Today we’re going to discuss the risks of investing in real estate. Whaaaat? A real estate company telling you why NOT to buy real estate? Well, not exactly. Everything comes with some level of risk, especially investments! Even the risk of the unknown is a risk!
For some of the upsides to investing in real estate, check out our blogs and videos called the “5 Benefits of Real Estate Investing” and “How Many Rental Properties Does it Take to Retire?”.
Let’s brainstorm all the possible risks of real estate! If you can think of any more, let me know in the comments below! Pessimists rejoice!
Tenants are the #1 risk I’ve heard people talk about when it comes to real estate investing. What if I can’t find a tenant? How about if they aren’t paying? If my tenants trash my property, then what? Let’s discuss.
What if I Can’t Find a Tenant?
The reality is that, yes, it is possible you won’t be able to find a tenant. But just because it’s possible, doesn’t mean it’s likely. If you’ve done your homework and have made an educated purchase, not finding a tenant is a very small risk. If you really can’t find a tenant, you can either lower the rents or improve the property to make it more desirable.
What if My Tenants Don’t Pay Me?
This is another classic risk that negative people like to use. Yes, it is possible tenants don’t pay you! Especially in recessions and hard times, things happen and people lose their jobs. If we’ve educated ourselves on how to ensure this doesn’t happen or hire great property managers, we can avoid the risk of tenants not paying. To minimize the risk of a tenant not paying, we can screen our potential tenants by having them fill out an application. Then check their credit and prior eviction record if they have one. We also want to make sure not to become friends with your tenants in the first place. You don’t want to get taken advantage of when they want to skip a month of payment and you cave to their request.
Lastly, if the tenant really refuses to pay, don’t be afraid to use the eviction process to solve the issue before it compiles! If you’re a real estate investor for long enough, you’re bound to have at least one eviction at some point. It’s just a numbers game. If nothing else is working and you need a creative solution to a tenant not paying, you can use the “Cash for Keys” method. With this method, you actually pay the tenant to vacate the property so the lack of rent payment doesn’t accumulate a large loss for you month after month. Evictions can also take a long time depending on your state’s tenant landlord laws so “Cash for Keys” can take care of getting a delinquent tenant out swiftly and on better terms than an eviction.
What if My Tenant Destroys My Property?
There are certainly nightmare situations in being a landlord where a tenant decides to do a little bit more than just put general wear and tear on the property. In this case, we as landlords must make sure to have an ample security deposit which is usually 1 months rent which we can use to repair damages upon tenant departure. Landlords also have rights in these situations and can take a tenant to small claims court to recuperate costs that exceed the security deposit amount. Unlikely, but it can happen! To get renters that have a higher pride of rentership, it’s important to look for properties in nicer areas which correlates with tenants with higher average income.
What if My Tenant Slips and Falls in My Property and Sues Me?
Liability is most certainly a risk that should not be taken lightly with real estate investing. However, we have a few ways to protect against a lawsuit happening. First, we can hold our real estate investments in an LLC, which allows us to protect the rest of our assets from a potential judgement, if a lawsuit did occur. Inside the LLC, we are holding the property as a business asset and if the business gets sued out of existence, yes it hurts, but at least our personal home, stock investments, cars, and other assets are not at risk. Second, make sure to get a good liability insurance policy for the property.
The average liability coverage per rental home is $1,000,000. Trust me, insurance is cheap compared to the risk you are taking on by not having it at all! Lastly, it’s important to have pride in the safety of your property to keep your tenants safe. Tenants are people too and we need to make sure we have the proper smoke and CO2 detectors, fire extinguishers, and other safety items to keep our property up to code and safe. Regular safety inspections and swift maintenance are also a large part of mitigating liability. Take care of tenant safety complaints right away if there is a health and safety risk such as a gas leak. Don’t be a negligent landlord!
What if I Get a Call from a Tenant in the Middle of the Night?
Being a landlord can be hard! That’s no secret. But real estate investors don’t all have to be landlords. Focus on the investing side of things and less on the maintenance by hiring a property manager. Not just any property manager, we want to find an experienced team that we can get references from to verify their track record. They can also get examples of their communication with other clients, and one that has fair prices. We want property managers that take a % of monthly rent, not a flat monetary fee. Property managers must only make money when you make money. We can also avoid calls in the middle of the night by simply buying a house that is newer and has lower maintenance costs.
