Investing in real estate involves three broad categories of investment risk. Sorabh Jain explains… 

The concept of risk in investing can be termed as the uncertainty of an investment yielding its expected rate of return.  In real estate investing, risks can be broadly categorized under three kinds. These are:

1. Overall market risk (i.e. national market risk of inflation, interest rates, capital flows), which is considered unavoidable;
2. Property Sector risk (i.e. inherent risk differences among residential, office, retail, industrial), which can be minimized;
3. Individual property risk (i.e. physical characteristics, location, quality, leases in place), which is avoidable.

OVERALL MARKET RISK

Factors that determine the market risk are: 

• Demand Supply - In a well functioning market, the price of a property should bring demand and supply into equilibrium.  If a surge in demand pushes the price of existing property above its replacement cost, developers have an incentive to build more.  But the new properties take years to complete. By the time buildings are built, demand may have fallen, so prices will slump. Worse still, because of the lags, supply will for a period continue to increase even as prices decline, pushing them lower. This lag between demand growth and supply response is a major cause of volatility in real estate cycles. Understanding the demand supply situation is a key to successful real estate investing.
• Interest rates and inflation The level of interest rate and inflation rate determines the state of activity in real estate market as it affects the cost of borrowing and expectation of return.  Further inflation has an impact on property prices and level of rents.
• Capital flows - There is a new capital order of discipline in the real estate market. Capital is rationally priced and allocated along the risk spectrum.
  Investors must have a clear understanding of the relative discipline of capital flows to the market.  One needs to understand whether capital is being rationally allocated (capital is chasing risk-adjusted returns) or it is being thrown at the investment (capital is chasing the product). As we saw in the early boom of 1990s in real estate, and in the late 1990s for the technology sector, if capital is chasing the product, then the market is doomed for large corrections later on. But for real estate today, capital is chasing risk-adjusted returns, which means that investors should look at real estate as solid investment opportunity compared to alternative investments.

• Yields - Returns on property investment usually follow the trend of interest rates. Rise in interest rates increase property investment yields and vice versa. Yields have decreased in past few years, mainly due to drop in interest rates.

PROPERTY SECTOR RISK

With the various property types (office, residential, retail, industrial, hotel) comes different property cycles. Economic dynamics directly affect each of the property types differently.
Real estate is relatively slower to respond to changes in the economy as compared to many other businesses. Knowing the background of a market and property type within a market can help to determine the risks and cycle length of a market. 

Office sector

Office properties have been the under-performing sector due to technology meltdown, a weaker business environment, closures, layoffs and mergers, absence of fresh demand, emergence of multiple business districts. As a result, vacancy levels have risen resulting in falling rents and prices. Further, this sector is still facing a supply overhang as new properties started during the commercial boom of year 2000 and 2001 are now being marketed.
               The outlook for this sector looks promising with the economy gaining momentum and prices of both rent and capital values looking reasonable from historical and international standards. 

Residential Sector

Lower interest rates, favorable taxation treatment on mortgage payments and easy availability of finance has contributed to the success of this sector. The average return has been more than 10% in residential sector over last two to three years.  This has led to a large development pipeline with developers wishing to cash in the rising residential boom. The prices in new projects continue to rise and so does the gap between new and resale properties. 

Retail Sector

The emergence of organized retailing and entry of foreign retailers has brought cheers to the retail sector.  Retail sector continues to provide positive returns. 

INDIVIDUAL PROPERTY RISK ANALYSIS

It is very important to assess the specific property, in addition to overall assessment of the property market, before making an investment decision. While obtaining information on individual properties (income and expenses, conditions, location, quality of construction, title, etc) requires work, it can be accomplished through a fairly simple and straightforward process. The understanding obtained through this process substantially reduces risk.

               Real Estate is, by far, the world's biggest single asset class. Investors have much more money tied up in property than in shares or bonds. Real Estate is just as prone to irrational exuberance as is the stock market. It should not be viewed as an easy way to make money.