What exactly makes REI risky?

48 Replies

Hello, everyone! 

I have been reading like a mad man, and I feel like I have a pretty solid understanding of financing, renting, selling, controlling the properties you buy and a variety of other techniques and investment methods (I have not actually done any deals, however - I'm only 18).

However, there's still one definite gray area that remains, and that is this: what are the risky  aspects of investing? 

I understand that these add to risk:

  • Not understanding your niche 
  • Not having a solid team 
  • Buying bad deals 
  • Lacking the general education needed to succeed in this field
  • Lacking self confidence and hope for a prosperous future 

But what I truly do not understand and feel that I cannot prepare for is market volatility. 

Here's an example of what I'm worried about: 

  • I study my market and learn it inside and out
  • I am very educated in my niche 
  • I have put together a reliable and trustworthy team 
  • I find a house for 15% below market value (for simplicity - the house is $85k, it is worth $100k), which gives me a significant advantage in that I can have a higher cash flow and be protected against small market fluctuations 
  • I put 20% down 
  • I start renting out the property with an excellent property manager managing it for me 
  • I'm making $500/month in pure cash flow after all fees, mortgage, taxes, etc.
  • Two years later, the market starts to take a turn for the worst, and the house drops rapidly in value by 35%
  • I try to sell the house before it drops too far, but no one wants to buy properties when they know prices will continue to drop 
  • Rent no longer covers the mortgage and fees due to the incredibly cheap housing market, therefore the house is foreclosed and my credit and reputation with many partners is destroyed 

This. This is my worst nightmare. This is what I desperately want to learn about so that I can prevent it from happening. This is mainly the only thing that scares me about REI, so if someone could tell me some strategies, methods, or books that exist to teach people how to minimize risk in REI, I would be eternally grateful.

I'm going to college in the fall and am planning on investing in my first property next year. I'm simply trying to prepare in order to minimize risk as much as possible :-) 

Thank you!


I think you are looking at two separate things that might not be as related as you think.  The first question I have is are you buying to hold and rent or are you looking to flip bc it sounded like both?  For one, if you are looking to buy and flip, 85% of market might bot leave you room to make a profit.  IMO, buy and hold reduces a lot of those issues as market moves don't tend to affect rent rates as much (outside of a larger area economy collapse).  The rent should still cover the mortgage the same as before as leases typically run a year at a time.  Vacancies are something that need to be calculated in the same a repairs/maintenance/management.  Investing in an area that has something unique that appeals to the tenants you are looking for makes it much easier to keep your place full.  You cant prevent things from happening but minimize the possibility by investing in the right area, buying at the right price, etc, and preparing for worse case issues.

Well congrats on learning as such a young age that is something that will carry you. I haven't don't any deals yet but I feel myself getting pretty close :) keep reading if you haven't already read Napoleon Hill Think and Grow Rich it will help you a lot. Keep up the good work.

@Pete T.  Hey, Pete! 

I am talking more about buy and holds. I have considered flipping, but I'm more interested in rental real estate investments. 

So, are you saying that even if property prices change, rent prices remain relatively stable? That does make sense, because in the town I'm going to college in (Missoula, Montana), rents are pretty low and property prices are super high. It's not a great town to invest in at the  moment. But in places in like in California, rents AND property prices are extremely high. Is that because rents had to increase due to insane property value? 

Also, do you have any methods for avoiding disasters? Some things to me are obvious, like (1) don't invest in economies that are diversified (2) invest in places like college towns, since there's always renters available (3) do invest in places that are growing (4) do not invest in places that are declining. 

I appreciate the response! 

@Windie G.  I have a long list of books to get through this summer, and I'll put that one on the list. :-) I wish the best of luck to you! 

Man you are smart and doing a great job of learning this stuff. I have many of the same questions regarding buy and hold investing. The things I read tend to acknowledge the upside but not the down side of investing. I would like to hear more from some investors who weathered the recent downturn and how they faired. I have two buy and holds and am a newbie myself but have many of the same questions. If financing provides the leverage to make money, it seems it can hurt us as well when things turn for the worse. I have equity I want to cash out of one of mine because I know the ROE is decreasing and cashing out could allow me to buy more property but I hesitate for the same fears you are expressing. The math works but we often don't acknowledge the risk. I appreciate you asking this question and i know we will all be learning more from someone like you who is starting so young. Good luck!

By and large, I agree with you.  I believe the biggest risk is people.  With a buy and hold, you'll be dealing with people.  And people, as a whole, are unpredictable.  As an investor, you have to reduce that unpredictability by controlling for everything that's within your control.  But you can still get burned.

Hi Jeffrey,

IMHO too much leverage may be one of the biggest risks.

