Scare me! What are the risks I need to be aware of before REI?

31 Replies

I'm actively searching for my first multi-family property which I plan to have professionally managed.  

The market I'm shopping is solid (not hot, but solid) with good rent prices relative to purchase price with good cash flow opportunity.  

I tend to use extremely conservative numbers in my analysis so I'm prepared for higher than average vacancy, maintenance costs, etc.  If my selected property cash flows with those conservative numbers, the deal is probably okay.  

What I'm trying to wrap my head around is what the bigger risks are and how to protect against them.   

Lawsuits - good management company + umbrella liability

High Vacancy - conservative assumptions in original analysis + cash reserves

What other risks should I be cognizant of? In the event of a serious economic downturn I could face inability to sell the property / foreclosure.

Obviously I don't really want to be scared out of a investing in real estate...I just want to be sure I know what the risks are so I can mitigate them.

Disclosure: you said "scare me" so here goes. 

  • Foundation issues
  • Termites
  • Floods
  • Inadequate insurance
  • Insurer fails to cover damages
  • Water leaks - old pipes breaking leaks and tenant caused leaks
  • Falling trees
  • Drug dealers moving next door
  • Meth cookers
  • Squatters
  • Copper thieves
  • Looters stealing anything of value (furnace, appliances, etc)
  • Multiple evictions back to back
  • Slip & Fall scammers
  • Tenants bring in people not on lease
  • Property Manager is inadequate or worse disappears/incapacitated

I've been in REI for 19yrs so not much I haven't seen, experienced or personally bite me in the assets.

Overpaying, failing to do due diligence, and choosing a bad location are huge.  There are a lot of things with real estate that can be fixed, but paying too much is hard and not getting into and understanding the details can be very costly, especially when you're new.  Location.  It's cliche' but cliche's usually are spawned from truth.  You can find a "steal" of a 1000-unit complex, but if it's in a horrible location that's getting worse, no amount of money will "fix" it.

I've met hundreds of investors since starting in 2005 and only a couple of them were successfully sued.  Dozens of them have fizzled out because they bought bad property that was too expensive to fix and/or was in a poor location, and it was a downward spiral after that.  That isn't to say you shouldn't be concerned about proper legal protection, but focus the bulk of your concern on getting the fundamentals of the business correct.  Evaluate your deals thoroughly: have an experienced investor with whom you are not in competition look it over.  Study market demographics in your location.  Find out which types of units rent quickly vs. which linger.

Here's a piece of good news: liability insurance is cheap because the insurance company rarely has to pay out, which means the odds of you being sued and them having to pay is very low.  I get $1 million for about $300/year, and above that amount it's even cheaper.

Work from the worst case scenario and go up from there. Worst case scenario is probably you lose all of your investment, and do something negligent that gets you sued for more than the asset. Insurance and LLCs can cover some of that risk but not all of it - for example, a huge mortgage that you default on, a bank could come after personal assets if it makes sense regardless of your "veil" of an LLC. Your protection of your personal assets, not including what you are going to invest, is either your investment is substantial enough to protect your partners (i.e. the bank) financially if things go south, or you have so few assets that bombing means no one can recover from you because you have nothing to recover.

@Anita Parsa you don't do a proper inspection of paperwork or property and what is in the leases does not match tenant copies. There are no deposits recorded by LL but the tenants will tell you differently when the time comes. You fail to use a buyer's agent and get insufficient disclosures and maybe much worse. No one tells you you may have money coming at closing. You fail to recognize that some sellers lie, some really badly! You think you hit the jackpot when you find an off market 20 unit seller finance deal. Hahaha! Do your homework, follow the process, trust no one, always have access to money and things will work out, trust me.

Originally posted by @JD Martin :

Work from the worst case scenario and go up from there. Worst case scenario is probably you lose all of your investment, and do something negligent that gets you sued for more than the asset. Insurance and LLCs can cover some of that risk but not all of it - for example, a huge mortgage that you default on, a bank could come after personal assets if it makes sense regardless of your "veil" of an LLC. Your protection of your personal assets, not including what you are going to invest, is either your investment is substantial enough to protect your partners (i.e. the bank) financially if things go south, or you have so few assets that bombing means no one can recover from you because you have nothing to recover.

In my situation, we have substantial assets because we are nearing retirement. The impetus for REI is to supplement retirement income.

What's the universe of personal risk in a default / foreclosure situation?  Is it limited to the size of the mortgage or is there a way it could be bigger?  

Originally posted by @Anita Parsa :
Originally posted by @JD Martin:

Work from the worst case scenario and go up from there. Worst case scenario is probably you lose all of your investment, and do something negligent that gets you sued for more than the asset. Insurance and LLCs can cover some of that risk but not all of it - for example, a huge mortgage that you default on, a bank could come after personal assets if it makes sense regardless of your "veil" of an LLC. Your protection of your personal assets, not including what you are going to invest, is either your investment is substantial enough to protect your partners (i.e. the bank) financially if things go south, or you have so few assets that bombing means no one can recover from you because you have nothing to recover.

In my situation, we have substantial assets because we are nearing retirement. The impetus for REI is to supplement retirement income.

