are attached to the properties (Eldred 2009, p. 26).
Additionally, real estate is susceptible to fluctuating mortgage prices in what could be described as value abyss. In such cases, the increasing mortgage could easily force landlords to increase the rental prices for tenants, thereby leaving them with no alternative but to abandon the houses or properties. For instance, the real estate bubble in the United States created a false indication that the sector was thriving, which led to many people taking mortgages to buy properties for renting. However, because of pressure on mortgage lenders, the rate of interest went high and many tenants were unable to service their mortgages. As a result, the rent was raised which resulted in tenants abandoning the properties because they could not afford the rental charge. In fact, most of the houses which are abandoned soon fall into a state of disrepair and sometimes become harbours of criminal groups and are thus linked to such social problems as robbery in the surrounding neighbourhood. Essentially, real estate crash leads to new suburbs remaining vacant or with fewer tenants. That is, it impractical to run such properties without their full abilities to generate income (Eldred 2009, p. 30).
Inasmuch as real estate properties are subject to similar international financial systems in terms of lending and mortgages, the same is not true when it comes to laws that regulate the management of real estate properties. Each is regulated by by-laws set by the municipal or city council in the cities where the properties are located. In many instances, most cities’ laws are retrogressive to the development of real estate. Local authorities are gradually realising the importance of having uniform regulations across cities in the same country or in the same region for purposes of avoiding strain to the real estate investors. In most cases, the municipal regulations are designed to protect both the landlord and the tenant. However, in instances where new regulations, commonly known as ordinances, are passed, they automatically create a new source of challenges to property owners. An example of retrogressive ordinances is the animal house ordinances that hold the landlord responsible for the activities of the tenants if such activities disturb the neighbours. It implies that landlords must regulate the activities and behaviours of their tenants. In cases where they want to accommodate stubborn tenants, such landlords are forced to purchase the whole estate. In the end, most people who would want to invest in property management shy away because they cannot meet the laws that are set out by city management (Lee 2010, p. 3).
Moreover, most houses in cities are purchased from developers who design them as multi-unit dwelling. The law often requires that in case a buyer wants to convert a unit into a single family house, he/she must acquire zoning permits from city authorities. This raises the cost of purchasing houses in the future, especially where such an issue is brought up after the buyer has purchased the house from the developer. Real estate is also subject to rates which make it difficult for the single property buyers to meet such requirements as most of the people who buy such houses are heading into retirement and getting an annual fee becomes a problem to them.
From a business angle, real estate is risky in terms of the social and political factors that may contribute to the damage of the property. Political risk is the possibility of bad consequences arising from unexpected political events. This is important in real estate investment because it is the unexpected part of politics that increases the risk associated with investing in real estate properties. Political risks can occur where there is a change of government and hence a change of rules concerning investment in properties. For instance, a new government may set new requirements that are not favourable to real estate investors and sometimes force them to leave their properties or considerably hinder their activities (Lee 2010, p. 5).
Another element of political risk is the fact that real estate can easily become a target of terror activities like bombing and arson in which case the owner may incur substantial losses. This is normally cushioned against through insurance in politically risky areas. However, it is a source of another cost of investing in real estate in risky areas as insurance is normally high. In this case, the government intervention together with unexpected political turn of events can easily form a barrier to capital flows, increase taxes, outright expropriation, and exchange controls, all of which can negatively affect investment in real estate. Furthermore, government intervention in real estate development is strenuous to the economy and can lead to changes in trade and demand. It can also create unexpected behaviours in response to internal forces such as a coup or a change in the ruling government. This will mostly have a negative effect on the international investors since instability in a country where investment is done normally means a greater uncertainty to returns on investment as projected by the investor. For instance, it is common for host governments to impose penalties on international investors in real estate when market conditions become unfavourable and thus affect the returns on investment. These penalties always come in the form of restrictions on repatriation of dividends and tight control on the remittance of funds. In many occasions such restrictions are more likely to remain until the local conditions become favourable, the international situation notwithstanding (Greer & Kolbe 2003, p. 15).
Real estate is also susceptible to institutional risk that investors must face, especially in international markets. Most of the investors lack information on legal or cultural practices in potential markets. The conventions and formal regulations in some markets may be restrictive and because investors do not have sufficient information on these markets, they occasionally end up being stuck in an environment that does not favour them. Lack of knowledge on local markets and the market trends is a risk that many investors in real estate gamble with while investing in new areas. This implies that institutional complexity and market variations in real estate investment pose more challenges to real estate investment than other factors, especially where the developer wants to invest more in an international market. Moreover, considerable differences exist in the factors that define the parties in real estate such as developers, real estate service providers, and investors in different markets. This impacts on the quality, comparability, and market characteristics of the information generated about investment in real estate (Freidman & Harris 2010, p. 32).
Real estate management is an area that requires strict coordination between the parties that are involved. This is because investors face different characteristics of the industry in different markets. For instance, the obligation of occupation as well as costs like lease lengths, real estate transfer taxes, broker fees, and non-rent occupancy costs which are always associated with transactions related to real estate management are a classical example of differences that investors must meet across the markets. The differences reflect the developmental stage of the real estate industry in a given market and may increase or decrease the associated risks that real estate developers and investors are likely to face in that market.
In management, real estate requires leasing of service providers to manage and control the maintenance of the properties. Some of the service providers are professionals in doing their work. But this is not always the case because as the market continues to grow, more unprofessional service providers come on the scene. It makes it difficult to engage a good and professional service provider to manage an estate. In such circumstances, the property owner stands the risk of losing money to negligent service providers in the management of real estate property. This can impact on the number of tenants who want to stay in that property. The costs of management of real estate property are also unpredictable as natural disasters such as storms or floods might cause a great damage to the property in an unexpected manner (Lee 2010, p. 10).
Real estate is a dynamic and volatile sector for investment owing to the political, natural, economic, and social factors that have an impact on the management of a property. As such, it is important that investors in real estate development, specifically in international markets, carry out proper research. This will help them determine the dynamics of a given market before deciding to invest in it. Gathering sufficient information on laws, regulations, legal and cultural practices, taxations, as well as the political conditions in a given area will assist in making sound decisions when it comes to investing in real estate. With proper information and favourable conditions real estate can be one of the best areas to invest in.