There is no risk-free investment. Higher investment returns usually carry higher risk — usually. There are some risk factors common to all investments including real estate investment, but they vary in how much effect they have on the performance of the investment.
Inflation Risk
Inflation is, in part, increased costs for goods and services. When it comes to stock shares, some corporations carry more risk than others based on their products, services, or business category. In general, if costs rise for labor and materials, all businesses are impacted.
Wage costs rise, as do the costs of everything from office supplies to raw production materials. When it costs more to operate, businesses must raise prices to maintain their profits. That could result in slower sales or the lowering of prices. Either way, lower profits often bring lower stock share prices and dividends as well.
Home prices also rise with inflation, as building a home is a material-consuming and labor-intensive process. If a rental property investor is buying a home, it can increase their cost and lower their cash flow. However, for the investors currently holding real estate investment, they can profit from inflation. As home prices rise, often rents do as well. With a fixed mortgage, higher rents mean higher cash flows.
Interest Rate Risk
Rising interest rates have a negative impact on corporations that borrow money, whether they do so by selling bonds or in other ways. Higher interest rates increase their costs of operation, which means lower profits unless they can raise prices. When competition doesn’t allow raising prices, profits suffer, and stock prices and dividends follow.
Real estate investment owners are not subject to much interest rate risk, as they usually either have no mortgage or they have a fixed-rate mortgage. However, if they’re shopping for more properties, they will have to adjust their process to factor in higher mortgage payment and still cash flow well. It can cut down on new investment opportunities, but existing rents keep flowing.
Market, Operational and Management Risk
Corporations have dozens to thousands of mid-level and upper management personnel making daily decisions that impact the efficiency and profitability of the company. There are also major outside market factors, from global economic events to local business and economic factors. Everything from natural disasters to governmental actions and regulations has some influence on the profitability of companies. Sometimes it’s good, sometimes not.
For the small rental home investor, there isn’t a multi-tiered management structure, usually, just the investor doing the management. That cuts down on the number of people who can make poor decisions. You’re the boss, and there is a strong incentive to do it right. As far as market factors, many things influence home prices, so buying a new rental property can suffer from market risk, but the homes already owned and renting are not usually bothered by outside factors. The one thing that can have a negative impact is downward pressure on rents due to competition and local economic factors.
Asset Security
Your stock market investments are uninsured. Sure, you can use options strategies to try and protect profits as they grow, but it can be an expensive strategy. If you’re willing to take a reduced return on investment, you can invest in corporate bonds, but they aren’t devoid of risk. Just ask General Motors investors who held bonds when the company filed bankruptcy. You can lose much or even all of your investment.
You can buy casualty insurance to protect your investment in a rental property. Even if it gets destroyed and you collect on that policy, you still own the land underneath to sell as well. You factor the cost of the insurance into your expenses.
These four risk factors all can have significant effects on your ROI if you’re trading stocks or bonds; not so much for real estate investment and in rental service. Consider these factors in re-allocation of assets from stocks to rental real estate.
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