Just about everyone knows somebody who has owned a rental property. It could be a house that they picked up on the cheap or it could be an apartment building that they bought or was passed on from a family member. Maybe you saw one of those infomercials back in the 80's or 90's that touted the benefits of owning rental property and they were going to sell you their free weekend seminar to teach you all their secrets. You took this dream to heart and started looking for answers to your questions and you asked those that were closest to you but unfortunately you chose the wrong people. They told you that investing in real estate is risky, that you will lose everything, that you should study hard, get a good job and save money. They said that because that is what they were taught, they were not taught how to manage risk in their investments and likely they were not taught how to invest at all. That is one of the failures of our education system, it is designed to produce workers.
It is true that investing in real estate is risky but so is investing in the stock market. All investments carry some degree of risk which is why they include a disclaimer stating as such. What is riskier than investing is not investing and trying to save your way to financial freedom or relying on your defined contribution plan to sustain you in retirement. If your goal is to work until you are 66 and retire so you can take a pay cut and live off your 401(k) and social security, then you can probably skip the financial education.
Risk in real estate can come during any part of the investment lifecycle but there are ways to minimize the risk during every step. Adequate due diligence, the correct financing, expert management, and a proper exit strategy are some of the ways you can reduce your investment risk.
We are going to address 7 of the most common ways people think real estate investment is risky and then talk about ways you, as an investor, can minimize that risk.
One of the old sayings in real estate is location, location, location. The location of your investment should be your first consideration, that is why one of the first things we wrote about was how to choose your market. There are many things you can fix about a real estate investment, but you cannot fix its location. If you buy a property in a bad area, you cannot easily move it, so you want to make sure the area and market are trending in an upward direction.
People find themselves in trouble when they locate a property that is comparatively cheap for the market and do not realize it is because the property is either in a high crime area or the area is becoming depressed and all property values are falling.
Ways you can mitigate the risk is knowing what the city zoning board has planned for the area. You also want to know what shopping is nearby and what shopping is planned to open in the short term. You should also check the area out during times of high traffic so you can gauge the relative safety and congestion. Finally, it is good to review the crime statistics and public-school performance. As the public schools in an area fail so does the value of the property.
Real estate is considered an illiquid investment and as such, you will have a large amount of capital tied up without a quick or easy way to access it. If you get in a bind you cannot sell off part of your portfolio like you can with stocks. It takes time to sell your real estate holdings and can be quite a lengthy process.
Knowing you exit strategy is paramount for a successful real estate investment. Having multiple options available can help if you need to sell or refinance the property at any point during the investment.
If you get in a position where you need to access some of the capital tied up in an investment there are options available. One of the best ways is with a cash out refinance. If you have been able to increase the value of the property you can often get a cash out refi for up to 75% or 80% of the new value of the property. The refinance proceeds are also a non-tax event so you can save yourself quite a bit of tax liability.
Bad property or structure risk
One thing people probably warned you of is that some buildings and sellers have hidden deficiencies and deferred maintenance. What are you going to do if this thing or that thing breaks? What if the previous owner hid a broken sewer main or a leaky roof? Or one of the many other "what if" situations you have been told or can think about?
Not catching a structural problem is certainly a risk when dealing with real estate but that is why a proper and thorough physical due diligence is imperative. When conducting your due diligence, you need to be sure you are granted access to EVERY unit and ALL common areas. You need to get in and fully inspect the mechanicals, and structure from the foundation to the roof. There can be no question of access, if the seller waffles on this one they are likely hiding something, and it should sound the alarm bells.
Leverage is one of the most powerful tools in a real estate investors toolbox, but some people misuse it which can lead to dire consequences. This often comes in the form of a loan and having more debt on a property will allow an investor to bring less of their own capital for a down payment. If the investor is syndicating the deal it also means they will need to complete a smaller raise to close on the property.
The risk comes when the cash flow and income of the property are unable to cover the expenses and debt service on the loan. You see, when you buy a property with leverage you do not actually own the property, your name is on the deed, but the lender owns the property. If you decide to stop making your payments, then the lender can take ownership of the property through a foreclosure.
