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Defining and Mitigating The Ultimate Risk for Long-Term Real Estate Investors

by Erion Shehaj on March 26, 2014 · 18 comments

  
Risk Real Estate Investors

It’s no secret that long term real estate investors as a “tribe” don’t like risk very much. Their choice to follow a long term investing path as opposed to more “creative” (read: riskier) one is a testament of their aversion to risk. In my experience, I’ve noticed that risk tends to appear as a set of vague and undefined “what if” scenarios in the minds of long term investors. As long as these doubts remain undefined, they have the potential to undermine the investor’s willingness to move forward and they can promote paralysis and inaction – the biggest wealth killers of all.

What’s interesting is that even though the doubts and questions are many, the risk of owning long term real estate investments can be synthesized into just one predominant question.

Related: Manage Your Investment Risk with the Help of This Technique

What if I have no tenants? 

Have you taken a look at an investment property’s profit and loss statement lately? The reason why it starts with Potential Rental Income is because that is the foundation that supports the whole structure. A great investment property can become nothing more than an money-sucking black hole without that blessed potential rental income. So it’s no wonder that the ultimate risk that terrifies all long term real estate investors when they get started is the scenario of a vacant property over long periods of time. Such a scenario, inevitably, conjures images of vast financial ruin and a predisposition to stay put and avoid the risk at any cost.

Defining the Ultimate Risk

I’m going to let you in on a little secret: There’s no such thing as “having no tenants”

You heard that right.

Here’s what I mean. Suppose you’re considering the purchase of an investment property that is projected to rent for $1500 per month. Your operating expenses plus the mortgage payment add up to $1150 per month with a projected positive cashflow of $350 per month. You’re worried about the devastating scenario that no one wants to rent your property. Let me ask you a question: If you reduced the asking rent price to $750 per month, would you have a tenant? You’d have a line out the door. What about at $1000 per month? Same story.

Therefore, there’s no such thing as “having no tenants” but rather, having no tenants at a specific price point. Now that we are clear on that important distinction let’s get back to the scenario above and evaluate the risk with a fresh pair of eyes. In a worst case scenario, you could reduce the rent by $350 down to $1150 and break even. That represents a 23% drop from your asking price which would only happen in the deepest of economic depressions.

Let’s take that one further: In the event that even dropping the asking price by a quarter of the projected amount won’t suffice, will you then be responsible for making all payments on the property? Not really. Because in the end there’s a lot of price points between break-even and zero.

Related: 12 Easy Tips to Reduce Your Vacancy Rates and Find Great Tenants

Mitigating the Ultimate Risk

However, price isn’t the only reason why you might find yourself in a situation where no one wants to rent your investment property. A couple of years ago I was attending a commercial real estate mastermind/workshop in Chicago and one gentleman there worked for the loss mitigation/REO department of a regional bank that dealt in apartment (multifamily) loans. He was discussing how risky making that type of loan could be for the bank when  one of the participants got up and said:

“In this business I hear a lot of people speak of risk in an excessive and obsessive manner. I don’t really get it. If you are lending money at 70 cents on the dollar on a property that is already at a certain level of occupancy, with income coming in regularly, even if you have to foreclose , where’s the risk in that?”

At that point the gentleman responded and shared this story. They had made a loan for 60% of the market value of a 90% occupied large apartment complex to an experienced investor. After a while, due to the recession, the investor had fallen into hard times and the bank repossessed the property with an 80% occupancy rate. Three weeks later after an altercation in the premises two people had been shot dead. Occupancy dropped to 10% as most tenants left en masse. The lender ended up dumping the property for a huge loss. “THAT’S the risk in that!” – he exclaimed before he sat down.

Now, that’s a very extreme example but I think it serves to make the point that the risk can come from circumstances unrelated to your ability to find and keep tenants. But there are some critical steps you can take to mitigate the ultimate risk.

