Defining and Mitigating The Ultimate Risk for Long-Term 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.
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.
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?”
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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!" â 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.
- 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
- 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.
- 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”…..