The Unknown Risks of Real Estate Investing
Real estate investing is not without risk.
In fact, it's full of risks.
Fortunately, anything can be overcome as long as it's not overlooked. If you work all the problems into the numbers up front, then you can never lose. That's why analyzing the investment property.
I think people would be more willing to tackle these risks if they knew what they were and how to mitigate those risks.
The Hidden Risks of Real Estate Investing
If there was no risk, everyone would do it and then no one would make money. We can make money because we can take these risks and limit them. Or, we can use the irrational fear of the risks to earn disproportional rewards in our investments.
There are two types of risks in real estate. The first type, or what I call 'the well known risks' are the obvious risks that everyone knows exist. The second type are the 'real risks' because they are often forgotten about.
Any risk can be mitigated, so something is only risky when you forgot to plan for it. Read on to see...
The Well Known Risks of real estate investments
Investment real estate is clearly made up of two things - buildings and tenants. It makes sense that these two things will form the basis of risk with your new real estate venture.
The biggest fear I hear is that tenants are bad and getting them out can be tough. This fear is completely justified as the inherent risk with real estate investing is not the land or buildings, it's the people. Though great economists may assume that all consumers are rational, I believe that irrationality of consumers is to be 100% expected.
The stock market has millions of investors, so it can only be irrational when herd-like behavior happens. With your single family residence on Oak Street, it's just you and the tenant. Sometimes it doesn't matter if you are a great landlord (learn how to be a great landlord), you simply don't have the law of large numbers on your side to average things out for you.
So the risk with tenants are that you cannot control them. They can cause damage, stop paying rent, steal from you, or even rob a bank and suddenly disappear when they get arrested (I speak with experience).
Unfortunately, there is no way to eliminate Tenant Risk entirely, but you can limit your Tenant Risk by implementing an extremely good tenant screening process (start learning about tenant screening ). Additionally, you always need to collect a security deposit and last month's rent, as well as have late fees or other fees as you are legally allowed to charge. Fees train people by punishing bad behavior.
Start by checking out the ton of free forms I have on the site (48+). Every one of them can be edited and printed to suit your needs. This will help you screen tenants and get a good lease in place to protect you and establish a proper landlord - tenant relationship.
What You Can't See and What You Don't Know
The second biggest risk, and the second reason why people are afraid of real estate, is the unknown. Building structures are very complicated (people do go to school for years to learn how to design them), and common people usually have no idea if something has a problem.
Additionally, most buildings are entirely covered by some surface. Drywall, siding, floors, and ceilings all cover our ability to see problems.
When you are making an offer on a property, it is essential to know all the problems so you can deduct those costs from your offer price. I've said before that you make money the day you purchase the property, so make sure it's at a good price!
So, due diligence takes on a much more important role when buying investment property than when you buy a personal residence (check out my article on due diligence).
You can limit risk in a couple ways. First, you need to either hire an expert, or become an expert at property inspection. I recommend doing both, as you can eliminate a number of potential deals before ever hiring an inspector, and thus saving that money, and time.
Second, you should build some of this risk into your numbers. You should always plan to go over budget on your project by at least 10% and I often build in an additional 10% by assuming I am estimating the market value as too high. So, by subtracting 10% off the estimated market value and adding 10% to my estimated costs, you can build in a strong buffer to the unknowns.
What Are the Hidden Risks of Investing in Real Estate?
Now that we got the easy stuff out of the way, let's take a look at the risks that are easily overlooked and often forgotten about. Like I said before, you can plan for anything (or even profit from it) if you know what to look for and plan for it accordingly.
Liquidity is a major issue with real estate and can take many shapes. I would say that liquidity is the primary reason for new investors to fail, though this is just from personal observation.
In its most basic form, liquidity risk simply means that the cash you may need is trapped inside the property, and you can't get it out. It takes shape in two primary forms:
The Equity Trap - For one reason or another, you cannot sell the investment property at the price you need to sell it at.
You may want to use your money to take advantage of another investment opportunity, or you may need to sell it because it’s causing you to lose money. It doesn’t matter why you want to sell your investment property, because you are having a hard time getting rid of it.
There are a lot of reasons that you could be sitting on a property that you cannot sell. If the market is quickly depreciating, buyers may sit on the sidelines and wait for it to stabilize. You also may own property in too small of a niche and there simply is very little demand for it.
You can limit this risk by ensuring you maintain your properties in a way that appeals to a broad audience, and you only purchase in areas that have robust demand. Even if you aren’t trapped, it can still take months to list and sell your property for you to access your money.
The Cash-Flow Trap - You may have a great property that is appreciation very well, or a project that will significantly increase the value once complete. Unfortunately, the cash-flow doesn't cover the expenses and you've run out of money.
These purchases were born out of speculation in real estate and not from a good rent analysis. (This article explains that flipping is not real estate investing) iJust like in the stock market, I believe you should not engage in speculation unless you are experience and also have a strong portfolio that can cover your losses.
Avoid the cash-flow trap by only buying property that has positive cash-flow at all stages of the investment. Also, ensure the project is properly capitalized up front an always expect it to take longer than planned.
Is an area getting older, or younger? Are incomes in the area going up or down? It's important to know how the neighborhood is now, and how it will look in 5 or 10 years.
There are many examples where great neighborhoods slowly decayed into poor, crime infested areas. There are also other areas that became very posh after a period of decay.
As best as you can, you should discern these trends and always avoid buying investment property in any neighborhood that is on its way down. Targeting a bad neighborhood that may be on the rise is speculative and should only be undertaken if you have other properties that can help offset any losses.
It’s also extremely important that you rent to only high quality tenants. One bad tenant can cause neighbors to move and make it more difficult to rent to good tenants in the future. This applies to your property and to the neighborhood as a whole. (Read about tenant screening)
Changing Regulations or Laws
It is extremely important to stay aware of your local city and state politics. Regulations and laws from our government, though often well-meaning, can have a disastrous effect on property values.
Sprinkler laws, for example, can make some properties lose most or all their value if they suddenly change. Changes could cause the purchaser to incur massive expenses to remodel existing sprinklers or to even add new ones on buildings that never had them.
People also bought properties with septic systems that were legal, just to find out a few years later they had to replace them upon sale. Imagine what that does to your property value!
These are just a couple examples about how changing regulations can impact your potential investment properties. Changes in tax law, special deductions, environmental regulations, or anything else can affect your ability to make money on your investments.
Something that can drastically affect property values, both positively and negatively, is city planning. When city officials lay out zoning for a city or town, it is to try to maximize the efficiency and value of those neighborhoods. Often, this makes all areas have a higher and better use and means more money for everyone.
There is always a negative to each positive though. You may find your new investment property is too close to a planned industrial complex. Perhaps the whole street was rezoned residential after you just bought a mix-use property to turn into a strip mall.
There are countless examples. Though these changes can seem sudden, they were probably planned for and even talked about for months at the city meetings, the local newspaper, or barber shops and cafes around town.
Limiting Real Estate Risk
There is undoubtedly a lot of risks involved with real estate when compared with other types of investing. These should not deter you from investing, but instead should encourage you to take learn about them. When other people are afraid, that just creates more opportunities for you.
You may have noticed a pretty common theme. Basically, anything that can change is a risk. There are undoubtedly some risks that I haven't written about, so please comment and let me know. For every risk there is, we can find a way to make money using it. I wrote an article about finding real estate deals that talks about how to find great deals using this method.
Now what? You can learn about analyzing rental property to help you make great deals.