What are the risks of REI?

Question

David Faulkner · Answer

Self management of a high quality property in a high quality neighborhood is extremely passive. All my property and systems are "dialed in" ... I can easily leave town anytime I like for extended periods of time and still easily self manage ... my units don't own me I can assure you. Managing a bad property manager and cleaning up the messes that they create on your behalf is what is NOT passive. And a vast majority of PMs are bad. Buying property in low quality neighborhoods with low quality tenants that you have to chase around for rent is what is NOT passive. This is what you learn to avoid with experience, but it takes a few duds, bad experiences, and resulting risk to get to that point. In addition to gaining this experience, you should listen to somebody that has actual experience and nothing to sell, not just stuff they learned from a couple hours of guru training or from the guru themselves.

David Faulkner · Answer

Once you have the knowledge to pick up the right kind of properties bought on the right terms and have the right management team in place (or better yet, learn to self manage), then it is fairly low risk and passive. The hard work and risk is in getting to this point. As a newbie, you are your own worst enemy and ignorance is your biggest risk, and no you cannot learn everything you need to know on BP, though it may help with some basics. You will likely buy a few dud properties (especially if you chase yield and compromise on quality and go a long distance away to a market where you have no knowledge or control to get it) and you will likely run through many property managers (because honestly most of them suck) before you find a good one ... each of these mistakes will cost you money, take a lot of hard work to correct, and hopefully you will learn from it so as to not repeat the same mistake again. This takes time, and some of the issues mentioned may not start showing up until years in (for example underestimating CapEx because you think it should be a percentage of gross rent, but home depot or your contractor doesn't ask you how much your rent is when calculating your bill), so if you ramp up and leverage way up in the meantime before you learn these lessons, then these risks can be amplified especially in a downturn ... this is how some new investors go bankrupt and some others burn out before they learn.

Frank Chin · Answer

Some folks are hard to convince about the benefits vs the risks of real estate. I had this debate going on for over fifty years with my dad about it. Even though a commercial property he owned appreciated well beyond expectation, he's not convinced.

I ran into these skeptics, a few of them close relatives. I happen to started with REI in a 3 family living in one of the units. To these people, it's OK, as you still need a place to live, right? In my case, I started off with the rental units covering the mortgage, so the skeptics can't complain about anything. Can they do better than living rent free?

This 3 family I got for $150K in 1983 shot up to $350K in 1986. So I tell them, look how well it's doing, can you imagine making $200K just like that? The skeptics would say, well it can still go down. Yes, it did. The housing market went into a dive, but bottomed out in 1992, where my home went down to $250K.

An exterminator I hired to treat one of my rentals, in the late 90's asked how I'm doing in real estate, after learning I don't live there. I said, "I did great". Asked me when I started, and I said in1982. So I asked him, when did you start, when he mentioned he got involved in REI. He told me 1987, with a dejected look, when it was at it's peak. He went on to say "I lost my shirt". He's not the only one, 2 owners next to my 3 family I bought in 1983 lost theirs. One bought it in 1986 for $350K, sold it in 1990 for $300K to another investor, who gave up on it, sold it for $250K around 1992. The problem with these guys is they started with zero or negative cash flow and can't hold on.

While it's not wise to time the market, you have to see what part of the cycle you're in. Around here, the market bottomed out in 2008-2009, and gradually rose. I followed the value of my current home, the FMV is $850K in 2007, $650K in 2009 (the bottom) and currently at $1,050M. Real estate cycles run in 8 to 10 year cycles, I think it's near it's peak again. I bought it at auction in 1993, the bottom of the last cycle for $200K.

Now, when I started in 1982, I looked at the FMV for properties I was interested in. Then I spent months to find those that's selling at 70% FMV. Took me close to a year to find something. At the time, I felt I needed some cushion if a market correction came. So I got a 3 family worth about $210K for $150K. I cashed flowed better, and when the correction came, it never went below what I paid for it. It takes time to find these, but if you spend the time, you'll find them. Some people give up too soon, paid close to FMV at market peaks, and lose their shirts.

