What exactly makes REI risky?

[Jeffrey Lester]

Hello, everyone! 

I have been reading like a mad man, and I feel like I have a pretty solid understanding of financing, renting, selling, controlling the properties you buy and a variety of other techniques and investment methods (I have not actually done any deals, however - I'm only 18).

However, there's still one definite gray area that remains, and that is this: what are the risky  aspects of investing? 

I understand that these add to risk:

• Not understanding your niche 
• Not having a solid team 
• Buying bad deals 
• Lacking the general education needed to succeed in this field
• Lacking self confidence and hope for a prosperous future 

But what I truly do not understand and feel that I cannot prepare for is market volatility. 

Here's an example of what I'm worried about: 

• I study my market and learn it inside and out
• I am very educated in my niche 
• I have put together a reliable and trustworthy team 
• I find a house for 15% below market value (for simplicity - the house is $85k, it is worth $100k), which gives me a significant advantage in that I can have a higher cash flow and be protected against small market fluctuations 
• I put 20% down 
• I start renting out the property with an excellent property manager managing it for me 
• I'm making $500/month in pure cash flow after all fees, mortgage, taxes, etc.
• Two years later, the market starts to take a turn for the worst, and the house drops rapidly in value by 35%
• I try to sell the house before it drops too far, but no one wants to buy properties when they know prices will continue to drop 
• Rent no longer covers the mortgage and fees due to the incredibly cheap housing market, therefore the house is foreclosed and my credit and reputation with many partners is destroyed 

This. This is my worst nightmare. This is what I desperately want to learn about so that I can prevent it from happening. This is mainly the only thing that scares me about REI, so if someone could tell me some strategies, methods, or books that exist to teach people how to minimize risk in REI, I would be eternally grateful.

I'm going to college in the fall and am planning on investing in my first property next year. I'm simply trying to prepare in order to minimize risk as much as possible :-) 

Thank you!

[Ned Carey]

There is nothing that will protect you from a dramatic drip in both rents and prices at the same time.  However that is very unlikely to happen.  Rents and prices do not necessarily move in parallel.  In the recent downturn rents went up as former homeowners moved into rentals. 

Understanding market cycles can dramatically reduce your risk and increase your returns.  The safest time to buy is after a dramatic drop. Risk was dramatically lower in 2008-2009 than it was in 2005-2006, although most people would have told you the opposite at the time.

The other protection you alluded to by saying don't do bad deals.  For the most protection only do great deals. Again despite what people will say, on any given deal, the higher the return the lower the risk. In general the types of properties that provide very high returns tend to be riskier deals. However on any given deal buying at a lower price increases your return and lowers you risk at the same time.

However the biggest risk has little do do with your concern.  The biggest risk is not understanding the hidden costs. New landlords don't think about things like vacancy rate, turnover cost, leasing commissions, capital reserves and others.  They also underestimate repairs, if they consider them at all.