April 30, 2016

Real estate investing is not without risk.

In fact, it’s full of risks.

Fortunately, anything can be overcome as long as you plan for it.

By working it into the numbers up front, you can really never lose on a deal. That’s why  analyzing the investment property is the most important step.

What bothers me, though, is that these risks scare people away from investing. If people understood it, then people wouldn’t fear it.

Risks of real estate include foundations, tenants, and other hidden problems.

But at the same time, risk is what makes it so rewarding. If there was no risk, everyone would do it and no one would make money. Investors can make a lot of money because they are willing to take those risks, then find ways to mitigate them.

So let’s talk about those risks.

I’m going to loosely categorize the risks into two groups. The first type, or what I call ‘the well-known risks’ are the obvious risks that everyone knows exist, though many often forget to think about.

The second type is the ‘hidden risks’ because they are rarely thought about, though they can be detrimental.

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.

Tenants are a risk to your investment

The biggest fear 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.

Tenants are risky because they cause damage Tenants are risky because they cause damage.

They are risky because they get mad and refuse to pay the rent.

Tenants sometimes spend their rent money on a new TV.

That’s why it’s imperative you learn how to be a great landlord so you can limit this risk.

No matter what you do, how you screen, or what your requirements are, you will always have the “tenant risk.” They can cause damage, stop paying rent, steal from you, or even rob a bank and suddenly disappear when they get arrested (yes, this happened to me).

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.

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.

It’s also important to have strong documentation backing you up. If you go to court, you want to have the evidence to support you, so I recommend downloading this free package of 48 landlord forms that you might need one day.

Hidden structural problems are a risk

People are often afraid to take on a project because they simply don’t know how extensive the work will be. Building structures are very complicated (people do go to school for years to learn how to design them), and most people usually have no idea if something has a problem.

What really makes it tough is how most buildings are entirely covered by some surface. Drywall, siding, floors, and ceilings all cover the structure and make it impossible to gauge the necessary repairs.

Walls and floors can hide risks such as insect damage.
Walls and floors can hide risks such as insect damage.

Just one hidden problem can turn a profitable project into a money pit. That’s why due diligence is really important when buying rental property.

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. It’s really great to be able to walk away from a deal before sinking any time or money into it simply because you know it has a major flaw.

You can work the numbers in up front with your initial offer. If they reject the offer, you barely wasted an hour. If you don’t find a problem until inspection, you’ve wasted a week or two and the money on the inspector.

Sure, it’s still better to walk away than get a bad deal, but wouldn’t you rather save that time and money? So, learn about what will end up costing you.

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%.

I often build in an additional 10% by reducing my estimate After Repair Value.

So, by subtracting 10% from 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 Risk

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 cash flow analysis. Speculating is always risky, that’s why I don’t list it as “investing.” (This article explains that flipping is not real estate investing.)

Just like in the stock market, I believe you should not engage in speculation unless you are experienced and also have a strong portfolio that can cover your losses.

Avoid the cash-flow trap – only buy property that has positive cash-flow. Also, ensure the project is properly capitalized up front and always expect it to take longer than planned.

Changing Demographics

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.

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 of 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.

City Planning

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.

There are undoubtedly some risks that I haven’t written about, so please comment and let me know. For every risk, we can find a way to make money using it. The key is to find great real estate deals and account for all the risks.

About the author 

Eric Bowlin

Eric is an investor that achieved financial independence at the age of 30. He started in 2009 with the purchase of his first triplex and now owns over 470 rental units. He spends his time with his family, growing his businesses, diversifying his income, and teaching others how to achieve financial independence through real estate. Eric has been seen on Forbes, Trulia, WiseBread, TheStreet, Yahoo Finance and other financial publications. You can contact Eric by emailing him at [email protected] or with this contact form

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