  1. Make sure your numbers are correct – Your analysis of the rental market for a specific property has to go deeper than average price/sf times the size of the property. You must pay attention to days on market, amenities and finishes and outliers that skew averages. If the market analysis shows the average rent for an area to be $1500 a month but it would take you 100 days to find that tenant, are  you really getting $1500 in rent per month? Next, if the average home for lease in that community offers granite counters, stainless appliances and hardwoods should you use the average rent figure for your plain Jane property? Finally, look deeper at the comps. Is there a property that for whatever reason leased at a far higher rate than everything else and is skewing the average higher? When in doubt err on the conservative side
  2. Make sure you screen your tenants properly –  Ninety percent of evictions, broken leases, unexpected vacancies and damaged properties can be avoided at the tenant screening stage. You have to set rules and guidelines on what makes an acceptable tenant and never break them. Would you consider a tenant with a broken lease? What about a tenant that has criminal history? If not, stick to that when the time comes and process applications like a business. Do you think Chase would approve a credit card for an applicant whose credit score didn’t meet their criteria but who had a very good reason for it? Finally, call  and cross check all references. Some of the best information sources on tenant performance are previous landlords. If they weren’t good tenants before, what makes you think they would become good for you? But you have to make sure the person you are calling is truly the previous landlord and not Cousin Vinny. A quick cross check of the property records should clear that right up but you’d be surprised how many investors can’t be bothered to do this simple check.
  3. Buy good quality properties in good quality locations – When you buy well located, quality properties in safe neighborhoods you won’t completely eliminate the extraneous factors that can disrupt the investment performance of your property but you can minimize them significantly. Moreover, the property you buy “picks” the type of tenant you are likely to get so if you’re looking for a tenant as responsible as you are, why would you buy a property in a neighborhood you would never live in?

Not Feeling Warm and Fuzzy?

I understand that talking about losses, vacancies, price drops etc. isn’t very exciting. We’d much rather speak of positive cashflow, full occupancy and wealth building. But the the number one rule of any investing still remains: Don’t lose the money! Therefore you have to start with a careful consideration of all risks involved. But you have to make sure that you define that risk so what you’re evaluating is the true potential for loss rather than a fear of vague disastrous consequences. Then you can take steps to mitigate the risk  by scrutinizing the numbers, screening tenants well and buying only quality properties in quality locations.

What are your thoughts on “the ultimate risk”…..

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{ 18 comments… read them below or add one }

Sharon Tzib March 26, 2014 at 5:53 pm

Your advice is solid, however, I think besides a lot of investors being “excessive and obsessive,” they also can be overly controlling with their investments, thinking that will help them mitigate risk as well (like being able to drive by their investments, doing some of the repair work or property management on their own, etc.). But what if there are no cash flowing deals in your immediate area that allow you to exert this control? Do you then throw in the towel and not invest at all, or do you go find a different area where you can find a great tenant base and strong property management to properly screen your tenants? Sometimes we have to let go a little in order to move forward with our goals.

Also, I heard a great tenant screening tip on BP, and darn if I can remember from who, but when you are making those reference calls to the landlord, say “I have an application here from Vinny, and he gave me your name as a former employer, is that correct?” If they say yes right away, you know they’re a fake. You can reverse the scenario when calling an employer. Tricky but effective :)

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Erion Shehaj March 27, 2014 at 10:09 am

Everytime an investor brings up the “I’d like to drive by my properties” spiel, I ask them if they apply the same logic to all their investments. For instance do they only invest in stocks that have facilities within driving distance so they can go by the plant and check the operation? Maybe do some maintenance repairs while they’re there to increase the profitability of the company?

The truth is if your investment performs as it should you should never have to drive by the property unless you just want to. Hire the right people and run it like a business.

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Chad Carson March 27, 2014 at 3:47 pm

I agree that trying to control everything and do everything is a bad strategy. But being local (or being willing to fly into town and get boots on the ground if you’re not), adds another layer of risk reduction when things get REALLY bad.

I’ve found some of the biggest problems (usually when I bought the wrong properties) could be solved or mitigated with some creativity and most of all with the human touch, face-to-face (like talking to and taking actions to reassure all the tenants who fled the apartment building in the article).

I’m willing to bet the bank who sold at a loss on the multiunit deal wasn’t local and wasn’t ready to get their shiny shoes dirty. I’m also willing to bet that they weren’t proactive to get boots on the ground to really access the problem, reassure tenants, take drastic measures, etc.

Mitigating disasters can be done when you’re not local, but it’s a heck of a lot easier when you can drive across town – either as a lender or as a landlord.

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Sharon Tzib March 27, 2014 at 4:08 pm

Chad, my only point was IF there are no cash flowing deals in your immediate area that enable you to exert this control, then you are better off investing out of area than not doing anything at all.

