How do you calculate risk when you are investing in residential real estate?

Question

I want to hear your thoughts on how you calculate the risk of failure for investing in real estate. As someone who has invested in equities my whole life I was trained to look at the WACC value or Beta of risk based on the fluctuation of similar equities. On the other hand, in real estate there are different metrics based on the type of investor you are. Do you calculate how much time you have to put into it? What about the risk of default? Do you mainly go on your gut instinct? I want to hear your thoughts and please feel free to be as creative as you want.

Scott Mac · Answer

Well this is not equities.

To me it's more like owning a 7-11 (than owning securities), you need satisfied customers with enough money to buy your products, and you need new customers who need and want your product.

There is long term maintenance to keep the asset value (providing the neighborhood does not slide downhill in 20 years and become a crime hole).

Realize your cash flow needs to be set aside for things like roof replacements, water heater replacements, etc..., (HUD has a service life list for things).

You benefit from loan pay down, natural appreciation over time, and any forced appreciation you can do.

You can get depreciation on an asset that appreciates.

You lose if you run out of money to pay the mortgage, insurance or taxes, and lower the rental value if you cannot or do not do required maintenance and replacements to stay current with local current demands.

You may face foreclosure, bankruptcy or personal asset dissolution, depending on how your assets are held and how your loan is worded.

I don't think you can put a numeric on the risk.

To me it seems more like a Zone thing.

You are in a more risky zone, if you do not know what you are doing, have little money to fall back on for business use, or etc...

An all cash deal would be the safest zone, with an experienced operator, who is a hammer swinging self fixer type person, owning very near their residence.

So I think it's kind of like defining what hot is with out using degrees, it's hot or cold outside and many shades of grey in between.

Just my 2 cents.

HUD Service Life Table:  https://www.hud.gov/sites/documents/EUL_FOR_CNA_E_TOOL.PDF

Randy Rodenhouse · Answer

As an investor of 30 years, the risk is really getting into a property that has poor cash flowing.  My first property was bought in 1992 and since then bought many properties and even during 2006-2007 at the peak was buying.  However, never had an issue with those properties since in every case those properties were paying me an income every month.  If the value dropped by 10,20, or even 30% it did not effect my cash flow and I just waited out the storm similar to when you buy a stock and it dips but comes back but in the mean time you are getting your dividend check.

Carlos Ptriawan · Answer

most of the risk in direct real estate, in reality, comes from unexpected events:- natural disaster- tenant issue- city issue or regulation- crime actionI have been thru all of that, and the key to overcoming that issue is to have a huge reserve and be a strong character, be resourceful and ability to fix problem/delegate issue extremely quickly.

Mike Dymski · Answer

Buy properties where there is little to no risk of extended periods of vacancy regardless of market conditions, where replacement cost is well below cost to build, add value, and have multiple exit strategies.  Many investors also carry large reserves in the form of cash, retirement funds, brokerage accounts, or HELOCs...and have their W-2s.  Lastly, buy properties with 20+% IRRs to have a lot of room for bad execution or market conditions.

Nicholas L. · Answer

@V.G Jason

my point is just that house hacking is lower risk than, say, buying a random property thousands of miles away and hoping for the best (like the CA investor buying in Cleveland thread that we both just commented in).

i didn't say no risk - all RE involves risk.

Ke Nan Wang · Answer

That's a great question @Ran Iarovich. I can only speak from my own experience, and that is: I don't have a method to calculate the risk to tell me either yes or no on an investment. It's learn as you go, and keep up with podcast, forums and network groups, and read books. Learned from others, and implement ideas, keep what's working and get rid of what's not working. It's the best way to learn. If you only have limited capital, start with lower risk project first (house hacking or buy real estate in the market you know, mostly in your local market). Once you have more capital, depend on your personal goal, maybe you are willing to take on higher risk investment project to make more money: use more leverage, long distance investing, investing into assets you haven't done before, etc.

Quick example:

You know T-bill is yielding 5% interest right now. So that's your baseline. Understand RE provides other benefits (tax shield, depreciation, etc.), and you do your analysis and see if the ROI is worth your time, effort and stress. Also keep this in mind, we use to pay 100k tuition to get a college education. So if you are young, even breaking even on a project but you learned valuable life lessons is a win. These real life lessons you can't learned in school. And the only sacrifice you have to make is your time. So getting start early is more important than getting a ROI in my opinion. After you do a couple of deals, then you look at the real numbers, and decide for yourself. "man last year I only made $100, or lost $2000 on these deals, but I learned valuable lessons and I think I will make more money in the next deal" or "real estate investment is just not my thing and I'd rather put my money to go buy stock or bonds."

I like RE investment because in my opinion, it's the more secured investment that provide tons of benefits where currently there are no other investment class can compete. Also you have the flexibility to make it as active or passive as you can be.

Eliott Elias · Answer

Most single-family investors are not this sophisticated. They plug-in numbers that takes them two seconds to figure out if the deal works for them or not. Those who make a career out of this and take this seriously evaluate risk on a high level.

Account Closed · Answer

Hi Ran,

Always set aside some cashflow from the rental income for general maintenance, or future renovations. When underwriting, always consider potential vacancies/tenant turnovers.

Account Closed · Answer

Risk management should be done before the purchase is final. Be a tad conservative with your earnings, and maybe a bit more liberal with your expenditures. Calculate a 5% vacancy fee, 10% management fee, and only use 2-3% for growth year to year.

John Morgan · Answer

@Ran Iarovich

I go with back of the napkin quick math and my gut. But I’m only doing single family which isn’t rocket science to figure out if it’ll be profitable. I don’t over think it. If I see a good deal, I jump on it right away.

How do you calculate risk when you are investing in residential real estate?

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