What's the universe of personal risk in a default / foreclosure situation?  Is it limited to the size of the mortgage or is there a way it could be bigger?  

It can be as big as the note you are willing to risk, leaving out legal risks like negligence lawsuits and the like since good insurance & limited liability can cover this for the most part. Let's say you put down 20% (200k) on a million-dollar apartment and borrow 80% ($800k). Now let's say the market has a severe downturn and your vacancy gets bad enough that you can't make your payments and your building goes into foreclosure, and let's say it gets sold or the bank gets it back at $500k. Unless you have a no-recourse loan, you can bet the bank is coming to see if they can get $300k from your personal assets. This is how people can go from flying high, with all kinds of properties and cash flow, to being flat broke. They can also get legal and collection fees. Some of this varies depending on your state.

So if you are a person with substantial personal assets, you would be wise to limit your risk from large individual judgments. This can be done by owning a lot of parceled debt - let's say you had 10 $100k single family homes, with the same scenario as above. If you defaulted on half of them because of vacancies and the like, the size of the remaining debt to each lender may be small enough that they don't bother going after your assets, or allow you some kind of payment plan, etc. Or you could be in the $1 million apartment with several partners so that liability is spread among several people.

A lot of people try to use the LLC to shield their assets and that is the purpose, but generally for legitimate business purposes and not for the pure investment used only for cash flow - those have been pierced by courts and will probably always be open to that.

Originally posted by @JD Martin :
Originally posted by @Anita Parsa:
Originally posted by @JD Martin:

Work from the worst case scenario and go up from there. Worst case scenario is probably you lose all of your investment, and do something negligent that gets you sued for more than the asset. Insurance and LLCs can cover some of that risk but not all of it - for example, a huge mortgage that you default on, a bank could come after personal assets if it makes sense regardless of your "veil" of an LLC. Your protection of your personal assets, not including what you are going to invest, is either your investment is substantial enough to protect your partners (i.e. the bank) financially if things go south, or you have so few assets that bombing means no one can recover from you because you have nothing to recover.

In my situation, we have substantial assets because we are nearing retirement. The impetus for REI is to supplement retirement income.

What's the universe of personal risk in a default / foreclosure situation?  Is it limited to the size of the mortgage or is there a way it could be bigger?  

 It can be as big as the note you are willing to risk, leaving out legal risks like negligence lawsuits and the like since good insurance & limited liability can cover this for the most part. Let's say you put down 20% (200k) on a million-dollar apartment and borrow 80% ($800k). Now let's say the market has a severe downturn and your vacancy gets bad enough that you can't make your payments and your building goes into foreclosure, and let's say it gets sold or the bank gets it back at $500k. Unless you have a no-recourse loan, you can bet the bank is coming to see if they can get $300k from your personal assets. This is how people can go from flying high, with all kinds of properties and cash flow, to being flat broke. They can also get legal and collection fees. Some of this varies depending on your state. 

So if you are a person with substantial personal assets, you would be wise to limit your risk from large individual judgments. This can be done by owning a lot of parceled debt - let's say you had 10 $100k single family homes, with the same scenario as above. If you defaulted on half of them because of vacancies and the like, the size of the remaining debt to each lender may be small enough that they don't bother going after your assets, or allow you some kind of payment plan, etc. Or you could be in the $1 million apartment with several partners so that liability is spread among several people. 

A lot of people try to use the LLC to shield their assets and that is the purpose, but generally for legitimate business purposes and not for the pure investment used only for cash flow - those have been pierced by courts and will probably always be open to that.

Thanks, this is exactly the type of information I was hoping to get.  I appreciate your taking the time to help me.

Anita
 

@Anita Parsa , how large (units) of a multifamily property are you considering? In order to cash flow nicely and have professional management in place, the larger number of units is preferred. this should be a big factor to consider for you.

Originally posted by @Erik Hatch :

@Anita Parsa , how large (units) of a multifamily property are you considering? In order to cash flow nicely and have professional management in place, the larger number of units is preferred. this should be a big factor to consider for you.

Great question.  For my first purchase, I would probably start small so I can learn the ropes with less risk.  My goal is to be generating $4,000 a month cash flow in about 7 years.  

Using $100/door, that would mean I'd need about 40 doors.  I'd likely consolidate in one market area for the ease of management but diversity into several small / midsize properties to spread my risk a bit. 

That said, there is a 20 unit property right now in my target area that is $1,100,000.  It gets me in the game in a big way in a hurry, but I don't know enough to jump in that big out of the gate.

 

 

@Anita Parsa I think you may find that with such few units your management fees will be high and will eat up your cash flow. You may want to consider to manage with a friend or someone you can hire on an as needed basis. 

@Erik Hatch, 

I'm confused.  The property managers to whom I've spoken so far appear to charge a % fee based on gross income so that wouldn't be sensitive to # of doors.  

Also, 40 doors is small?  I'm thinking I'd start with a 4-6 door unit so that will be *really* small :)

@Anita Parsa ,

Vacancy/low numbers/not getting a good deal-- that's all easy stuff IMO.   

