In my previous article, I discussed three big risks that anyone considering a real estate investment needs to know about. Although real estate investing can be hugely rewarding, if you don’t do your due diligence, it can also be a nightmare.
Here are four additional risks you need to watch out for. (Click here to read about the first three risks.)
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 behave badly, and you decide to not 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.
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 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!
Have 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 for 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. Constantly 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 principle 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 a 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 a good 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.
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 quickly 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 really hurt.
Risk arises from uncertainty. Risk management for real estate investments involves limiting uncertainty. This requires ongoing diligence and a strategy that needs to be constantly 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.