Don’t Let the Risk of Investing in Real Estate Paralyze You: Here’s How
As a real estate investor, every time you make an investment you take on some degree of risk. You may risk your capital, your credit, and even your reputation. You may also have other types of financial risks, involving interest rates, rent control, or even your exit strategies (such as refinancing). We take risks every day, and with our investments, some of us could be taking them more than we realize. Some of these risks are warranted, while others can be unnecessary, and sometimes there are even risks that aren’t as big of a deal as you may think.
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When the Risk Was Worth the Reward
Years ago, when I first started buying properties, I didn't have much money. In fact, I had almost no money, but I had a good work ethic and with discipline had built up good credit. At the time, I was a part-time real estate agent looking to make more out of my job. I signed up for a real estate investing course to obtain my broker's license, and on the first day, the instructor asked me and the rest of my class a question. He said, "How many of you have credit cards?" And like magic, every hand in the classroom instantly went up. He then proceeded by asking us, "How many of you have bought a house with your credit cards?" And again, like magic, every hand fell.
At the time, credit card companies just began issuing credit card checks, and cash advance fees weren't even close to what they are today. After telling us his strategy, that night I went home and couldn't sleep. I kept thinking about how I could apply it: If I wrote myself a credit card check, I could deposit it in my account and then turn around and buy a house for cash. I could then proceed to fix the house up with a credit card, and then I could pay my contractors with another credit card check. After all of that, I could even pay my credit cards with another credit card! Then it's just a matter of moving in the tenant and eventually going down to the bank, showing them my lease, refinancing the property, and paying all my credit cards off with a refi loan. The beauty of all this was the tenants could pay back the refinance loan, I still cash flowed, and I used no money out of pocket.
Immediately upon devising this plan, my mind went right to the risks. Well, I was poor, so it’s not like they could take anything I already had because I didn’t have anything. They couldn’t even take the house because credit card debt is unsecured so they could only file a judgment against me. Before making up my mind, I thought to myself, what’s the worst that could happen? They could take my credit cards away.
It’s a good thing I thought this through and didn’t listen to that initial negative voice inside my head because I successfully used this strategy to acquire my first 10 properties. And the funny thing was, I actually paid off all of these credit cards when I refinanced, and the bank just kept upping my limits of available cash! Now, I wouldn’t necessarily advocate this exact concept today, as cash advance fees are much higher now, and eventually all these rentals could whack out your debt to income ratio, affecting your ability to finance real estate in the future. But the important thing was, I didn’t let risk stop me. Many times, the biggest risk in scenarios like these is your credit, and how much is that really worth?
What’s Your Credit Worth?
After the last real estate downturn, this became a popular question as real estate values plummeted (think strategic defaults), and folks were forced into bankruptcy after encountering various financial hardships (think divorce, death, jobless, and medical issues). Working in both the real estate and the mortgage industry, I saw what foreclosure and bankruptcy could do to someone and what it took to come out of that. It was much to my surprise that it’s not always as bad as you might think.
Since the downturn, I know many people who lost investment properties due to foreclosure and have since already seen their credit bounce back. I even had a buddy who went through a bankruptcy from a divorce, and I watched him rebuild his credit and purchase three investment properties within three years. Sure, he had to pay a little higher rate, but he was still able to pull it off.
To determine how much it could affect you, you have to ask yourself what your credit is really worth. Is it $20,000, $50,000, $100,000, $1 million? At some point, good credit is only worth so much, and depending on what you want to do, it may not be worth much at all.
What does good credit really do? Well, for us investors, it usually makes it easier to buy a house. For consumers, it helps to buy a car. And for everyone else, it really only helps the credit card companies. Now, I’ve consistently had a 750 to 800 credit score my entire adult life, but with so many doorways to my name by owning properties, I still to this day have trouble getting a traditional mortgage, so what do I do? I rent — and well, too.
In fact, I’ve argued in the past articles that renting high-end can make more fiscal sense. I also haven’t been affected positively by good credit when buying a car since my company leases one for me. Of course, not everyone has the same options I have afforded to me, but the important thing is, there are workarounds. So, what good is having great credit when I’m at this stage? Not much, other than maybe cheaper insurance. I don’t really have any consumer debt, so discipline-wise, I’m right on target. But in terms of credit, despite what they say, I learned that it isn’t the end of the world. And in some scenarios, with the right investment strategy (like the one I illustrated above), your good credit is just not worth the risk of you NOT using it.
