Historically, investing in real estate has been one of the best ways to build long-term wealth. Many of the world's wealthiest people made their fortunes by investing in properties.
However, just as with any other type of investment, real estate investing is not without risk.
Here are a few pitfalls you should be aware of before becoming a real estate investor.
Risk #1: Choosing the Wrong Location
When buying any investment property, the location should always be your primary consideration. You can't move house to a more desirable location if the neighborhood deteriorates or a strip mall goes in a block away. For commercial properties, you don't want to own the only occupied storefront or office on a vacant block.
Things to Research
You'll want to research the market trends and zoning in the area you're targeting:
- What has been the property appreciation rate over the past few years?
- What changes, if any, are being planned by the zoning board?
Additionally, you'll want to study the neighborhood:
- Survey the shopping amenities
- Drive around during rush hour to assess traffic congestion
- Look into the crime rate trends and check out the ratings of the school system.
These factors matter to anyone who may want to rent or buy the property.
Why Location Matters
The location also determines supply and demand, which comes into play when you want to sell. Don't tempt to buy in a specific area where prices are lower. But this could be a terrible choice. If prices are low, there's usually a reason.
The location may lack a growing population or a good job market. Or too many available investment properties may be bringing down rental income. Low demand will be reflected in a lower sales price and a higher number of days on the market. And these increase your holding costs.
Some areas will have a high tenant occupancy rate with few owner-occupants. Owners who live on-site usually take better care of their property. They also monitor crime in the neighborhood. So, areas without owner-occupants often have a lower quality of tenant.
Thus, your initial cash outlay may be lower, but you may end up paying more in repair costs. And that does not help your bottom line. Also, you may face an increased risk of getting vandalized or robbed. No one wants that. It all can lead to unexpected expenses and high repair costs, in addition to legal matters.
Location is also the most significant determinant of property appreciation. Low appreciation can mean a negative return on investment when you decide to sell. No appreciation means you'll likely lose money when you sell, after paying commissions and transaction fees. You may be tempted to purchase a cheap investment property, but in most cases, the risk is not worth it.
Risk #2: Paying Too Much (Or Not Getting What You Think You Paid For)
Buying the right property at the right price is arguably the most critical part of succeeding as a real estate investor.
It's paramount not to overspend on the purchase price or the renovation. In the purchase process, it's far too easy to buy a property that's more damaged than it looks. (You can't see behind the walls or test all the systems during a walk-through.) You have to calculate costs with diligence and take some leaps of faith. That means there's a risk that you are not getting what you think you're paying for. This increases the chances of facing unexpected renovations, repairs, and maintenance costs.
Always get an inspection even when you're buying “as is.” That way, you know what costs you will have once you become the owner. If you're financing the purchase, your lender will do an appraisal, which will give you a good insight as well. Property appraisers and inspectors are the buyer's friend.
Once you purchase the property, resist the urge to over-improve it beyond what the local market expects. Most rental units don't need granite countertops or top-of-the-line fixtures. Be sure to run — and rerun — your numbers to prevent overspending.
Risk #3: Bad Tenants
Finding quality tenants is paramount to your real estate investing success. It's essential to place tenants who pay the rent consistently, respect you, and take care of your property. While that sounds simple enough, I've found that I need to weed through a lot of potential tenants to find these gems.
You want to avoid having bad tenants. So, you need to prequalify potential tenants. Go through a thorough tenant screening process. This includes verifying their employment, checking their credit score, checking their criminal background and court records, and contacting their previous landlords. Or use a tenant placement service, but make sure you do your due diligence on them as well.
Getting stuck with a bad tenant can be worse than having no tenant at all. Having your property empty means not collecting any rental income, but bad tenants can be worse. Some will continuously fall behind on paying the rent. This, of course, jeopardizes your cash flow. And you may be stuck dealing with the eviction process, which is time-consuming, costly, and just downright unpleasant.
Risk #4: Vacancy
In rental real estate investing, your property could become vacant for an extended period of time. There is a variety of reasons this can happen. Families grow and need a bigger place. Tenants misbehave, and you decide not to renew their annual lease and ask them to leave.
You'll lose rental income during the transition time between tenants. You need to prepare the property for the next tenant and find and screen applicants before someone moves in.
A vacancy is a huge risk for real estate investors who rely on rental income to pay their mortgage payments, insurance, property taxes, and other expenses.
