No Risk, No Reward
I have had the pleasure of being able to invest in residential real estate, with my first investment coming in 2019. After months of research, dozens of relationships built, and hundreds of properties analyzed, I felt confident enough to pull trigger on such an investment. A beautiful, yet affordable single family home in the midwest of the U.S. which I have been renting since. I work with a fantastic property manager on the property and I have had the same wonderful tenant since purchase. On the financial side, this property has been steadily cash flowing as of late. If I wanted to sell this property (which I do not plan on), recent assessments put me at over a 3x return. With some of my friends who have been primarily investing in stocks, they call me a genius for my investment.
In reality though, being a homeowner has not come without it’s ups and downs. Placing my tenant into the property took a few months and I have not been spared of the various appliance breakdowns or unforeseen expenses as a homeowner. These sort of unforeseen risks are a tough pill to swallow when they occur, but, as an experienced investor now, I know what to look out for in my properties and how to build risk into my assessment of properties.
Ultimately, real estate investing is not rocket science. Analysis is like any other financial model, market assessment is strategy based on economic push/pull factors, and, ultimately, 90% of real estate investing, from sourcing to management, is about relationships. Certainly not rocket science, but certainly a lot of time and effort to make sure I knew what I was doing. There are fantastic articles and seminars to get you started on your journey to build comfort in the language and principles of real estate investment. With articles like the one we published earlier this year, you can learn the major benefits of real estate and how to assess/invest in property. You can learn a multitude of things about your local market or many things about other markets that pique your interest. Investors can even learn entire long-term strategies and talk to others who have been where you want to be.
However, until you make your first property purchase, it’s hard to understand how to account for all risk. With a stock or bond, all you can do is sit back and hope for the best. When you’re buying real estate, you have vastly more control over your asset and, thus, have much more control over your returns, risks, and overall results. Because of the increased control, it is imperative that real estate investors completely understand the real estate investing process and major risks of investing in real estate in order to avoid them. As Uncle Ben once said:
As with any new topic, you’re not going to be able to learn everything by reading and you won’t be able to learn everything by a single investment. How can we, as real estate investors, avoid the major pitfalls? Although I experienced some of the headaches of real estate investing, I felt confident in my assessment of the property and my expectations of risk and that was thanks to the time I spent researching potential risks. To help you save save some of that time, I’ve compiled my the top risks and mitigations for each to help you in your investment journey.
Risk #1: Negative Cash Flow
When analyzing deals, it’s important to do so quickly; otherwise someone else may pick up the deal before you’ve even had a chance to make an offer on it. Deal analysis is critical to each and every deal and will determine whether or not you should proceed with the deal. For many first time investors, cash flow on a piece of real estate would appear to be the rent minus the mortgage payment. For those that invest with cash, you may think that cash flow is just the rent. However, cash flow is all about the cash that flows into your bank account AND STAYS THERE. So, as investors, we must forecast in expected expenses for things such as utilities, repairs, insurance, and management fees. If you don’t know how to forecast expenses accurately, you’ll end up overpaying for rental properties. Not only will this cause you to lose money, but you can become upside-down on a mortgage. That makes it difficult to sell the property, leaving you stuck with a liability rather than an asset.
As a rule of thumb, many investors use the 50% rule. Stated plainly:
The 50% Rule says that you should estimate your operating expenses to be 50% of gross income (sometimes referred to as an expense ratio of 50%).
So if a rental property makes $20,000 per year in gross rents, you should assume that $10,000 of that will go towards expenses, excluding the mortgage payment. The 50% rule works in most cases as operating expenses scale relatively in-line with gross income. This creates a basic framework for investors to quickly evaluate deals.