Investing With No Credit, Money, or Risk
Whether you find yourself with very little credit, bad credit, or you don’t want to risk it at all, there are other options. In fact, I find some of these options to be a lot less risky than other common strategies investors use when wholesaling, doing a fix and flip, or doing a traditional buy and hold. Let’s look at an example of how many investors who buy/own investment properties take on risks. It usually starts out the same way every time. They find the deal, they borrow private/hard money (a potentially costly risk, with collateral as well as credit, if they personally sign), they hope they complete the repairs under budget and nothing goes wrong (a risk), and then they hope that they can sell it quickly or refinance (another risk).
So, what happens if the investor gets turned down for the refinance loan? Now there's certainly ways to minimize that risk, like getting pre-approved, but it's always a possibility that the bank could change their mind. Or what if the property doesn't appraise for high enough, affecting the refinance LTV, where the investor doesn't even get enough money back for the private money loan and repair costs? Let's say the investor is able to refinance to get their money back, but what if they are unable to rent the property? Or what if they rent it out, the tenant destroys the property they just rehabbed, and they have to rehab it again? All of that's just in the acquisition stage!
Let’s not even mention the legal risks, such as trip and fall lawsuits or bankruptcy filings by a tenant or a borrower. Sometimes our equity is at risk when owning rental properties, especially if market values fall. Our cash flow can be at risk if taxes, insurance, or even use and occupancy repairs were to increase. But hey, I can’t say these risks are never worth the reward. Personally having owned over 40 units, I know they can be. But what if there was a way to receive many of the same rewards without all the risks?
One of My Best Risk-Free Investment Properties
Over the years, I’ve done my best to acquire properties without taking on much risk, but one of my best risk-free investment properties was one I don’t even own! It’s actually a sandwich lease option. Here was the scenario. I found a motivated seller one day looking to get rid of a property. Their story was one I heard often: He bought a property as a handyman special, fixed it up, rented it out, and the first tenant destroyed his rental within six months and moved out. There was nothing he could do to recoup the losses, and he couldn’t sell as is without incurring too much of a loss, so he was forced to renovate the property again. Needless to say, he was a tired landlord and now he wanted to sell. But he couldn’t find a buyer. That’s where I came in: I offered to do a rent-to-own, and since I knew the local area pretty well, I knew that market rent averaged higher than what I negotiated him down to — a $1,000 deposit and $700/month rent with the option to purchase in 5 years. And the most important part of this contract was the right to sublease.
So, I listed the property as a rent-to-own, with the rent at $1,000/month, plus I got a non-refundable option deposit of $3,000 (equal to the first month, last month, and a month security). With that cash, I gave the seller his $1,000 deposit, immediately began cash flowing $300/month, and drew up a 5 lease and option-to-buy contract. The best part was I had the stipulation that any repair under $300 would be covered by the tenant buyer, and any major repair over $300 the seller would take care of. (If I were unable to do this, I could’ve gotten a homeowner warranty to cover any maintenance expenses). Plus, if the guy bought it and chose to exercise the option, I’d make an additional $10,000 since I had the option in my contract to purchase the property at anytime for $75,000, and the tenant buyer had the right to purchase the property from me for $85,000. It was a way to invest without the responsibility of ownership; it didn’t impact my credit, and it required no money down from me personally. Plus everyone was happy — I got the property off of the motivated seller’s hands and got a tenant who normally wouldn’t be able to buy a property to be able to purchase one anytime during his 5-year lease.
Now, this isn’t something I invented, although I like to put my own spin on the strategy. Instructors like Jack Miller and Pete Fortunato promoted these investing strategies, as well as Wendy Patton (who has a great book I often recommend called Investing in Real Estate With Lease Options and “Subject-To” Deals). Another great book on investing with little to no money is written by David Finkel and Peter Conti called Buying Real Estate without Cash or Credit. Not only do they teach how to invest without credit, banks, or your own capital, but they also tell you what to say. They even tell you which tools to use and when to use them.
So don’t let risk paralyze you. Know your risks, know your precautions to limit them, and reap the rewards!
Now let me ask you, how do you measure and assess risk — and what determines for you whether the risk is worth the reward?
Let’s talk in the comments section below.