Historically, real estate investing has been one of the best ways to build long-term wealth. Many of the world's richest people made their fortunes by investing in property.
However, like any other type of investment, real estate investing is not without risk.
Here are some pitfalls to be aware of before becoming a real estate investor.
Risk #1: Choosing the Wrong Location
Location should always be your primary consideration when purchasing any investment property. You can't move to a more desirable location if the neighborhood decays or the mall a block away disappears. For commercial real estate, you don't want to have the only occupied shop or office on a vacant block.
Things to Research
You'll want to research market trends and zoning in the area you're targeting;
- What was the property appreciation rate in recent years?
- What changes, if any, is the zoning board planning?
Additionally, you'll want to explore the neighborhood.
- Check out shopping services
- Drive during rush hour to assess traffic congestion
- Look at crime rate trends and check school system rankings.
These factors are important for anyone looking to rent or buy a property.
Why Location Matters
Location also determines the supply and demand that come into play when you want to sell. Don't be tempted to shop in a specific area where prices are lower. But this can be a scary choice. If the prices are low, there is usually a reason.
The location may not have a growing population or a good job market. Or too many available investment properties can reduce rental income. Lower demand will be reflected in a lower sales price and number of days on market. And they increase your maintenance costs.
Some areas will have high levels of tenant occupancy with few owner-occupiers. Owners who live locally tend to take better care of their property. They also monitor crime in the neighborhood. Consequently, areas without owner-occupiers often have lower tenant quality.
So your initial cash outlay may be less, but you may end up paying more in repair costs. And it doesn't help your bottom line. Additionally, you may face a greater risk of vandalism or theft. Nobody wants that. All of which can lead to unexpected expenses and large repair costs, as well as legal problems.
Location is also the most important determinant of property valuation. A low valuation 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 buy 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 the most important part of being successful as a real estate investor.
The priority is not to spend on the purchase price or renewal. During the buying process, it is all too easy to buy a property that is more damaged than it appears. (You can't see behind the walls or check all the systems during the walkthrough.) You need to do some diligent costing and take some leaps of faith. That means there's a risk you might not get what you think you're paying for. This increases the likelihood of unexpected repairs, renovations and maintenance costs.
Always check, even when buying “as is”. That way, you'll know what your expenses will be when you become an owner. If you are financing the purchase, your lender will do an appraisal, which will also give you a good idea. Property appraisers and inspectors are friends of the buyer.
After purchasing a property, resist the urge to upgrade it beyond the local market. Most rental units don't need granite countertops or high-end appliances. Be sure to run and rerun your numbers to avoid overspending.
Risk #3: Bad Tenants
Finding qualified tenants is critical to the success of your real estate investment. It is important to accommodate tenants who pay rent consistently, respect it and take care of their property. While it sounds simple enough, I found I had to weed out a lot of potential tenants to find these gems.
You want to avoid having bad tenants. Therefore, you must pre-qualify potential tenants. Go through a thorough tenant screening process. This includes checking your employment, checking your credit score, checking your criminal and court records, and contacting previous landlords. Or use a tenant placement service, but be sure to do your due diligence on them as well.
Being stuck with a bad tenant can be worse than having no tenant at all. Having your property empty means not collecting rental income, but bad tenants can be even worse. Some will continually fall behind on rent. This of course compromises your cash flow. And you may have to deal with the eviction process, which is time-consuming, expensive and downright unpleasant.
Risk #4: Vacancy
With a rental property investment, your property may be vacant for a long time. There are a number of reasons this could happen. Families are growing and need more space. The tenants misbehave and you decide not to renew your annual lease and ask them to leave.
You will lose rental income during the transition period between tenants. You must prepare the property for the next tenant and find and screen applicants before anyone moves in.
Vacancy is a big risk for real estate investors who rely on rental income to pay their mortgage payments, insurance, property taxes and other expenses.
By diligently placing qualified tenants, you can avoid most of the costs of vacancy and tenant turnover. And if your investment property is in a prime location where rents increase annually, you can provide yourself with positive cash flow that increases with inflation.
Avoid the risk of high vacancies; buy your investment property in a good location where rental properties are in high demand. These locations are usually safe neighborhoods with nearby services such as transportation, shopping centers, and schools.
Risk #5: Negative Cash Flow
An investment property's cash flow is its 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 rents you collect. When this happens, you will use other income to maintain the property. Never a good thing!
Was the property inspected prior to purchase? This may cost several hundred dollars, but you will be able to more accurately project costs and create a budget. You must cover your storage 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 in a negative cash flow situation. (The exception is if your property is located where home values are skyrocketing.) The number one reason real estate investments fail is having negative cash flow for a long period of time. This is not sustainable and may force you to resell the property at a loss or become insolvent.
Prepare for positive cash flows that grow with inflation. Choose an investment property in a prime location where rents are increasing annually.
Risk #6: Real Estate Market Unpredictability
The real estate market has been doing quite well in most areas over the past decade. However, there is no guarantee that this positive trend will continue.
Many of those who believed that real estate values ”always appreciate” have found themselves “over the top” in real estate. This is when you owe more on the property than the current market value. This happened to many when they bought between 2005 and 2007 during the buying spree that led to the housing bubble.
The real estate industry is a market that goes up and down depending on many factors. Just like in the stock market, you want to “buy low and sell high.”
A “buyer's market” is when the supply of homes on the market is greater than the number of buyers, and prices tend to fall. A “seller's market” is the opposite. Buyers are flocking to buy homes, and the supply of available homes is not keeping up with demand. This leads to higher prices. A neutral market is when supply and demand match.
No one can predict the future. Mitigate your risk through due diligence and research. And avoid emotional buying and selling.
Don't buy investment properties when demand is high. If you do, you risk selling it for less than your purchase price. Even if the property is making a profit through rental income, you can lose money if its value has fallen.
Although investing in real estate is a long-term investment, it is not an illegal 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 with cash because cash buyers get the best deals and can buy distressed properties that lenders won't finance. Then you have it ready to rent and tenant occupied. And then you refinance it at the new appraised value to fund your next cash transaction.
For investment properties, lenders generally require a 20% down payment. So you can cash out 80% of the new appraised value. Then you have 80% leverage on the property. Do this over and over and you'll be exposed to high leverage risk.
Leverage is a force multiplier. You can move the project forward quickly and increase profitability if all goes well. But if cash flow becomes a problem, investors tend to lose fast and badly. This usually happens when the rental income is not enough to cover the principal and interest.
As a general rule, the more debt you have in an investment, the riskier it is. And like any investment, you should expect a higher return for taking on more risk.
I use leverage very sparingly. I know it's as easy to dominate real estate as it is to abuse a consumer credit card.
Make sure you get an excellent return to compensate for the risk, regardless of your risk tolerance. This is a good rule of thumb. leverage should not exceed 75% of asset value.
Conclusion
Real estate is a form of asset with limited liquidity. It's not like the stock market where you can sell stocks quickly if you need cash. You can't sell a house instantly for sudden and unexpected expenses. Investing in real estate also requires a significant amount of money.
If these factors are not well understood and managed, real estate becomes a risky investment. And since investing in real estate involves putting down a significant amount of money, losses can hurt.
Risk arises from uncertainty. Real estate investment risk management involves limited opportunity. This requires ongoing diligence and a strategy that must be constantly monitored and adjusted as the market changes. But the rewards, additional income stream and opportunity to build wealth can be worth it.