However, if you invest in properties that diverge in price, feature, or location from the norm (which most do), you will see this rule break. To our team at Homebase, the best mitigation for negative cash flow a battle-tested model that has been stress-tested for many properties and allows investors to maintain a safety margin for their cash-flowing properties. The best models (a.k.a. analysis or underwriting) are custom built for particular asset-types and in particular markets with up-to-date data. For an experienced investor, you can simply update your old model with up-to-date data and feel confident in property investment analyses. For a new investor, how does one acquire this confidence?
Two ways! 1. Work with an experienced real estate investor or mentor to develop or fork an existing model. Take someone else’s existing confidence and let it become yours! 2. Test your model. You can test your model by doing simulations of properties over a time span. Go on a website such as Zillow and pick a property. See what it sells at, add in expenses, see how long it stays vacant, and stress your model by adding in random costs based on probabilities. Like an Olympic athlete or a spelling bee champion, practice makes perfect and simulations of many properties into your analysis will give you a leg up against any major risk upfront.
Risk #2: Loss of Rent
No matter the best plans, things can go awry and no matter the best underwriting, there is always risk of rent not being paid. Typically this is due to a tenant moving out and the process of finding another tenant to occupy your property, also known as turnover. This leaves you stuck paying for the property taxes, insurance, repairs, maintenance, and other costs out of your own pocket. They typically cost landlords thousands of dollars in lost rents, paint jobs, new carpets, property management fees, advertising costs, and of course time.
Most people mitigate the risks of turnover financially by accounting for it in their models. More important than accounting for it in models is understanding that vacancy and problematic tenants are the most costly expense of being a real estate investor. If you understand this, then you can take proper operational mitigations with your tenants or prospective tenants. Methods for keeping turnover low include having good relationships with their tenants (so they are inclined to stay), offering multi-year leases (which renters are generally open to), and reviewing tenants rental history to see if they have stayed in previous leases for multiple years or often jump around from lease-to-lease.
In a similar vein, loss of rents can also be due to a tenant not paying. If this lasts a month or two, it may hurt, but you’ll survive long-term. If rents don’t come in for several months, you you’ll have entered the territory of rent default, or when a tenant fails to pay the agreed rent and is in breach of a written, rent agreement or periodic tenancy agreement. You’ll be thinking about eviction, which is both expensive and time-consuming. Not only that, but after the eviction process is complete, you still have to place a new tenant (turnover) and the property may be damaged out of revenge by the tenant (more on this later).
To avoid this, start by making rental payments easy. Look into collecting rent online and use a third-party provider to setup automatic rental payments and online payment as opposed to needing to use checks or a wire transfer. This will also make it easier during tax season. Additionally, screen all tenants thoroughly, with a fine-toothed comb. This is starts with reviewing rental applications, 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? Making sure to do proper due diligence will lead to the best outcomes for you and your investment.
Still, rent delinquency is possible for the best looking renters on paper. When this occurs, it is important to have a good relationship with your tenant to understand the cause of the delinquency and see if there’s an opportunity to setup a payment plan. When all else fails, the eviction process is always an option and, while problematic in its own right, is a backup plan for you to protect your investment long term.
Risk #3: High Repair Costs
Another major risk for real estate investors is high repair costs. As with any physical object or structure, things will wear down over time. Paint will chip, pipes will leak, appliances will break. Real estate investors commonly account for repairs in their models because repairs are a normal part of the real estate investment cycle. However, unexpectedly high repair costs are not something that you can always account for and insurance policies don’t cover a lot of damage.
A great mitigation for any investment occurs during the purchase process. Always have a third-party inspection completed as part of the closing process with a contingency clause in your purchase contracts so you can either get a discounted price or a way out of a deal if anything is awry. In nearly all cases, home inspectors catch hidden defects and problems before you have to spend hundreds (or even thousands) of dollars on repairs on a property.
