How many times have you heard - Buying Real Estate with Nothing Down is risky? Let us examine the risk factor in nothing down deals:
Few Words About Insurance
I often write about the duality – the proverbial ying & yang that exists in life. Well, let me tell you – nothing is more of a duality than the concept insurance. I’ve never met an investor who likes insurance or likes paying the bill for that insurance, and yet everyone does. Now, how is that…?
Let us understand the premise behind insurance. In most basic terms, the function of insurance is to protect you from a catastrophic loss – a loss of such magnitude that expense associated with it would send you into bankruptcy. For instance, you don’t need auto insurance most of the time, but on a day when you have an accident you really do because you’ve caused $200,000 worth of damage and have no means with which to pay up. Same goes for health insurance, fire insurance, flood insurance, etc.
So – all that we are doing by purchasing any given insurance policy is we are transferring the risk of an over-seized expense some time in future away from ourselves and onto an insurer. The more the actuarial risk of such an event, the more we can expect to pay in premiums. That’s the name of the game – transfer the risk…
It seems to me that real estate is no different from any other circumstance in life in that if we can, as much as we can, it is desirable to transfer the risk of a future loss away from ourselves. Let’s agree to define the ultimate loss in real estate as loosing the property – what can cause this and how can we offset the risk?
Basic Protection #1: Cash Flow
First of all, our capacity to hang onto property is a function of Cash Flow. When we buy property, in most cases it is evident that we can not support the costs of ownership with earned income. Yes indeed – the property must support itself. Put differently, if there’s more money coming in than the cost of ownership, then you can hold onto property indefinitely, or until you find a way out. The safety, then, is a function of the magnitude of Cash Flow.
By buying property with substantive Cash Flow, therefore, you effectively transfer the risk of a loss to the tenants who make your payments for you, so to speak. Your cash flow – the quality of the tenants that your building can attract is the only reason the lenders would so much as consider your deal: Good tenants = Cash Flow. This is why I don’t slumlord – I could never attract stable tenants and create stable Cash Flow which would in my mind as well as my lender’s constitute safety. This is also why I don’t flip – there’s no tenant there to transfer the risk onto; the risk is all on the owner in flipping…
Basic Protection #2: Financing
This is also why it is important to finance property in ways that do not force the exit, especially if you are new at this. There’s nothing worse than having to sell when either you are not ready, or the market is not conducive. Now – as you grow, specifically if you aim to become very sophisticated, you will most likely have to learn to play with things like adjustable rate mortgages, balloons, negative amortizations, blankets, ect. and there are some ways to offset the risk posed by these, but at the outset you should stick to vanilla financing…
Ultimate Risk Transfer
OK – so you have to agree that putting money on the table in any enterprise is by definition a risky activity – you could loose it. Real estate is no different from anything else in this respect. Therefore, logic would have it that the ultimate way of offsetting risk of loss in real estate is by not putting any money down! Who are you transferring the risk onto in this case – the financier.
I know – I’ll get a lot of flack for saying this, but it’s the naked truth. Having said this, let me outline some realities. Since the lender(s) know that by allowing you to finance the deal 100% they are assuming all of the risk, certain thresholds will need to be met:
- The deal must be VERY STRONG
- The Cash Flow must be VERY STRONG
- The opportunities to force appreciation and therefore create equity must be VERY STRONG
- Your track record must be VERY STRONG
Photo Credit: Max-Design