There are a couple ways to make sure you do not find yourself overleveraged. The first, and most obvious, is to use the correct down payment. Most lenders will require at least a 20% down payment so you are only leveraging 80% of the property’s value. The second way to ensure you do not become overleveraged is to ensure your cash flows remain high enough to cover the expenses and debt service. Because market forces can be out of your control, proper stress testing during your underwriting is essential to your cash flow projections.
Unpredictability of the market
What if the market tanks and the property loses its value, isn't that a huge risk? Many of us have been around long enough that we have seen multiple times where real estate prices have fallen sharply, the most recent that I recall was in 2008. It is true that real estate prices fall at times but so does the stock market and the volatility in the stock market is not mirrored in real estate. The real estate market is often referred to as a lagging indicator, meaning the rise and fall of prices are reflective of what has happened and not necessarily of what is to happen. Additionally, the slow transactional speed of real estate helps prevent the sharp peaks and valleys of other investment types.
Knowing your exit strategy and what point of the investment cycle the market is in is key to making a successful investment. Some markets are in a great position for quick flips while some are primed for buy and hold. When the demand is high in a certain area the prices will rise which will make it difficult to have adequate cash flow. Conversely, when demand falls so do prices. Your investment strategy needs to keep pace with the current cycle so you can maximize your returns and the returns of your investors.
But what if you do not make money in a month, maybe you need to buy a new roof or furnace, so you do not have the cashflow? What if you have a spike of vacancies, what are you going to do?
The reality is that at times during an investment there may be occasions where returns are not met as expected. This happened to many operators in early 2020 when Covid shut the economy down. In order maintain adequate reserves, many operators held quarterly returns until things settled down and collections continued.
These are all real possibilities, but proper stress testing and expert asset management can greatly reduce the risk. Vacancies are a fact of life with real estate investments but that should be accounted for during the underwriting before purchasing the property. Deal sponsors need to perform a stress test to determine the minimal occupancy to maintain the expected returns. After the acquisition, it falls to the asset manager to ensure those key performance indicators continue to be met on an ongoing basis. The asset manager is also responsible for maintaining the reserve accounts to be able to cover times where cashflows do not meet expectations.
What happens if a tenant wrecks the unit they are renting, and you need to fix it? What if they burn the place down!? I have seen these things happen; they have happened to good operators in good areas. Real estate is a business about people and when you are dealing with people nothing is guaranteed.
To best mitigate the risk of bad tenants it is imperative to conduct a thorough background check. This will usually include a criminal background check along with a credit check and employment verification including current salary. As an operator it is your duty to find the best tenants for your community, this is not just in your best interests, but it is also in the best interest of your current residents.
Of course, not all tenant problems can be solved proactively with excellent screening so there is need for additional protections. This is where insurance comes in and choosing the right insurance for the right property is another task that falls to the expert asset manager. If too much insurance is chosen, then it could negatively impact the cashflow but if too little insurance is chosen then the property can be financially liable during a loss. A proper balance is key.
So is real estate really that risky?
It is true that investing in real estate can be risky, but is it any riskier than investing in the stock market? Would you rather trust your hard-earned capital with a hedge fund manager whose main goal is to collect the fees associated with your capital investment? Or would you prefer to invest with a real estate sponsor who you can reach out to and have a direct conversation when you have question? I would argue that an investment in real estate with an expert asset manager is a far safer investment than one that relies on the market forces within stocks. In stocks, the President of the United States can send a tweet and the market can shed a thousand points for little reason but in real estate, the prices do not wildly fluctuate.
To mitigate most risks during the life cycle of a property, proper planning is mandatory. This begins before the acquisition of the property, when it is still in its underwriting phase, and continues until the property is sold. An expert asset manager is one of the most important team members to a successful investment and can greatly reduce the inherent risk associated to this type of investment.
If you have any questions or if there are any topics you would like to see covered please reach out to me at Mack@InfiniteFocusCapital.com