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The key to successful investment real estate is understanding risk. All investments by their nature have risk associated with them. Understanding investment property risk can be especially daunting if the investor is trying to transition into an asset class they are not familiar with.

For example; an investor owns apartment properties and now would like to enjoy the fruits of his/her labor. The investor wants to maximize cash flow, eliminate the headache of management and minimize risk.

The most common way to eliminate management responsibility is by acquiring Net Lease and Tenant In Common investment properties. Using a 1031 exchange all capital gains taxes can be deferred when replacement properties are acquired.

The investor understands owning and managing apartment buildings but now needs to grasp the nuances of other asset classes such as office, retail and industrial properties and the way these assets are owned and managed in order to clearly understand the risk involved.

Each asset class has a different set of characteristics that can produce different results and risk for the investor. Asset classes also vary in their response to changing economic conditions.

Net Lease investment properties generally are retail, office or industrial. Tenant In Common investment properties are available for virtually any type of property whether retail, office, industrial, multi family, hospitality or land for investment.

The following criteria can be helpful when screening and sorting out investment real estate (replacement properties) to consider.

1. Location and Demographics: Where is the investment real estate located, what type of population growth is historical/anticipated, what does the current and future employment picture look like?

2. What is the term of the lease or leases? Are they for five years, ten years or more? Will the lease rate be increased, and if so, how often, are the increases fixed, adjusted for inflation, or based on the performance of the tenant (percentage lease)? Who pays what expenses?

3. How credit worthy is/are the tenant or tenants? Are they a national credit tenant like Bank of America or Walgreens, or a local merchant? The risk profile (how likely they are to pay) is very different for each.

While there are a number of additional risk factors to consider, the above can be a good place to start when comparing investment properties. If an investment property fails any one of the above tests, the investor should seriously consider eliminating that investment property as a possibility.

For example the investor might be comparing a Class A office building and a regional shopping center, both with major credit tenants in a strong metropolitan market and similar projected returns.

On reviewing the rent rolls, the investor notices that two of the major tenants occupy over 60% of the Office Building and their leases are up for renewal in two years, while the regional shopping center has staggered leases over the next ten years. All other factors being equal, the risk of having to re-tenant 60% of the office building in two years is far greater than the staggered leases in the shopping center. The return on the office building would have to be significantly higher to make it a competitive alternative.

Even with a higher rate of return, the office building could be the wrong investment property for an investor looking for steady, uninterrupted cash flow.

A common mistake inexperienced investors make is to think that a low return investment is by its nature low risk. The market is imperfect and there are many high risk/low return investments waiting for the unsuspecting investor. As with the case of the office building sighted above, a careful review of the facts should reveal the underlying risk.

By understanding the risk for a given investment the investor can then compare investment returns and select the best property for their individual needs.

Every investor’s needs and risk tolerance are different. The secret to successful investing is to truly understand both the investor’s needs and the risk and potential reward of a given investment. In the final analysis only the investor knows the amount of risk he is comfortable with and the type of return that will satisfy his individual needs.

TM 1031 Exchange writes articles that are published in newspapers throughout the United States. If you would like to receive a free copy of the articles please click here.