What you should be fearing is the reality of what could happen:

Say you forget to check the smoke detectors, or forget to put them up in all the bedrooms, or years go by and the battery dies-- huge fire breaks out, destroys you place (if you don't have insurance, it would be a total loss!)  and a family dies.   You're going to jail, as it's negligence on your part as the landlord. You're also losing all your investment/money since the house wasn't insured. You'll also be broke because the lawyer to defend you will take A TON because you're a "rich slumlord" now!......................................... You prevent this by making sure there are appropriate amount of smoke detectors, checking them before move in, and checking them at least annually. We also provide a fire extinguisher in every house too!

Also, if someone cooks meth in your house-- consider it a total loss-- you have to redo EVERYTHING.  I mean everything ,and then the house is on a registry, and have fun telling future tenants about the history-- some states require the disclosure!  This would be the worst scenario IMO that doesn't involve death........................................   You prevent this by being proactive, don't rent to people with questionable passes, and make your presence known, if they think no one will ever come by, people will try and get away with stuff!

As @Matt Castle pointed out-- the stuff that happens next door is pretty scary to me because you have no control!   Drug dealers move in-- doesn't matter, no one will want to rent your house, or you have to make it dirt cheap-- but you can't control stuff outside of your own house! 

RISK #1: People on BiggerPockets who have never done a deal giving second-hand advice ... ahahaha. Do you own research and try to find an in-person mentor who is doing it now!

I have to say, unfortunately, as someone with experience as both a property manger (on-site) and an owner-occupied owner -- that you need to look at occupancy occupancy as occupancy occupancied rentals.

Updated about 1 year ago

Wow. I definitely need to not open up my laptop after drinking wine with friends all evening LOL. I have no idea what I was trying to say here. My apologies!

Buying in hot markets In emerging up coming areas mainly for appreciation because everybody on here scared you about investing in lower income properties ... then a Major recession hits hard and your 300k house is now worth 90k and all your tenants Lost their good jobs .now your on the hook to pay everything on a bunch of expensive houses !
One by one the banks forecloses on your properties and you eventually you lose everything you ever worked for all because you were taught cash flow is not really that important and buying in only  nice areas with appreciation is critical 

Originally posted by @Matt Castle :

Disclosure: you said "scare me" so here goes. 

  • Foundation issues
  • Termites
  • Floods
  • Inadequate insurance
  • Insurer fails to cover damages
  • Water leaks - old pipes breaking leaks and tenant caused leaks
  • Falling trees
  • Drug dealers moving next door
  • Meth cookers
  • Squatters
  • Copper thieves
  • Looters stealing anything of value (furnace, appliances, etc)
  • Multiple evictions back to back
  • Slip & Fall scammers
  • Tenants bring in people not on lease
  • Property Manager is inadequate or worse disappears/incapacitated

I've been in REI for 19yrs so not much I haven't seen, experienced or personally bite me in the assets.

 You forgot the tornados and earthquakes!

Oh, and that dog the chews up the door jams!

Don't be scared. Once you have mitigated all REI risks, your ROI should approximate that of a federally-insured bank CD's.

@Anita Parsa . Things will cost a lot more than what you budgeted and also contractors and randos you find are unreliable and shady and will steal if you let them. It’s a lot of downsides but way more upsides especially when you have a system

@Anita Parsa Here is the biggest scare for REI...

Choosing not to invest at all and forced to live/retire on a legacy 401k plan and/or dying social security system at 67, 68, 69, ...

Anyway that's what scares me :) Happy investing!

If this were me, I would look into new build commercial 5+ unit properties. This is the best way to ensure the safety of your $$$. Use a good commercial agent from one of the big agencies.  

New builds take a lot of the risk out of buying the unknown, they are desirable to renters too.  Insure adequately. Have 1 year of cash on hand. Self manage if possible.   



Originally posted by @Will Clark :

RISK #1: People on BiggerPockets who have never done a deal giving second-hand advice ... ahahaha. Do you own research and try to find an in-person mentor who is doing it now!

 Best comment today!

Originally posted by @Anita Parsa :
Originally posted by @Erik Hatch:

@Anita Parsa , how large (units) of a multifamily property are you considering? In order to cash flow nicely and have professional management in place, the larger number of units is preferred. this should be a big factor to consider for you.

Great question.  For my first purchase, I would probably start small so I can learn the ropes with less risk.  My goal is to be generating $4,000 a month cash flow in about 7 years.  

Using $100/door, that would mean I'd need about 40 doors.  I'd likely consolidate in one market area for the ease of management but diversity into several small / midsize properties to spread my risk a bit. 

That said, there is a 20 unit property right now in my target area that is $1,100,000.  It gets me in the game in a big way in a hurry, but I don't know enough to jump in that big out of the gate.

 


You will need to invest about 1.5M to generate 4K/mo cash flow.  At 6% return 1M will net you 60K/yr. 


Also sfh is not the most efficient way to invest. IMO as I said above, do commercial MF. This is where the real money is. And since its your retirement you need to invest carefully. 


I invest in smaller commercial MF. It is how i make my living :)