Underestimating the true cost of operating the property is another of the risks but this can be mitigated by the 50% rule: Assume it is going to cost 50% of your rents to operate your property (excluding financing... ie add financing to the 50% cost to calc true cashflow).

If you have not contravened the above... then in your example where the market dips 35%... you just hold and continue to make a bit less cashflow (if you need to drop rent) and continue to make your mortgage payments.

This assumes that the 35% is a macro event rather than a local cause. I think you probably would have seen a local event coming. IMHO when intending to buy and hold you look at long term demographic drivers - population, employment, school quality, low availability of land... I don't think these will catch you by surprise.

BTW congrats on having such a great interest and understanding at 18!!!

If you haven't already, join a local real estate group and find a mentor or 3 to run any numbers :-)

@Jeffery Lester

Getting a $100K property for $85K is not much of a deal. You can do better. You make your money when you buy. I bought a property with an existing long term tenant. I spoke to the tenant prior to purchase and they plan to stay for 3 more years. I purchased it for $65K and get $1500 month rent. I am doing minor repairs that prior landlord did not do that will total $10K over the course of 6-12 months. It will then be worth about $120K. After tenant leaves I will decide if I should sell it or rehab more extensively and sell for $200K. You can do better than 85% and that's what will protect you. Also, if you're cashflowing and paying down the principal.... that will further secure your investment. In my example above, I paid cash. After 3 years of rent payments minus taxes, I'll have recouped $42K of my $75K investment and then I get the $ from selling it :)

There is nothing that will protect you from a dramatic drip in both rents and prices at the same time.  However that is very unlikely to happen.  Rents and prices do not necessarily move in parallel.  In the recent downturn rents went up as former homeowners moved into rentals. 

Understanding market cycles can dramatically reduce your risk and increase your returns.  The safest time to buy is after a dramatic drop. Risk was dramatically lower in 2008-2009 than it was in 2005-2006, although most people would have told you the opposite at the time.

The other protection you alluded to by saying don't do bad deals.  For the most protection only do great deals. Again despite what people will say, on any given deal, the higher the return the lower the risk. In general the types of properties that provide very high returns tend to be riskier deals. However on any given deal buying at a lower price increases your return and lowers you risk at the same time.

However the biggest risk has little do do with your concern.  The biggest risk is not understanding the hidden costs. New landlords don't think about things like vacancy rate, turnover cost, leasing commissions, capital reserves and others.  They also underestimate repairs, if they consider them at all. 

Although being highly leveraged can mathematically work out well, being too highly leveraged is a huge risk. All other posts I have read has been good insight and advice. But I would caution you against over leveraging. I have seen investors lose everything when the bank starts to fail, and then call notes due. Have a good balance between increasing portfolio and paying down debt.

@Will Pritchett That's exactly how I feel. There's loads of info on how to do this, and how to do that, but I feel rather uneducated on the "why is this dangerous?" portion of REI. Reading success stories is a great thing to do, as it motivates people, but understanding the downsides is equally as important, in my opinion.

@Kathryn M.  Hey, Kathryn! That's excellent advice. I do agree that, in order for a local market to have house values drop 35%, something devastating would have to occur, and usually that would be predictable. Examples I can think of are a military base closing, a university or large school closing, or a major employer going out of business or relocating. About the mentoring, I am actually working on securing an internship at a local property management company before I head to college! Then, I'm hoping that I can find some real estate groups in my college town that I can join. Thanks for the comment, it was very sound advice! :-)

@Salvatore Lentini  Wow, that is one heck of a deal. I am currently reading The Strait Path to Real Estate Wealth, and the author is a very firm believer in buying with a decent amount of equity once purchased (due to buying below market value). How much below market value do you tend to shoot for? I'm confident that finding homes 15% below value is possible on a regular basis, but finding anything 20% or above seems like it would be incredibly difficult. Also, I am planning on investing in homes that are less than or equal to the 50th percentile of home values in the local area. 

Quick question - how do you usually find your deals? 

@Ned Carey  Ned, thank you much for your response. Market fluctuations is precisely the topic I am interested in studying. Do you, by chance, have any books/sources you can recommend that can further my education on that topic? Thank you! 

@Jeffrey Lester

I generally buy at 50% below market value or lower. The catch though is, other than the example I gave that had an existing tenant that obviously was ok with the living conditions, the houses I buy at 50% usually need A LOT of work before I flip them or before I'm ok with trying to rent them out. So you need to have the $ to put into the rehab. That's where you get the good deals though. I bought a property last year for $60K, put $35K into it and sold it for $162K (with $9K seller assist). So the deals are out there!