Franco Li · Answer

Think about this, rather than understanding your risks of real estate, lets look at opportunity costs:

1.) Leaving the money in the bank

100% safe, FDIC will cover you, and you'd be earning roughly 0.01% APR - although GS Bank which I use is offering 1.00%

2.) Putting your money in stocks or bonds

Assuming you don't want to spend time looking up and analyzing different companies and various investment grade or junk bonds, and you put the money into an index fund or a mutual fund. You will be making roughly 5-10%/ year and face just as much risk from the market and economy. On bonds, you'll be making maybe 1-5% on short duration investment grade, and maybe 8%+ on high yield junk bonds. You will also leave your capital gains to be taxed which you cannot offset with expenses.

3.) REAL ESTATE

Real estate is more of a business than an investment. You have to manage the inflow and outflow of your investment, the actual property, and you do a lot more work. Your earning potential will vary, but if you are competent and intelligent then you can perform anywhere between 10-50% ROI. If the market goes bust, hey dude, you at least still own a property that can still house someone (even at lower rents). When you want to leave the market, yes you may face residual risk on the value but that comes with being an intelligent investor in the first place!

Also, if you are scared about a housing market downturn, check out my view on that:

https://www.biggerpockets.com/forums/48/topics/430...

Kenneth Garrett · Answer

@Ryan Morgan

Welcome to BP.  There are no guarantees.  There is risk in any type of investment including mutual funds.  Education is the most important thing.  Learn as much as you can.  Pick an area that you want to invest in and become an expert in that market.  This could be your neighborhood, a subdivision, a pocket within a few streets.  Narrow it down so you are not all over the place.  Attend REIA, meetups, etc.  Learn as much as you can.  When you invest you want to make educated decision/risk.  Find a mentor who is actually successful.  Maybe on your first investment you partner with an experienced investor so you can learn the steps.  I partnered on my first buy n hold.  I now have 10.   Most importantly, you need your spouse to be all in.  Without mutual consent from both of you, you could encounter problems.  We always try to avoid problems but they come with the territory.

Good Luck.

David Dachtera · Answer

@David Faulkner,

Well, as I've never bought any guru training, I'm not stuck with that.

Once of my current friends / mentors is a property manager - he's also my landlord and an RE agent/broker with 40 years experience. He also leads the buy-and-hold study group at my weekly meetings. I have plenty of access to first-hand experience, even if I have not yet acquired much myself.

If you're out of town and a property emergency arises, I do hope you have someone you can call to address the issue promptly. I doubt such an issue would wait 36 to 48 hours until you can arrange travel back from the other side of the planet to deal with it.

It may be that there are a lot of bad PMs out there. That's THEIR problem, not mine. If I fail to manage my PM properly, that's MY fault, not theirs, including replacing them, when needed.

David Dachtera · Answer

@David Faulkner,

"low risk and passive" and "self-manage" in the same sentence constitutes an oxymoron. The two are diametric opposites.

To self-manage means you are NOT a business owner: the business owns you.

Having a manager / management company means the business runs without you, and you are free to get sick, take vacations, have a life, ...

My $0.02 ...

David Dachtera · Answer

@Ryan Morgan,

A market downtown would have little or no impact on residential rentals. Your cash flow doesn't change, even if your equity position does.

Not sure what "major house issues" might include. All properties - even your own home - have challenges.

Mutual funds are more risky and volatile than real estate.

There are no risk-free investments. You just trade one risk for another.

Note also that you can NOT "save" for retirement! It's impossible! You MUST invest for income, that means you must accept certain risks. Higher returns translate to greater risk.

The risk on the other side is running out of money in retirement.

Risk aversion is THE #1 wealth killer!

Roy N. · Answer

@Ryan Morgan

As with any investment, there is risk.  However, if you do your diligence and take reasonable steps to mitigate the risk, real estate can be a low to moderate risk investment in relation to the yield it produces.   I would contend the risk - not to mention annual costs to hold - are less than that of mutual funds.

While there are many different ways to invest in real estate and you will need to identify those which appeal to you, if one seeks out buy-and-hold rental properties with a focus on maximizing cash-flow, then you care little about a down-turn in the housing market as you are not banking on the appreciation of your properties.  Naturally, you will still be concerned about the stability of the underlaying local economy as that effects the viability of your tenants, but the actual market value of your property is insignificant until you dispose of the property.   If the property has produced good cashflow for 20 years and your tenants have paid off the mortgage, you will have great flexibility in the price at which you can sell the property and still come out ahead.

What are the risks of REI?

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