Even if you aren’t brand new, sometimes it’s helpful to get a very general overview of things as a way to help drill it in and help you better understand it.
Before even talking about the risks, one thing you want to be very clear about when it comes to rental properties is the numbers. I didn’t know a thing about how to run numbers on a prospective rental property when I first got interested in real estate, and I’ve since learned that most people really don’t have a clue about them.
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The truth is, most properties don’t make good rental property investments.
I usually hear it’s in about the 80% range for properties that actually don’t pan out financially as rental properties. Why is this? Because the numbers don’t work.
What do I mean by “the numbers don’t work?” It means that your actual expenses (which are usually more than what people realize) exceed the income on the property, and therefore, you lose money. Losing money is not the point of investing. Making money is.
All risk involved with rental properties is directly related to the numbers. I can tell you the risks of rental properties, and you will understand them well enough. But if you really understand more about the numbers and what goes into actually receiving returns from them, the risks will just make all that much more sense.
There is something that all seven of these risks have in common: They all cost you (the owner) money. See the logic there? If the whole point of owning a rental property is to make money, then all of the risks of owning rental property would be associated with losing money, right? Say “yes.”
If you want, you can alternatively phrase the question, “What are the risks associated with owning a rental property?” as, “What are all of the ways you can lose money with a rental property?” Pick your poison. Again, a seemingly pointless distinction to the more advanced investors, but at the beginning levels of learning all of this stuff, certain distinctions aren’t so pointless to make.
In no particular order, here are what I deem to be the seven primary risks of owning rental properties (aka seven most likely ways to lose money with a rental property).
Unfortunately, vacancy poses a bigger financial issue than most buyers realize. Keep in mind that the tenant could unexpectedly break a contract and move out at any time. During vacancies you deal with:
- Lost rental income, which you absolutely must take into account if you are currently paying a mortgage on the rental property
- Turnover-induced repairs
- Payment to an agent handling your property (usually the equivalent of one month’s rent)
Even though the expenses of vacancy pose a risk, there are several things you can do to avoid them.
- Buy in a growing market, not a saturated one. You don’t want a market that has an excess of rental properties for a prospective tenant to choose from.
- Research vacancy rates in the general market and the sub-markets so you have an idea ahead of time about what to expect.
- Don’t purchase investment properties in a neighborhood that typically only attracts owners, which means it will be hard to find renters for a property.
2. Damage, repairs, and maintenance
The cost of fixing things can range all over the board—and sometimes it can cost more than appreciation. Minor repairs could be less than $100, while major repairs could hit tens of thousands of dollars, with every cost possibility in between. These fixes could include theft or tenant-induced damage as well as wear and tear or CapEx-level maintenance. Here are some of the more serious issues to keep in mind.
- Water heaters
- Structural issues
- Internal wiring
- Something you didn’t know when you bought the rental property
There are several ways a landlord can minimize the risk of high costs from fixing a rental property.
- Never, ever buy a property without getting a full, professional property inspection done on it.
- Always estimate the costs, and be financially prepared for minor repairs as well as CapEx maintenance and such, in these calculations.
- Have a prospective tenant fill out an application that includes a look into their rental history and bank account statements to make sure they are high-quality renters. This is not always foolproof, but it does narrow the chances of you getting financially burned.
3. Decreased rents
The risk of decreased rents occurs in cases where the economic conditions of the market change such that you can no longer get as high a rental income as you once could. If general rents decrease, then you also have to decrease how much rent you ask for in order to stay competitive. This means you could have an income level that doesn’t necessarily support the expense level of the property.
The advice for a landlord trying to avoid the market fluctuation is to buy in a solid growth market—not a market that is just stable (and certainly not one that is declining), but one that is in a solid trend of growth.
4. Decreased property value
If the neighborhood where you purchased your rental property experiences several foreclosures or short sales, then the value of the entire neighborhood depreciates. This is important to keep in mind if you plan to buy, sell, or refinance any of your investment properties. You never want to be in the situation where the market for your rentals declines in such a way that you can no longer collect high enough rents (or any rents) to cover your expenses, putting you as the landlord underwater.
There is a simple way to avoid the risk of potentially decreased property values: Buy in a growth market. If a market is growing, values should go up. If a market is declining, values are likely to go down.
Also, you don’t want to buy at the top of the market (when properties are most expensive). Take a look at the history of the other neighborhood properties and remember to avoid purchasing property for rentals in a neighborhood full of foreclosures.
5. Market unpredictability
It’s important to keep in mind the role that the market economy plays in the future value of investment properties. If you were to buy investment properties during peak times, then you have to consider that when the time comes to sell them, their value may drastically have gone down as the market moves away from the peak. Even if you have considerable profits in income from rentals, the property value loss may result in larger expenses than you collected from your tenants.
The best way to avoid this issue of negative equity is to really research and acquire a deep understanding of the market’s economy. Once you have a handle on the knowledge for forecasting the long-term results of a real estate investment on a rental property, then you will be able to determine if it is the proper time and type of property for you to invest in.
This can also be mediated by expanding your portfolio to include many types of investments, such as apartments, malls, REIT funds, and office buildings.
6. Bad location
Location, location, location! If you have not heard this phrase before, then the real estate business is not for you. Choosing a good location is one of the very first things real estate investors must consider. While some locations with lower prices may seem like a steal, keep in mind that neighborhoods with high crime rates have lower purchase prices for properties. This means you run the risk of having your rental property vandalized or robbed, which you would have to pay to have repaired.
While choosing a bad location may seem like one of the biggest risks in buy and hold real estate, some investors still choose to take the risk since the purchase price is so low. This might be a good idea if you have the extra capital and the neighborhood is showing signs of future real estate development. If it’s headed in the right direction, the location of the neighborhood might be worth the risk of investment in the long run.
7. Negative cash flow
After paying for your mortgage payments, expenses, and taxes on your rentals, the amount of profit left over is defined as your cash flow. If your income from the collected rent from your tenants is less than your expenses, you have a big problem—a negative cash flow. You obviously want a positive cash flow when it comes to your investment properties because the whole reason you invested in the first place was to make a profit.
The best way to avoid a negative cash flow is to thoroughly calculate all your expected and unexpected expenses before you purchase the property. This includes calculating potential repair and maintenance costs, property management expenses, and vacancy rates. Even the smallest expenses add up in the long run, so these financial estimates are essential to the pre-purchase process.
Buying rental property—also known as the buy and hold strategy—helps investors secure both steady cash flow and equity. With this method, real estate investors purchase properties and rent them out long-term while the value appreciates. BiggerPockets’s guide to the buy and hold strategy will teach you how to analyze rental markets, budget for your investment, choose the best property, and finance your purchase.
Ready to start investing in rental property? Start with Buy and Hold: An Investor’s Guide to Purchasing Rental Property.
Real estate investors know that there is risk associated with every single method of real estate purchases. If there weren’t, more people would do it.
You can never completely eliminate risk, and things can happen even when the highest levels of risk mitigation have been achieved, so always know what you are getting into. Don’t completely fry yourself with analysis paralysis but spend some time getting educated on the risk factors associated with any investment opportunity.
Ultimately, real estate investing should be fun. Be smart about it but have fun with it. You know what they say—no reward is without risk. Now that you know how to identify and avoid seven of the biggest risks in buy and hold real estate, go have fun making your first investments.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.