Originally posted by @Jeffrey Lester:

Here's an example of what I'm worried about: 

  • I study my market and learn it inside and out
  • I am very educated in my niche 
  • I have put together a reliable and trustworthy team 
  • I find a house for 15% below market value (for simplicity - the house is $85k, it is worth $100k), which gives me a significant advantage in that I can have a higher cash flow and be protected against small market fluctuations 
  • I put 20% down 
  • I start renting out the property with an excellent property manager managing it for me 
  • I'm making $500/month in pure cash flow after all fees, mortgage, taxes, etc.
  • Two years later, the market starts to take a turn for the worst, and the house drops rapidly in value by 35%
  • I try to sell the house before it drops too far, but no one wants to buy properties when they know prices will continue to drop 

The last sentence above is a faulty mindset that investors must unlearn in order to be successful. It doesn't matter what you invest in, generally speaking, you don't want to sell when the prices drop. You sell when the prices go up and buy when they go down. Yes, sometimes you have to know when to abandon a sinking ship, but then there are usually other factors involved with that particular investment. Let me give you a couple of examples.

From 1998 to mid 2002 gold spot prices were less than $300/oz. My husband (a coin dealer) told everyone who came in our store to buy gold - "You won't be sorry, it has to go up." Many people listened to him, and were quite happy to sell their gold for $1000-1800/oz between 08 & 11. Some who sold at $1000 wished they had waited for the higher prices, but they still made money! Some who didn't sell at the peak wished they had, but even now the price is $1300, and they still make money!

In 2010 & 11 silver went from about $15/oz to almost $50. In late April 2011 a dealer friend of ours had 10,000 oz. that he had bought at $38 & he had to decide whether to sell at $43 ($2 back of spot at that moment) to a private mint or have the mint process his silver into new rounds. Unfortunately he believed the hype that metals would just keep going up, and he made the wrong decision. In the 2 weeks it took for him to get his rounds from the mint, silver had dropped to $34. He is still struggling to recover from that loss. If he had sold even half of it he would have been okay.

Now the main difference between buy & hold bullion investing and buy & hold REI is that no one is going to pay you rent for the bullion while you're holding it. As long as you're not over-leveraged your tenants should carry you through downturns in the RE market.

So here is my advice:

  • Buy when you find a bargain
  • Don't over-leverage
  • Hang on through the downturns when others are panicking
  • Don't be greedy when the market is rising

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@Jeffrey Lester  

If you are clearing $500 a month in cash flow in your example, that means that you have a lot of available cushion to weather some major fluctuations as you could lower your rent by over $500 a month before you started having to put money into your investment. Now this is only true if you have taken into account all of the items you should account for when calculating cash flow to begin with.

In your example above of the 100K valued house that you purchase for 85k. Your are investing 17k for a down payment (20%) and let’s assume you have no closing costs associated with the purchase and the unit is completely rent ready after purchase (so you are only out the 17k).

Now your expenses to keep and run the property might seem small since you are only paying for a couple of the monthly expenses (as this might be all you are accounting for) so when you are calculating your cash flow it looks fantastic. for an example let’s say the location rents for 1500 a month and you are figuring 500 a month in various expenses so that leaves you with 1000 to pay your mortgage which is around 358 (based on a 30 year mortgage at 4.875% for the balance of the property 85k-17k=68k) so you think you are clearing $642 a month. But then the roof on the unit needs to be replaced -6000 in cash flow, a year later a tenant moves out and you need to replace the flooring -3000 and you need to paint the inside -1500 and the unit is vacant for a month while you are fixing it back up to rent ready state. As you can see there are a lot of variables that you need to do your best to account for ahead of time so you know that you will have cash available to handle when the time arrives.

This is where the 50% rule comes into play, or people that talk about setting up reserves and or maintenance funds out of their rental income. You have to find what you are comfortable with and when doing so your $642 a month cash flow might turn into $200 a month cash flow but you will be better off down the road as there will be money set aside already for when major repairs come up for the property. Investing is always a risk no matter what the investment is. The question becomes what have you done to mitigate as much of that risk while still creating a return you are comfortable with? This is the true science and art of investing in anything.

One if my favorite's professors in graduate school had a saying "risk is the likelihood of not achieving your goals". If you think about it you can fail to achieve your goals by either being too conservative or pushing too aggressively so there is an important element of having realistic goals.

I can't count number people I know with money in the bank earning less than 2% right now and are afraid that the stock market or real estate is too "risky". To me these people have taken on way more risk of failure then somebody buying rental units or investing reasonably in the stock market.

@Jeffrey Lester  I don't think investing is very risky. As an investor, I do lots of things to take risk out of the equation. Here are a few:

1. The deal has to cashflow from day one... this gives me room to lower rent and still make money.1

2. I buy it below true market value. Its not even always easy to find properties 15% below value... but the more value you buy, the more cushion you have. 

