Avoiding going bankrupt

5 Replies

So I’m 21 and brand new to the whole idea of real estate investing and I’m really just trying to learn all I can and maybe start investing in about a year once I’ve saved up a chunk of change.

Anyways, I’d like to work my way to where I can make my living off real estate investing (rental properties specifically).

So here’s my worry. I know that there are risks involved, especially when you’re essentially borrowing all this money.

I’ve heard lots of success stories and how they got there, but I’ve also heard horror stories of people going bankrupt. But I really don’t know how they got to the point of bankruptcy. People (who aren’t involved in real estate investing) make it sound like one day a bubble is going to pop and there will be nothing you can do about it and everyone who relies on rental properties is going to go bankrupt and become homeless.

I would hate to dedicate a bunch of time and money into this venture and end up bankrupt in 10-15 years. So, tell me, those who end up bankrupt, is it because of something they did incorrectly or is it really just a huge stroke of bad luck? And how can I prevent it besides avoiding investing completely?

The short answer of how you go bankrupt is this. You buy a bunch of property using a lot of debt and leverage and have very little equity. The market now tanks and the house you bought for 100k with 90k in debt is now only worth 70k.

This is what’s called being underwater and if you have many properties like this it’s very difficult to stay afloat and often ends in foreclosure and maybe bankruptcy

And If your success is predicated on rent coming in.. and your leveraged and renters leave then that is how you lose properties.. not happening today.. but it did happen 08 to 2011 in some markets.. Not all but some.. and it could happen if you say buy in a one horse town and the horse goes lame.

Elizabeth,

You bring up a very important point. There are a few ways to go bankrupt in real estate. The two most common are 1) lack of knowledge (also not applying your knowledge) and 2) bad breaks.

The knowledge thing you are in control of,  that is to say you can learn the correct way(s) to buy, hold and sell real estate. It's not rocket science by any means, but you do have to be careful which routes you choose to use. For example,  it's very easy to use leverage to purchase real estate.  

The harder question is at what level of leverage is safest? 97% of purchase price is easily done (FHA Owner Occupied 1 to 4 units) but that might be disaster if the economy contracts and you loose your job and you can't find tenants to cover your mortgage.

On the other hand, if you own the property outright  (no mortgage) then you can most likely cover taxes and insurance, even if you don't have a job. 

Of course #2 takes a whole wack of cash and and what return are you making? 

I think to be at 50 ish percent LTV is best. It's not always possible, but it's a level that makes most sense to me.

For #2, If the stuff really hits the fan (think 1929) then those at a 50% LTV are probably in trouble. If it's 2008 all over again, 50% will probably be ok. But life doesn't come with gurantees.

#2 can also happen if your assumptions are incorrect. Let's say your thoroughly considered analysis, that has been checked and rechecked and run by a trusted associate turns out to be wrong for reasons beyond your control. Something stupid like an undiscovered earthquake fault right under the property that you didn't insure for. Then you could be in for a bankruptcy that has nothing to do with your skill, knowledge or LTV.

Bankruptcy can also occur if you are just plain stupid, overly optimistic or have a life event (divorce, hospitalization etc.). These are control able through education,  discipline,  and insurance.

Your best method of prevention for going bankrupt is to constantly be learning, have equity in your properties (or use all cash, yours or someone else's) and some multiple of monthly expenses in the bank at all times to cover stuff that comes up. For example,   I have friends that hold 1 year of salary (about 1.5 years expenses) available immediately.  Other  friends think they are nuts and could do with half that and be using the rest to invest.

Hope that helps.

Good luck, 

Jim 

@Elizabeth Richter risk is reduced by knowing your market. Not just in it's current condition, but what did it do during the worse recession of our lives? Knowing what a good deal is in your market reduces your risk. Some things we can control, like location, and others we can't. What if interest rates go back up to 10%? Fixed rate mortgage or paying cash is a control measure. I suggest learning, looking, watching, and saving up cash. When you see a good deal, you can jump on it.  Don't be afraid of the unknown. Learn what is unknown to you and you will be less afraid.

you have to purchase well under market value to give yourself a cushion. Avoid very short-term financing with balloon notes. Build slow and steady and taking stock of your reserves because our landlords will have to deal with new roofs new water heaters Etc.

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