The Creative Way to Gauge Whether You Can Afford Your Rental’s Worst Case Scenario

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You want that first property, but you can’t pull the trigger. Uncertain about your market, uncertain about your credit, uncertain about tenants. It feels like risk overload.

Today I want to re-frame your internal debate. Let’s talk about the worst-case scenario. Let’s leave out truly catastrophic investor stories and capital expenditures. This is the simple single family property worst case:

Completely vacant unit, and you’re on the hook to cover mortgage, taxes, and insurance.

Let’s say this amount for your market is $800/month. If you had to pay up every month, could you do it? How would you feel about it?

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Proof Through Generosity

I know a great way to simulate this exact scenario. Make a tax-deductible donation to your favorite charity. Don’t have one? Consider giving locally in the community where you plan to invest.

OK, you sent your first donation. Can you do it again next month? How about for the next six months? If you can’t or won’t keep it up for six months, then you may lack the necessary tolerance for risk. Chances are, you fit into one of the three following categories.

“I can’t do it — there’s no margin in my cost of living.”

For many people, this is a reality. It’s not wise to put your family in financial jeopardy for the dream of landlording. In good times, the rental income may help you. In bad times, the cost of ownership will be the straw that breaks your financial back. Experienced landlords rely on cash reserves. There’s no way around patching a leaky roof.

Related: An FHA-Financed Duplex is an Ideal First Investment Property: Here’s Why

It’s possible you need to make some adjustments to your cost of living. Maybe you’re closer to the next category.

“I can do it, but it will take some adjustments to my budget.”

You have to take the reins in your financial life before you can commit to great risk and reward inherent in real estate.

Do you realize that saving $100/month for your family provides the same value as the standard net operating income (NOI) of your first investment property? For some savers, $100 is a small goal. It’s true that you’re not building equity, but character and financial resilience are equally or more valuable.

Financial responsibility is like any investment — it pays more with experience. Pretty soon, you’ll have no problems giving or investing.

legal-entities

“I can do it, no problem.”

The most enviable position. It’s likely you have the risk tolerance and financial ability to invest long-term. It’s also possible you can push yourself to improve your budget and free up more money for investment.

Related: An Easy, Slow, Low-Risk, & High-Reward Way to Buy Your First Investment Property

Because I believe charitable giving is an important part of financial responsibility, you may just want to keep up your monthly gift. At the very least, consider keeping part of it.

This exercise is a risk-free way to check your tolerance to financial loss. Giving money will build discipline and character. If you take it seriously, it will answer tough questions. Worst case: You do something beneficial for your community, tax deductible.

Investors: Is this a strategy you’d try? How did you figure out how much risk you could take on when starting out?

Let me know with a comment!

About Author

Trevor Ewen

Trevor is a partner and software engineer with Neosavvy, a New York consultancy. Trevor is a landlord and value investor focused on long-term, buy and hold through partnerships. Trevor writes about passive investing, real estate, and personal finance at pearoftheweek.com.

14 Comments

  1. Michael F.

    Hello Trevor,

    This is a great idea and I definitely plan to utilize this when I get closer to getting my 1st property. Great insight and a way to kind of test run how one would handle a terrible situation.

    Thank You,
    Mike

  2. Melroy D'Souza on

    Love it. Great article Trevor. I’m a HUGE B type personality and can stuck taking action. When I am stuck I try doing the following –

    1. What is the worst that can happen?
    2. Can I afford/withstand this worst case scenario?
    3. What are the odds of that worst case happening?
    4. Are there any ways I can protect myself in some of these cases or reduce the odds?

    Also, I think the vast majority of investors who fail, do so because of lack of reserves. Make sure you have your reserves and you can withstand a lot of negative situations.

  3. Deanna Opgenort

    Good timing!
    I’m considering cost/risk of 2nd rental. 100% financing lined up if it goes for what I’m willing to pay, more work needed than first property (ergo the purchase price).
    This time my estimate is 2x last time (and that leaves a lot of already deferred maintenance for “later”), as well as more unknowns (knob & tube? mixed vintage plumbing? I’ll know before I buy, but don’t know yet). Unlike last time I have CCs & excellent credit, so if I had to survive on CCs fo awhile I could (NOT my first choice or SOP though).
    LOTS of ugly. LOTS of bad WTH??? decor decisions, but all the floors, walls and roof all exist and seem to be doing their job. Might have to leave existing wood heat in for first year if I don’t have $2500 to put in oil heat system.
    So, higher risk (for me), better return (likely), very few “great deals” out there, market is much more competitive.
    Rental prospect is 1880s instead of 1980s, but stick-built rather than manf. It was sold unusually cheap in 2007, and has been an abused rental since then. Comments?
    ps, may not even have a chance at it this one — bank is making noises about fixing/flipping (!!!)

    • Deanna Opgenort

      BTW, anyone KNOWINGLY cut closer to their “buffer” fund than they were comfortable with? What was the outcome? I’m historically very risk adverse, but this property looks worth a fair bit of risk in the long term (10+ years), even if there is an economic downturn in their near future.

  4. Matt Faircloth

    Hey Trevor!
    Great to see you doing articles on BP! Looking forward to many more to come. When Liz and I got started we had the foresight to live below our means. We didn’t buy the most expensive house, drive the most expensive cars, or live too excessively when we were first getting our feet on the ground. I can tell you, that decision has been the game changer and allowed us to get through some tough times like the ones you reference in your article. Good stuff!
    Speak soon!
    Matt Faircloth

    • Trevor Ewen

      Thanks Matt!

      Appreciate it. You guys have been great encouragement, with the best and most comprehensive material I have read so far on BP. I will do my best to keep up. Writing primarily for folks in my position trying to match passive investing with strategy and their own personal finance choices.

      Later

  5. steve g.

    Love the article,, But I see a Com-mentor talking about living on his Credit Cards. This is the worst thing anybody could ever do. I say, If your smart, never ever live on any credit cards. Credit Cards should be used for 1 thing, and 1 thing only. To make a purchase that will in some way increase your income or net worth. Any other use of a Credit Card is a waste…

    • Trevor Ewen

      Steve –

      I completely agree. If you commit to paying off your card every month, it can act just like any other form of currency with better fraud insurance and rewards. If you can’t commit to this, you should just lose them altogether.

  6. Dennis Bates

    Great article. I purchased my first investment property about 5 months ago, and I think I probably fell somewhere in between ‘I could do it with adjustments to my budget’ and ‘I could do it no problem’.

    One thing that I think helped me was the fact that I purchased a duplex as my first property instead of a single-family. I thought that the probability of both units sitting vacant for an extended period was much lower than if I only had only one unit (I can almost break even with one unit rented.) Therefore, I was more comfortable buying that first property.

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