Natural Disasters & Weather
Natural disasters and weather. So, what happens if my property burns down or gets hit by a tornado? We touched on this before, but insurance is the name of the game! Some areas will require that you have special types of insurance such as flood insurance, but you can turn the dial on risk by getting bigger and better coverage regardless of your situation.
Market Crash, Recessions, & Corrections
What if I’m buying at the top of a market and everything comes crashing down? Won’t I lose everything like what happened in 2008? These are all important questions. However, there is some nuance to real estate investing. Here at Rent to Retirement, we preach sound, buy and hold, income properties, and we don’t get involved with fix and flip properties. There is an important distinction between buy and hold and flipping. With long term, buy and hold, rentals, we are looking primarily at the cash flow or income that the property produces. Not necessarily the price of the home itself.
So, if you buy a home at the top of a market and it loses half its value over night, we’re not sweating. We still have cash flow coming in through rent. Where people get burned is when their properties aren’t cash flowing or barely cash flowing. Rents can go slightly down in recessions. If you’re just staying afloat because of the price of your house, you’re no longer investing. You’re speculating. In 2008, people lost their jobs and could no longer make their personal home payments. Some people also had two, three, or even four houses all being supported by their active income.
As Robert Kiyosaki might say, homes in 2008 were not assets, they were liabilities. To further hedge risk, we need to make sure we are locking in long term, fixed rate financing. So if a recession hits, our payments stay the same and a lender doesn’t suddenly raise our loan’s interest rate like happened to many owners in the great recession. We can also hunt for deals that we can buy for under market value to make sure we have a financial buffer right off the bat. Lastly, let’s make sure to keep reserves in the bank because, hey, you just don’t know what you don’t know! Things happen that nobody can expect, so make sure to have 3-6 months worth of expenses in the bank at any given time. It will help you sleep better at night.
In real estate, the value of a property never goes to zero. The property always has some utility to it such as the ability to use it as a home for yourself, store your stuff, or take it all apart and sell the materials! Land is almost never worthless either. Unless you bought a house on top of a radioactive material dumping site that is!
Lack of Liquidity
What if I want to sell my property but I can’t? That is the essence of liquidity – how quickly can I sell an investment and turn it into cash if I wanted to? Real estate is known for having low liquidity as it takes time to put a property up for sale, have buyers come look at it, put the property under contract, let the buyer inspect it, and let the bank appraise it. Even in hot markets this process can take weeks unlike a stock where you can click a button, sell and have cash in hand.
What’s the risk here? Maybe you need the money for something else like buying a new car or paying for your kid’s college. There is a risk in having your money tied up somewhere without having the ability to access it. In this case, we can mitigate this risk as much as possible, by taking care of the property and making sure there isn’t a lot to be fixed when a buyer is in the due diligence phase.
Changes in the Tax Code or Insurance Premiums
It’s no secret that real estate has massive tax benefits for investors. However, it is a risk that the tax code we have right now may not read the same forever. Tax code changes based on politics and who is in positions of power in Congress. As we know, politics is anything but predictable, so it’s important to not base our numbers for our investments off of anything related to the tax codes or people in power. The tax benefits of owning rental property are just icing on the cake!
Inaccurate Budgets or Timelines
There is something known as a pro forma, or a document showing our expected numbers we will see on an investment property. If we take all of these numbers and calculations at face value from a seller or agent, we could be putting ourselves at a big risk. Don’t believe what other people say if they don’t have the same motives as you. Sellers want to sell, but you want to get a good deal.
This is why we encourage all of our investors at Rent to Retirement to check the projected numbers out for yourself. Check our work and use as conservative underwriting as needed to feel comfortable before making an investment. Before you buy, also make sure to do tons of due diligence on a property such as inspections, appraisals, and get rehab prices locked in up front. Also, be sure to have capital expenditure funds up front in case things go wrong early on in your ownership of a property. Just using cash flow to build your capital expenditure fund can add risk to your investment.
Opportunity Cost Risk
An unrealized risk of real estate is the opportunity cost risk, or missing out on something else that could be making you even more money than real estate! Well, I dare you to find a better investment than real estate from an overall returns perspective, and a risk perspective. Let me know if you find one! You should also only ever invest according to your investing goals. Buying a stock you think is going to soar when your goal is to build your passive income and retire early is not a congruent or smart move to make.
How to Reduce Risk
Educate yourself! The only true way to reduce your risk is to get educated. Learn as much as you can from others. Make sure not to make the same mistakes they did. If you have to make those mistakes yourself, make them all early on so you don’t make them again in the future. As Warren Buffet says, “Risk comes from not knowing what you’re doing.”