I’ve been an out-of-state investor since ’07. One year one of my homes got hit by a tornado, which you might agree is pretty disastrous. Did I get on a plane and rush there to handle it? Nope, didn’t even occur to me. Called my tenant first to make sure they were ok. Then called my Property Manager and my Insurance agent, and they handled everything. My tenant was very pleased that the home was repaired quickly with minimal inconvenience to her. My experience has been that with the right team members, there’s rarely, if ever, a need to be present at your investments.

Chad Carson March 27, 2014 at 6:22 pm

Good points Sharon.

My main point was that while out of state investing can obviously work fine, local investing does have advantages in certain situations like management crises when unusual action needs to be taken (usually with people problems). But as Erion and others pointed out, better properties, locations, and tenants will almost eliminate these types of rare problems in any case.

Good team members do make life easier – locally or long distance. If you’ve got great ones, hold on to them. I don’t check mail, collect rent, fix toilets, or file paperwork either and I love it.

Jason March 26, 2014 at 7:31 pm

Nicely done.

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Eric March 26, 2014 at 8:33 pm

Tenant screening is key. Many times I have had ‘cousin Vinny’ listed as a landlord reference. You would think they would use a fake name too, not someone with the same last name…

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Sharon Tzib March 27, 2014 at 9:31 am

Ha! Well they’re not always the brightest bulbs in the pack, now are they John? :)

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Erion Shehaj March 27, 2014 at 10:11 am

If that can slide that past the owner, why not? It’s your responsibility as the investor to make sure everything is buttoned up.

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Sharon Tzib March 27, 2014 at 4:09 pm

Sorry, I meant Eric!

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Eric March 27, 2014 at 3:53 pm

I agree there is always demand, at the right price. Unfortunately, too many ‘investors’ either under market, or over price. Then, they wonder why all they have is subpar tenants applying.

The fact is, if you are priced too high, and outside of a fair value range, the solid tenants go elsewhere. The subpar renters go where they can, and they pay more for it.

As an investor with 24 tenants, I know when I am $25 overpriced. Pricing in the Winter in MN, might be different than the summer.

Know your market!

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Erion Shehaj March 28, 2014 at 1:52 pm

@Eric

Thanks for sharing. I think the issue most investors run into is that they confuse price with value and as such want something for nothing. If you have an average property and you demand higher than average rent, you get underqualified tenants that don’t have many options but to overpay. By the same token, if your property has nice finishes, great tenants don’t mind paying middle upper or top rent. Value vs Price. All that matters is what they get for the money.

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Eric April 2, 2014 at 5:33 am

Many investors cannot get that simple concept, high rents attract trash. I actually have a post about that on my blog.

Another simple concept of being able to ‘sell’ a property, and a vacant apartment is no different than a truck load of bananas, is another concept many investors do not get. A post I just wrote too…

I recently took a class ‘D’ apartment complex and turned it into a class B complex. There are plenty of solid renters out there, and they want to rent.

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Jeff Brown March 27, 2014 at 8:50 pm

The reason I abandoned my own local market, San Diego, was that even though investors could ‘drive by’ their properties, that wasn’t the problem. The real culprit was they’d paid up to 22 times the gross annual scheduled rent for a 2-4 unit property. Driving by that travesty didn’t reduce any risk whatsoever. It merely reminded the ‘local’ investor they shoulds listened when they were offered opportunities in other states. :)

There’s simply no magic tied to the ability to ‘drive by’.

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Erion Shehaj March 28, 2014 at 1:52 pm

“Driving by that travesty didn’t reduce any risk whatsoever”

Poetry :-)

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Lisa Phillips April 2, 2014 at 4:15 am

Lol

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Lisa Phillips April 2, 2014 at 4:13 am

SPOT ON!! 10000% Thank you! I tell this to new investors, in many different ways, all the the time! You can ALWAYS get a tenant, just lower your price a bit. I mean, If I can rent my living room out (seriously, a living room), you can rent an entire house. Its all about the price point.

Thank you for this article, I will definitely link to it in the future when someone asks!

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Eric April 2, 2014 at 5:36 am

Selling vacant apartment is no different than selling a truck load of bananas. A vacant unit will ‘spoil’, if it is not sold. People intuitively understand they must lower price on bananas, but on their rental, they hang tight. It makes no sense…

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