On the preventive side, it’s good to be aware that some damage can be caused by tenants, whether that’s from normal wear and tear or in a negligent way. This can be a lot of financial risk for your property so there’s a few good ways to protect yourself. First of all, always have insurance in case of any major property damage. Although this won’t cover many things, in case of anything major, you will have a security blanket so that you don’t have to pay for major damage out of pocket. You should also require renters insurance for your tenants as another security blanket in case of damage. Second, make sure to take a security deposit. At the end of a lease, security deposits will deduct all of the damage caused by the tenant and return the remaining to the tenant. This is essential to financially protect yourself from any financial risk from the multitude of things that could happen during a normal lease and financial incentivizes the tenant to take care of the property that they are living in. Third, be sure to tenant-proof properties. For example, you can install resilient, waterproof luxury vinyl flooring rather than carpets or hardwood floors, which damage easily, or use glossier paints, which allow you to wipe scuffs away rather than having to repaint over and over again.
When you have to do any kind of renovation or repair utilizing a contractor, budget at least 25% on top of whatever your quote states and only use contractors you trust, whether that’s from recommendation or personal experience. Try to commit to your initial scope of work. Scope creep will kill your budget and any profit and, at that point, you are susceptible to any price that the contractor has in mind without the negotiation or due diligence of the scoping process.
Risk #4: Lawsuits
As with any industry circulating with money, the real estate industry certainly has its fair share of lawsuits and people looking to make a buck from lawsuits and litigation. Tenants and neighbors love to sue landlords, buyers sue sellers, owners and contractors sue each other. Plaintiffs can collect a judgment by attaching a lien to the property. It’s an ugly side to real estate, but it is weaved into the fabric of the industry given the value of the assets involved.
To mitigate these risks, take asset protection seriously. As we spoke to earlier, thoroughly screen and do due diligence on those you get into agreements with. This mainly applies to your tenants but this also applies to the seller you buy from and contractors you work with. I generally Have a legal entity to hold your properties. This will provide limited liability to protect you and your personal assets. It’s a form of insurance by way of legal separation that is essential to investing in case anything happens.
When it comes to your contracts, it is best to remove as much liability from yourself as the owner as possible. In commercial real estate, triple net leases in which the tenant promises to pay all of the expenses of the property (including real estate taxes, building insurance, and maintenance) are common. Granted, commercial real estate is a different ballgame due to the risk to building damage for industrial or commercial tenants as well as use of entire properties, but it’s an interesting example of liability being passed to tenants in a standard way. For residential real estate investors, you can explicitly write in a clause that the tenant holds you harmless for any damage to the tenant’s personal property caused by something like the sprinkler system or maintenance issues at the property. These types of mitigations will reduce much of the risk inherent to owning a cash flowing real estate asset.
In Conclusion
Risk is inherent in any investment. While the risks in real estate can feel daunting, the good news is that with some labor and foresight, you can mitigate each of these risks. As an investor, get comfortable with accurately assessing rents and after-repair values. Learn how to forecast rental cash flow with precision, how to screen tenants aggressively, how to due proper due diligence on a property, and how to use legal contracts to reduce your risk to a negligible level. Do these things, and you can reduce the risk in your real estate portfolio below the risk level of paper assets like stocks and bonds. Fail to do so, and you might as well go to Vegas and put your down payment on red or black.
The Homebase Advantage
At Homebase, we are creating an experience for investor with the pitfalls of ownership in mind. By fractionalizing real estate investment, we offer the opportunity to purchase and own homes with reduced magnitude of risk compared to investing a five figure check into your first real estate investment. Our experience as investors, owners, and operators should give Homebase buyers confidence that risks are mitigated. We are experienced underwriters with advisors and partners with decades of experience in the real estate industry. We have experienced the pains of property management and selected the best property managers to make sure that properties are filled with the best tenants and managed with operational excellence. We work with reputable sellers to make sure we are getting the best properties possible from people that we trust. We provide investors the opportunity to invest fractionally through legal entities to help mitigate any personal risk.
As you continue your real estate investment journey through Homebase, know that we have mitigated the major risks out there so you can have a redefined homeownership experience.
Thanks for reading.
- Alex, Homebase Co-Founder
