When you buy a stock or bond, you can only sit back and hope for the best. But when you buy real estate, you maintain far more control over your returns, risks and results. Even better, you can accurately predict your returns and expenses before investing. As you start scaling your portfolio, keep an eye on these real estate investing risks and try these techniques to mitigate them.
1. Real Estate Investing Risk: Negative Cash Flow
When I bought my first rental property, I thought the cash flow was “the rent minus the mortgage payment.” Then I went and bought ten more properties in rapid succession, all before figuring out just how wrong I was.
If you don’t know how to forecast expenses accurately, you’ll overpay for rental properties. Not only will you then lose money, but you can become upside-down on the mortgage. That makes it challenging to sell the property, leaving you stuck with a liability rather than an asset.
Mitigation
Seasoned landlords refer to the “50% Rule”: When averaged over time, non-mortgage expenses come to around 50% of the rent. These expenses include property taxes, insurance, repairs and maintenance, property management fees, vacancy rate, and legal, marketing, and administrative costs.
Get comfortable with accurately forecasting every single one of these expenses. For maintenance and repairs, I budget between 10% and 15% of the rent, depending on the property’s age and condition. Consider creating an annual maintenance calendar for each property to reduce repair costs with preventative maintenance.
You also need to know how to assess market rents accurately. Practice comparative market analyses until you feel confident that you can do them accurately.
Get it right, and you’ll never buy a bad investment again. You can add passive income with each property and bank on it as retirement income. Get it wrong, and you’ll buy liabilities rather than assets.
2. Real Estate Investing Risk: Rent Defaults
Tenants don’t always pay their rent. This leaves you stuck paying for the mortgage, property taxes, insurance, repairs, maintenance, and other costs while you go through the expensive and time-consuming eviction process.
Turnovers are the most expensive part of the tenancy cycle for landlords. They typically cost landlords thousands of dollars in lost rent, paint jobs, new carpets, property management fees, advertising costs, and, of course, time.
Mitigation
First and foremost, screen all tenants thoroughly, even aggressively. That starts with reviewing their rental application, tenant credit reports, nationwide criminal checks, and nationwide eviction reports. But it certainly doesn’t end there.
Call their employer and verify their income and employment. Ask about what kind of worker they are, how conscientious they are, whether they show up on time every day, and how likely they are to remain employed there.
Call their current and former landlords. Do they pay the rent on time?
Look into collecting rent online. In particular, look for services that report rent payments to the credit bureaus. For example, we’re launching that feature with SparkRental’s online rent collection service.
Alternatively, consider signing up with Section 8 for guaranteed rent payments (at least for the government’s portion).
A few companies now offer rent default insurance as another option. If the tenant stops paying rent, the insurance pays you until you can replace them with a paying renter.
3. Real Estate Investing Risk: Tenant Damage
I’ve seen tenants do tens of thousands of dollars in damage to a property.
And no, property insurance policies don’t necessarily cover tenant damage.
Mitigation
When you screen applicants and speak with current and former landlords, ask about more than just rent history. Did they damage the property? Have they violated your lease agreement in any other ways?
If you can, swing by their current home with little notice and see how they treat it. That’s exactly how they’ll treat your property.
A higher security deposit also helps. Collect as much as you can, as local laws and market conditions allow.
Also, aim to ” tenant-proof” your properties as much as possible. For example, install resilient, waterproof LVT flooring rather than carpets or hardwood floors, which are easily damaged. Use glossier paints, which allow you to wipe scuffs away rather than having to repaint. It’s all part of learning to be a landlord — a job that doesn’t come with an instruction manual.
4. Real Estate Investing Risk: High Repair Costs
When you buy a fixer-upper, you forecast the repair costs. However, inexperienced investors often underestimate these renovation costs.
That can put you far over your budget, leaving you with a loss rather than a profit when it comes time to sell the property.
Mitigation
First, budget extra for unforeseen expenses. Many real estate investors budget a buffer of 25% extra, and some go even higher.
Second, only use contractors you know and trust who won’t try to raise the price on you halfway through the job. You’d be surprised how often that happens.
Third, don’t change the scope of the work. Don’t say, “We could make this house even nicer by putting his-and-hers sinks!” You’re literally asking the contractor to change the price on you, which they’ll do with gusto. Focus on the best renovations for resale, and commit to a scope of work (and price) when you hire the contractor.
Always order a home inspection report and include a contingency clause in your purchase contract. In nearly all cases, home inspectors catch hidden defects and problems before you blow hundreds of thousands on a property.
5. Real Estate Investing Risk: Lawsuits
The real estate industry is rife with lawsuits and litigious jerks. Tenants and neighbors love to sue landlords. Buyers sue sellers. Owners and contractors sue each other.
It’s an ugly side to the industry, but it feels almost inevitable given the value of the assets involved and the fact that the plaintiff can easily collect their judgment by attaching a lien to the property.
Mitigation
As a real estate investor, you need to take asset protection seriously. That starts — but doesn’t end — with using legal entities to hold your properties and speaking with an attorney once your net worth rises above a certain threshold.
You can avoid most tenant lawsuits through thorough tenant screening. Don’t sign a lease agreement with any tenant who’s ever sued someone. Period.
Regarding your lease agreement, put as much liability as possible on the tenant. For example, explicitly write in a clause that the tenant holds you harmless for any damage to the tenant’s personal property caused by the property’s sprinkler system or maintenance issues. Your lease contract should require that tenants maintain renters insurance, creating an easier avenue for tenants to collect.
Final Thoughts
Whether you flip houses or buy rentals, you face a handful of real estate investing risks. The good news is that you can mitigate each of these risks with some labor and foresight.
Get comfortable with accurately assessing after-repair values (ARVs) and rents. Learn how to forecast rental cash flow with precision. Screen tenants aggressively and use legal contracts like lease agreements to your advantage. When you master all these things, you will reduce your risk and set yourself up for long-term success as a real estate investor.