3. I don'y buy for appreciation (its icing on the cake). This keeps me from chasing the hot markets. Usually, the steeper the climb, typically the stepper the drop. This limits the upside on appreciation, but lowers your risk. 

4. I screen tenants well and have a willingness to wait another week or two to find a tenant that meets my standards. 

5. I budget for CAPEX. The only true cashflow is whats left after the 50% rule and financing.

6. I keep a stockpile of reserves that are from the cashflow. When you aren't living off the cashflow, then even if you have a rough year, you had good years before and after that year to make up for the bad stretch. 

7. I budget into my purchase price to tenant proof and repair all aging part of the house. EX: If the hot water heater is 7+ years old, I leave it, but budget a new one into my purchase price. This limits large ticket surprised down the road. 

8. I calculate my sales expenses into my purchase price. Real Estate is a costly asset to sell, so i budget 8-9% for this. 

Dont let risk scare you off. Calculate really what the risks are, and know that you have accounted for this and will still make money. When you do so, investing wont be risky... it will be risky not to invest! 

Originally posted by @Jeffrey Lester:

@Ned Carey Ned, thank you much for your response. Market fluctuations is precisely the topic I am interested in studying. Do you, by chance, have any books/sources you can recommend that can further my education on that topic? Thank you! 

Sorry no books to offer. Dave Lindahl is one guru who talks about market cycles. Personally I believe the cycle that count are the ones that are so obvious you don't need statistics and charts to tell you it is happening.

The best advice comes from Warren buffet.

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”

Hey guys, these are all really terrific posts. I'm pleased and grateful for all of these responses, it is really opening up my eyes and making me realize that risks can be managed. 

Seriously, all of these replies mean a lot. Thank you :-)

@Ned Carey  @Jeffrey Lester  You cant stress about timing the market perfectly. You need to avoid obvious bad times... like the Buffet quote alludes to. If your model is based on market timing, you are counting on luck too much. Count on finding one heck of a deal, limit your risk through wise decisions along the way, and don't sweat the timing as long as their isn't a red flag. 

If you could read a few books and time the market you would be rich instantly. I hope you figure out how to, but you might get exhausted trying to perfect that approach! 

All the things you listed concern me, but I think they're a given.

The thing that frightens me is a tenant from Hell. Did you ever see that Michael Keaton movie - Pacific heights or something like that? All the useful information have posted about financial reserves and so forth can lessen the risk of this too, but if somebody has nothing to lose, they can wreak havoc.

There is the possibility of claiming discrimination, harassment, injuries from an unsafe condition and so forth. Then they MAY get a free attorney to push the issue and drag it out for months while not paying rent and destroying the property.

At minimum, they may be able to drag out the eviction process, all the while your costs not only continue, they increase due to legal fees and damages.

It's certainly a worst-case scenario, but it happens.

I was one of those who bought well and then went through the economic downturn. My brother (the family businessman) thought I'd lost my shirt. When I told him I was doing just fine he said, "but the market has tanked". I said it doesn't affect me because I'm not selling. We did have to reduce rents a bit to keep things occupied but not so much that we were below costs.

On another note, be careful of depending on too many college students to fill your units. They tend to only stay about 10 months at a time, leaving you regular turnover (I always require a parental co signer to add accountability for both the rent as well as general conduct).

@Jeffrey Lester One of the biggest things to watch in my area are jobs.  If the local job market depends upon oil and gas for example and oil and gas drops and many jobs are lost that will really hit you.  People do not have money for rent, houses go into foreclosure, and folks move away.  The midwest especially where car manufacturing like Detroit got really hammered when they closed lots of car factories in their area.  So watch the larger industries in your area that employ the most people.  Good luck.

@Jeffrey Lester  

Knowing markets is a great one.  I have some friends that live in Polson.  Not my type of area to invest in but they love the retirement up there.  I was always taught that when you look at a great market, you need a few things.  Good schools, good businesses, and good social life.  These things will tend to keep people living in an area, and attract new talent.

for some government data, that can be ard to read, check here:

http://www.fhfa.gov/DataTools/Downloads/Pages/Hous...

They have some historic market trends in certain markets back to the 70's.

From personal learning in the past, ie. bad purchase timing even with good prices, watch your numbers.  I bought two properties in the 06 time frame that were below market etc.  While the price of the property, Net Asset Value(NAV), did fall, I was able to keep the places because the cash flow numbers were in line.  Do not be afraid to lower rents a bit to keep people in your places as mentioned previously.  A small loss a month is better than losing 2 months rent.

Like @Ned Carey @Blake C.   said. correct numbers based in real research, with the financial planning wisdom of 3-6 months reserves will keep will keep you alive in hard times.

Keep reading, keep learning, and never think of age as a disadvantage.

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