If you are diligent about placing qualified tenants, you can avoid a large chunk of vacancy and tenant turnover costs. And if your investment property is in a prime location where rents are increasing annually, you can set yourself up for positive cash flow that increases with inflation.
Avoid the risk of high vacancy; purchase your investment property in a good location with a high demand for rental properties. These locations are typically safe neighborhoods with nearby amenities such as transportation, shopping malls, and schools.
Risk #5: Negative Cash Flow
Cash flow from an investment property is your net income. This is the amount you earn after paying all expenses. Expenses include maintenance costs, taxes, HOA fees, property management, insurance, and mortgage payments.
Negative cash flow is a situation you want to avoid. This is when your expenses are higher than the rent payments you collect. When this happens, you'll be dipping into other income to keep afloat with the property. Never a good thing!
Has the property inspected before you buy it? This may cost several hundred dollars, but you'll be able to more accurately project costs and create a budget. You need to cover your holding costs and maintenance and repair costs. Avoid negative cash flow by accurately forecasting your income and expenses before you buy.
It's rarely a good idea to be in a negative cash flow situation. (The exception is if your property is located where house values are increasing dramatically.) The primary cause of investment failure for real estate is going into negative cash flow for a long time. This is not sustainable and could force you to resell the property at a loss or go into insolvency.
Set yourself up for positive cash flow that increases with inflation. Choose an investment property located in a prime location where rents are increasing annually.
Risk #6: Real Estate Market Unpredictability
The real estate market has been growing quite well in many areas for the past decade. However, there's no guarantee that this positive trend will continue.
Many who believed that real estate values “always appreciate” found themselves owning properties that were “upside down.” This is when you owe more on the property than the current market value. This happened to many people when they purchased in 2005–2007 during the buying frenzy that led to the housing bubble.
Real estate is a market that goes up and down based on a lot of factors. As with the stock market, you want to “buy low and sell high.”
A “buyer's market” is when the supply of houses on the market is more than the pool of buyers, and prices typically drop. A “seller's market” is the opposite. Buyers are flocking to purchase homes, and the supply of available homes isn't keeping up with the demand. This causes prices to go up. A neutral market is when supply and demand match.
Nobody can predict the future. Mitigate your risk through due diligence and research. And avoid emotional buying and selling.
Don't buy an investment property when demand is high. If you do, you may risk selling it lower than your purchase price. Even if the property generates profit through rental income, you could lose money if its value has dropped.
While real estate investing is long term, it's not a set-and-forget investment. Regularly monitor the value of your holdings and adjust your entry and exit strategies based on the current market.
Risk #7: Becoming Over-Leveraged
Most real estate investors use leverage to buy and hold properties. You buy the property for cash since cash buyers get the best deals and can purchase distressed properties that lenders will not finance. Then you get it rent-ready and tenant-occupied. And then you refinance it at the new appraised value to pull out funds for your next cash deal.
For investment properties, lenders typically require a 20% down payment. So you can pull out 80% of the new appraised value in cash. You are then leveraged 80% on the property. Do this over and over again, and you end up with a lot of leverage risk.
Leverage is a force multiplier. It can move a project along quickly and increase returns if things are going well. But if cash flow becomes an issue, investors tend to lose quickly — and by a lot. This typically happens when rental income isn't enough to cover the principal and interest payments.
As a general rule, the more debt you have on an investment, the riskier it is. And as with any investment, you should expect a higher return for taking a higher risk.
I use leverage very sparingly. I know it's as easy to become overleveraged in real estate as it is to abuse a consumer credit card!
Be sure you are receiving an excellent return to compensate you for the risk, whatever your risk tolerance may be. Here's a good rule of thumb: Leverage should not exceed 75% of the asset's value.
A real estate is an asset form with limited liquidity. It's not like the stock market where you can quickly sell shares if you need cash. You can't instantly sell a house to pay for sudden and unexpected expenses. Real estate investing also requires a significant amount of money.
If these factors are not well understood and managed, real estate becomes a risky investment. And because investing in real estate involves putting a significant amount of money at stake, the losses can hurt.
Risk arises from uncertainty. Risk management for real estate investments involves limiting possibility. This requires ongoing diligence and a strategy that needs to be continuously monitored and adjusted as the market changes. But the rewards — an extra stream of income and the opportunity to build wealth — can be very much worth it.
Have you invested in real estate? What have been your experiences? Comment below.