Posted over 9 years ago

How Do I Manage Real Estate Investment Risk?

There are risks involved in real estate investment just as in any investments. This article covers these risk factors and possible ways to manage them.

Risk Factors

In general, we divide investor risks into the following categories:

Legal risk - A tenant sues you.
Price risk - you pay too much for a property relative to the rent and can not make a profit.
Vacancy and rent rate risk - You can't rent the property at a profitable price now or in the foreseeable future
Rehab risk - You expected a $2,000 rehab and you are now looking at a $20,000 major rehab.
Maintenance risk - You have large unexpected repair cost like having to replace the AC or the roof.
Tenant risk - A tenant stops paying rent and you cannot get them out and they damage the property.

Legal Risk

The concern here is that a tenant or another party will sue you and you end up losing the property or other assets. To protect against this you can put each property (title) under its own separate entity so the exposure is limited to that one single property. Our clients typically choose to take advantage of the low cost and easy to set up Nevada serial LLC. (source 1, source 2). Know that we are not attorneys so you need to seek competent authority before making any legal decisions.

Price Risk

You pay too much for a property relative to the rent and cannot make a profit. This is the easiest one to manage because you decide how much to offer for the property. Make all offers based on your desired return and not the listing price. There is another protection in that lenders require appraisals and they will not loan more than the property is worth. Lastly, as long as you buy investment real estate in a good area, all but the worst mistakes will be corrected over time through appreciation, inflation and rent increases.

Vacancy and/or Rent Rate Risk

This is potentially the most serious risk because if you can't rent the property at a profit, you have the nightmare of a never-ending cash sink. This is why buying an investment property in the right location (both at the metro level and at the area level within a metro) is critical. You need to look at the location in which each potential investment property is located both as is today and how it will likely be in the foreseeable future.

The current situation is not hard to analyze as long as you include all the major cost drivers (property taxes, landlord insurance, state income tax, etc.). The challenge is what will likely happen over the next 10+ years. Some factors you must consider include:

Population - If the population is decreasing, property prices and rents will tend to fall. If the population is stable or growing at a sustained rate (avoid boom towns), property prices and rents will tend to increase. Note that nation migration maps can be very deceiving since they tend to have a macro view of an area. Urban sprawl, which may not change macro area migration trends can result in the prime renters leaving for a new area leaving your property vacant.
Job Quality - In many parts of the US, manufacturing and similar high paying jobs are vanishing and what remains are service sector type jobs. These jobs tend to pay less so the families of these workers have less disposable income. Less disposable income means they cannot afford to pay the same level of rent as they did in the past. A metric you can use is inflation adjusted per capita income. If you see a falling inflation adjusted per capita income, you need to carefully consider the long-term risk associated with buying a property in that location.

Rehab Risk

We have heard of situations where people started a rehab and discovered huge problems. The best way to avoid this is to work with a skilled property manager, Realtor and property inspector. Each can provide valuable insight. Below are examples:

Avoid buying older properties or areas which have severe cold weather. Plumbing, riding, siding, driveways, etc. only last so long and you do not want to be the one to replace them. Moisture and cold are major factors in maintenance costs and property damage.
Property managers know which areas have higher rehab and maintenance costs.
Realtors know what areas are problematic due to prior sales in the area.
Property inspectors are good at finding such issues. They have probably been in similar properties in the same area hundreds of times and know what to look for.

Maintenance Risk

Maintenance issues will happen, especially during the first year. In addition to the inspections and such during the due-diligence period, buy a one-year home warranty which covers all the significant costs like the water heater, AC, heater and more. You need to be careful selecting a home warranty company because many do little more than taking your money and denying claims. Talk to your property manager concerning who they would recommend.

Another important aspect of maintenance risk (or cost management) is a good property manager. The property manager we work with tracks every service call they receive. If a tenant has frequent maintenance requests, they proactively deal with the situation. Also, when the property manager's service people are in the properties they check the condition of the property. If the tenant is not taking care of the property the property manager proactively addresses the situation. Don't forget preventative maintenance. A good property manager monitors the properties and when (for example) tree limbs start touching the house or the roof they are trimmed back before they do damage.

Landlord insurance is critical. If there is major damage and the property is unrentable, most policies pay you market value rent until the property is back online in addition to the cost of repairing the property.

Tenant Risk

To manage the tenant risks the property manager must have an effective screening process. In addition to a detailed credit inspection, the property manager must also check:

Criminal history (national, state, county, city and sex offender). If they are on any of these lists, you do not want them.
Employment history - Are they job hoppers? If so you may not want them.
Back child support and alimony - If it comes down to them paying money to the court or you, guess who is going to lose?

One of the major issues you also need to consider is the laws affecting landlords and rental properties in the area you are considering. For example, an eviction in Las Vegas usually takes less than 30 days and costs less than $500. Clients tell us that in California, if the tenant knows what they are doing, it can take up to one year and cost thousands of dollars to evict them. The property manager can tell you all about the relevant laws and regulations in the area you are considering.

If you have any questions or comments please post them below, we will get back to you as soon as we can.