Real Estate Investment: How to Balance Risk and Reward

Real estate investing is a long-term endeavor—there are no overnight successes.To thrive in this field, you must carefully balance risk and reward. It’s not just about choosing the most financially appealing option, but understanding the unique risk and reward associated with each property. Whether you’re flipping houses or building a rental portfolio, aligning your investments with your financial goals and risk tolerance is key to sustained success.

Property remains the top choice for investing in the United States with the annual Economy and Personal Finance survey by Gallup finding that 34% of people saw it as the best long-term investment, outperforming gold, stocks, and savings accounts for long-term investments. However, real estate investing isn’t a guaranteed win.

Understanding how to mitigate risks and maximize financial returns is crucial to the success of any real estate investor, whether it’s your first or twenty-first investment. At Privy, we give you real-time on and off-market data and automated deal finding to help you quickly identify profitable investment opportunities—making risk mitigation and reward maximization easier. This article looks in-depth at balancing risk and reward as a real estate investor. 

Understanding the Fundamentals of Real Estate Investing

Every type of real estate investment carries its own risks and rewards. It’s important to choose a type of real estate investment that aligns with your financial goals, risk profile, and long-term priorities. Residential properties are typically seen as having a lower risk due to continued demand, while commercial properties have a higher earning potential but carry a higher risk profile.

Other types of real estate can be location-dependent, such as vacation rentals, which may be lucrative in high-demand areas but struggle with seasonal demand and maintenance. Investors focused on solely earning passive income can work with real estate investment trusts (REITs) or explore crowdfunding to make investing more accessible.

Real estate investing is dual-natured. Most properties will experience capital appreciation as their value increases, creating cash flow through leasing or renting to cover operating costs and generate income. 

Balancing Risk and Reward in Real Estate Investing

It’s important to identify when a potential investment has the right balance between risk and reward. You’ll always want to consider your personal circumstances and the amount of risk you can reasonably undertake from a property. 

Research is crucial to understanding the current and potential value og a property by investigating future development plans and analyzing market trends. As your portfolio grows, it’s vital to diversify your real estate investing to mitigate risks across different property types and locations. You’ll want to choose the right financing option for each property that suits your financial situation, for example, a real estate loan may be the most suitable option for expanding your portfolio.

After researching a property, it’s important to conduct a risk assessment by determining how the investment might react during market volatility, while considering its location and condition. Balancing risk and reward require you to estimate what the potential reward could be. 

Establish SMART goals for your investment, deciding whether it’s a fix and flip, or a long-term rental. These goals will make it easier to create an investing strategy that balances risk and reward for sustainable growth with a reliable exit strategy. 

The Rewards of Real Estate Investing

While most of this article will focus on risk mitigation, we shouldn’t lose sight of the potential rewards when investing in real estate. Many investors focus on rental properties to generate a steady income stream to grow their personal wealth or fund further investments. It’s important to assess a property’s potential rental yield when balancing risk and reward.

Historically, real estate has almost always appreciated in value. Development trends, population growth, and inflation result in an ever-growing demand for both commercial and residential real estate. Property appreciation means that there are sustainable gains that can be made when selling a property after renovations or using it as a rental property.

Real estate investors can also take advantage of an array of tax benefits, such as deferring capital gains tax, deducting mortgage interest, and depreciation. Creating a tax strategy that maximizes cash flow will also help to balance the risks and rewards of an investment property.

Types of Risks Involved in Real Estate Investments

There’s no gain without a little risk. Like any type of investing, real estate has no guarantee of being profitable. Some risks impact almost every type of property, such as market volatility, while others may face specific risks, like potential environmental damage and locational risks.

Here are some of the risks every real estate investor should be aware of:

1. Market Volatility

Before the 2008 financial crisis, there was an assumption that the real estate market could only ever go upwards. The housing market bubble eventually popped, teaching future investors a valuable lesson that not even real estate is exempt from market volatility. 

While historically real estate value rises over time, investments can deprecate, and the market can be unpredictable. For example, rental commercial properties struggled in the aftermath of the pandemic due to the rise in remote working. Interest rates, demographic changes, the economic outlook, and government policies all play a role in potential market volatility. 

2. Negative Cash Flow

Cash flow is crucial in real estate investing as you’ll want your property to generate enough income to at least cover all the associated costs. Your cash flow is the surplus capital left after paying the mortgage, insurance, expenses, taxes, and any other associated costs relevant to the property. Negative cash flow occurs when there’s more money going out than money coming into a property.

High vacancy rates and increased maintenance costs can disrupt your cash flow, while high financing costs on loans can also make it difficult to achieve positive cash flow. Conduct your due diligence and research before investing to calculate your predicted income and expenses for a cash flow analysis. 

Read our guide on ‘How Much Cash Flow is Good for a Rental Property?’ for more advice on cash flow calculations and tips for improving cash flow.

