The interplay of risk and return is inherently tied to balancing risk and expected return. A fundamental principle is that higher risks should be matched with the potential for higher returns. Conversely, if you seek higher returns, you must be prepared to accept increased risk levels. Understanding investment risks and personal risk tolerance is crucial for making informed investment decisions.

The spectrum of investment risks is multifaceted, encompassing various sub-risks that can affect the performance of your portfolio.

Main investment risks in real estate crowdfunding

Here’s the list of main investment risks you should know when making real estate investments.

Market risk

Market risk is the potential for an investment’s value to fluctuate due to macroeconomic factors, political instability, or social unrest.  Mitigating market risk involves diversifying your investments across different asset classes and regions.

In real estate crowdfunding, market risk could manifest as a downturn in property values due to a recession, changes in local employment rates, or shifts in demand. For instance, the 2008 global financial crisis led to a significant decline in real estate prices worldwide, with some markets seeing temporary drops of over 30%.

Liquidity risk

Liquidity risk arises when an investor cannot quickly sell or exit an investment without incurring substantial losses.

Real estate is an excellent example of an illiquid asset, meaning it can’t be quickly sold without a potential loss in value. For example, if you need to sell a property quickly due to a personal financial emergency, you might have to accept a lower price than the market value, realising a loss.

This risk is relevant in real estate crowdfunding, as investments are often tied up for several years, and there may not be enough liquidity on the secondary market to sell them. For example, suppose you are an investor in a 3-year residential development project and need funds for an emergency. Without a liquid secondary market, you may have to hold onto the investment or sell it at a significant discount.

Currency risk

Fluctuations in exchange rates can impact returns when investing in properties in foreign countries. While hedging instruments exist, they have costs and complexities.

Currency fluctuations can significantly affect returns on investments in foreign real estate.

For instance, a U.S. investor in a European real estate project might see their dollar-denominated returns diminish if the euro weakens against the dollar over the investment period.

Inflation risk

Inflation erodes the purchasing power of money over time. The erosion of investment value due to inflation is crucial, particularly for long-term investments. If your investment returns don’t outpace inflation, your real returns (adjusted for inflation) could be lower than anticipated.

For example, if you have lent money to a real estate developer at 8% annually, and the inflation is at 5%, your real return is 3%.

Legal and regulatory risk

Changes in laws governing real estate, investment activities, or taxation can impact your investment. This is particularly pertinent in crowdfunding, a relatively new investment model subject to evolving regulations.

For example, the government may change the tax laws that govern the taxation of income earned by the investor, or a new zoning law could restrict the height of buildings in an area where the project owner owns a development site, potentially reducing the site’s value.

Political risk

Geopolitical events can significantly impact real estate values. This risk is heightened when investing in emerging markets or politically unstable regions. Radical changes in the economic or legal environment (such as nationalisation), internal or international political affairs or social crises (such as civil unrest) are all examples of political risk.

For example, Venezuela’s political unrest and economic policies led to hyperinflation and a collapse in property values, devastating local and foreign investors.

Environmental risk

Environmental risks such as natural disasters or changes in environmental laws can affect real estate values.

For example, if you own a coastal property and new regulations limit development due to rising sea levels, the value of your property could plummet.

Interest rate risk

Changes in interest rates can significantly affect property values and financing costs. Higher rates generally adversely affect real estate prices and vice versa.

For example, in 2022-2023, the European base interest rate rapidly increased to 5%, stalling the housing market and reducing property values.

Concentration risk

This risk arises when your investment portfolio focuses on one asset type, geographic region, or even a single property. Diversification across different real estate types (residential, commercial, industrial) and locations can mitigate this risk.

For example, an investor with all their crowdfunding investments in short-term rental apartments would have been severely impacted by COVID-19 travelling restrictions during 2020-2021.

Project owner risk

In real estate crowdfunding, you’re not just investing in a specific property but also the expertise and integrity of the project owner. Their financial health, track record, and business practices directly impact your investment.

Examples of the realisation of project owner risk are cases where the project owner decides to steal the investors’ funds instead of using them for the purpose originally disclosed to the investors or fails to execute the initially disclosed exit strategy.

Crowdfunding project risk

Each real estate project has its own set of risks that can impact the investment returns. These risks are inherent to the specific property, its location, the proposed development or management plan, and the broader market conditions. Understanding these project-specific risks is essential for making informed investment decisions.

Examples of crowdfunding project risks that have been realised include construction cost overruns, timeline delays, and misjudging the market demand for a specific product.

Operational risk

This includes risks from poor management or operational failures. 

If you invest in a property managed by a company that neglects maintenance, the property’s value could decline due to its deteriorating condition.

Credit risk

There’s always the risk of borrowing project owners defaulting on their loans.

For instance, if you provide a loan to the project owner, and some of the risks of the crowdfunding project outlined above are realised, the project owner might not be able to repay the loan.

Valuation risk

Valuation risk is the risk of inaccurate or inflated property valuation.

An accurate property valuation is crucial in real estate crowdfunding, where investors grant loans to project owners. It underpins investment decisions, determines risk ratios, and influences projected returns. However, property valuation is more art than science, involving subjective judgments and assumptions. Misunderstandings or manipulations of these valuations can lead to significant risks for investors.

Examples of valuation risks include cases where the appraiser willingly or mistakenly overvalues the property using irrelevant or misleading comparatives or making incorrect assumptions about development costs or future revenues.

Crowdfunding platform risk

When engaging in real estate crowdfunding, investors must recognise that the platform itself introduces a layer of risk. These platforms act as intermediaries, connecting investors with developers or property owners. The platform’s operational integrity, financial health, and business practices directly impact the safety and success of your investments.

For example, in 2019, several fraudulent Latvian real estate crowdfunding platforms (Kuetzal, Monethera, Envestio) disappeared with investors’ money.

Understanding Your Risk Tolerance

Risk tolerance is your emotional and financial capacity to endure fluctuations in investment value. Factors like age, wealth, investment horizon, and personality influence it. Generally, investors are categorised as:

Conservative

Conservative investors prefer capital preservation over high returns. Conservative investment strategy is suitable for short-term investments or investors nearing retirement.

Moderate

A moderate risk tolerance accepts moderate risks for moderate returns. Moderate-risk investments typically suit mid-career professionals with a 10-15-year horizon.

Aggressive

Aggressive investors seek high returns and can tolerate significant volatility. This investment strategy suits younger investors with long horizons (20+ years) and stable incomes.

Assessing your risk tolerance

When assessing your risk tolerance, consider:

• Loss Tolerance: How much of your investment can you afford to lose without impacting your lifestyle?
• Investment Horizon: Longer horizons generally allow higher risk tolerance as you have time to recover from downturns.
• Emotional Resilience: Can you avoid panic-selling during market dips?

Conclusion

Real estate crowdfunding offers exciting investment opportunities, but it’s not without risks. By understanding these risks and your individual risk tolerance, you can build a portfolio that aligns with your financial goals and emotional comfort. Diversification across crowdfunding projects, property types, and geographies can significantly mitigate risks.

If you’re contemplating real estate investment and believe it aligns with your financial goals, do not hesitate to sign up with Crowdestate for free to explore our investment opportunities.