3. Property Specific Risks

Every property is different and comes with its own potential risks, both for today and tomorrow. Hidden defects may not be apparent during the sales process and zoning changes can negatively impact an investment’s return. 

Location is ultimately the biggest factor for property-specific risks. Your property’s location is the one thing you can’t change and will impact its rental rate, potential appreciation, demand, and tenant pool. Properties in desirable areas will typically generate a higher return on investment (ROI) long-term, but will be more expensive to initially invest in.

4. Problematic Tenants 

Risks can come from more than just the property itself. While investing in rental properties can generate passive income, problem tenants can happen anywhere. It’s vital to avoid having vacancies, but a problematic tenant can be more of a financial risk than not having your property generate any income for a short time.

Potentially problematic tenants may damage your property, not report maintenance issues, fail to pay on time, or host extra people (including unauthorized pets!) in your property. This risk is one of the easier ones to mitigate against with a thorough tenant screening process and credit check.

5. Lack of Liquidity 

Where real estate investing falls short is its lack of liquidity. If you need to release capital, you can quickly sell stock or cash out other investments. However, it’s not as easy to sell real estate. 

If you need a fast sale, you may end up selling below market value or at a loss once accounting for the additional fees that are the responsibility of the seller. Diversification and properly managing your finances with a resilient risk strategy can help you avoid the need to quickly liquify your real estate investments.

Strategies for Mitigating Risk as a Real Estate Investor

The good news is that there are plenty of ways to mitigate your risk as a real estate investor. Market research, understanding neighborhood-level data, and diversification are crucial to mitigating risk. A data-driven approach can help you tackle the learning curve of becoming a real estate investor and give you the market insights to balance risk and reward in every investment.

1. Understand the Local Market

Market research can enable you to understand local economic trends and the growth potential of a property. Connecting with a local real estate agent through Privy can give you invaluable insights, including identifying future infrastructure projects and the area’s demand-supply dynamics. 

2. Diversification 

Diversification is important in any type of investment, including real estate. As your portfolio grows, you’ll want to start diversifying across different asset classes, geographic locations, and property types to minimize risk. Many investors will choose to balance commercial, residential, and industrial investments in the event of market volatility.

Read our guide on ‘Expanding Beyond Your Market: How Privy Helps Investors Diversify’ for more advice on diversifying your portfolio across multiple locations.

3. Risk Management Tools

Be proactive and don’t wait for unfortunate circumstances to happen. Insurance may be an additional expense, but it helps protect your investment against loss, liability, and physical damage. 

There is also an array of risk management tools available to help investors assess potential risks, including property condition assessments. Basics like mastering the 1% and 2% rules of real estate can also help assess a property’s risk profile. 

4. Due Diligence

Every type of investment requires due diligence, especially in real estate. It’s crucial to do your research and get a complete picture of the property’s current state and its potential financial performance. Title searches, property inspections, and feasibility studies can all feed into your risk mitigation strategy. 

Strategies for Maximizing Reward in Real Estate Investing 

Investors accept the risks involved with a property because of its potential rewards. Successful real estate investors will seek to balance the risk and reward of a property to suit their investing profile. 

While a property may have a lower risk profile, it might also come with lower rewards. Similarly, many high-reward properties also carry high-risk profiles. Developing a strategy to maximize the return on your property is crucial and is something every investor should consider before signing on the dotted line. 

1. Value-Add Opportunities 

There’s always extra value to be found or generated within properties. You might find hidden value through operational efficiencies or by making tenant improvements. Savvy investors can improve the value of underperforming properties with strategic repositioning or investing in upgrades and renovations.

2. Choosing Short-Term Flipping vs. Long-Term Investing

Not every property works as a short-term flip or a long-term rental. Before investing in a property, maximize its potential reward by determining its best usage, accounting for your short and long-term investing goals. A short-term fix and flip can generate income to invest in a property with a higher reward potential, while long-term positive cash flow can stabilize your portfolio. Don’t forget to consider what an exit strategy would look like for each scenario. 

3. Financing Options and Tax Strategies

Choosing the right financing option for your investment can increase its potential return. Every financing option has its own risks and rewards, such as using a self-directed IRA to fund your investment. Working with a financial professional can help you identify the smartest use of your capital and available financial instruments to increase your reward and potential return.

Don’t forget to consider tax strategies. An accountant or real estate manager can help you create a tax strategy to maximize cash flow, using tax deductions for property-related expenses or options like a 1031 exchange. Effective tax planning is crucial to enhancing a property’s potential rewards and long-term profitability. 

4. Property Management 

Investing in property management can enhance the reward potential for your investment by maximizing its rental income. Many investors choose so-called ‘turnkey properties’  managed by professional property management companies to handle everything from tenant screening to overseeing property repairs. While these properties may produce a lower return, they are ideal for investors looking for a more hands-off approach.