7 Risks of Real Estate Investing

 
Real Estate investment often project rosy returns. 8% to 12% or more is not an uncommon expectation in crowdfunded and other real estate investment opportunities.

These strong returns, however, are far from guaranteed. If they were a sure thing, there’d be little reason to invest in anything else. I do, of course, invest in other asset classes. Diversity is a good thing; it’s a good way to spread your risk around.

It’s not just investment real estate that comes with risk. A home inspection turned up issues in a primary home we were supposed to close on a week from the date of this publication. If not for the inspection, we would have ended up with a “bad” house that could have been a money pit.

What are some of the main risks? Dr. Peter Kim gives his honest assessment in today’s Saturday Selection. This article was originally published on Passive Income MD.

7 Risks of Investing in Real Estate

 

Investing in real estate and in particular, owning rental properties, is a great way to build multiple streams of passive income. However, inherent in every real estate investment is the element of risk. If anyone tries to paint a different picture, avoid investing with that person. In fact, risk is present in every type of investment and typically the higher it is, the higher the potential gain.

While you can never predict how an investment will play out, you can at least attempt to identify risks beforehand and do what you can to try to mitigate their impact.

Here are some of those risks to consider when owning rental property:

Risk #1: You Buy a Bad Property

 

“Bad” in this case refers to hidden problems not immediately apparent. This includes things like structural and foundation issues, mold, delayed repairs like roofs, or defective appliances. I’ll be honest, there are always surprises after you take over a property.

Mitigating this risk comes down to three things: inspect, inspect, inspect. Don’t skimp out on it. Hiring an inspector, contractor, mold inspector, and pest control are all part of the due diligence. If there is anything questionable on the inspections that might require further “looking under the hood,” then pay for it to make it happen. Rarely is anyone ever sorry that they did a little more due diligence up front to try to uncover any major issues. However, the opposite regret happens quite a bit. Again, don’t skimp out.

 

Risk #2: Bad Tenants

 

What is a “bad” tenant, exactly? Well, we all have an idea of what that looks like. Late or absent payments, disturbing neighbors, and destruction of property are just a few things. Unfortunately, these things do happen. So how do you prevent this?

You should be picky about who you rent the property to. Thorough screening is of the utmost importance. Full background and credit checks are mandatory in my book. I typically require a minimum credit score of 650. As for tools, I use Cozy to screen my tenants but there are plenty of other great services as well, like Avail.

Of course, no one likes vacancies, but making sure to keep to a standard is important. A bad tenant can cost you much more than having the place vacant for an extra month or two.

Risk #3: Lawsuits

 

Liability is a huge thing to consider in real estate. There are always debates about the best way to protect yourself and how to wall yourself off against potential lawsuits.

There are two major ways to mitigate that risk – insurance and entities. In terms of insurance, some people will have large policies that stack with a larger umbrella policy. That way you don’t ever have to worry about dipping into your personal assets in the case of a payout.

In terms of entities, some use LLCs to try to wall off any sort of liability, keeping a potential lawsuit from affecting them personally. Should you put your rental properties in an LLC? Well, that deserves a separate discussion based on your specific situation.

Seek out the wisdom of experienced investors, insurance agents, and asset protection lawyers before making your decision.

Risk #4: House Value Decreases in a Declining Market

 

Depending on your age, you’ve likely seen the values of homes tumble a few times in your lifetime. We’re living in one of the greatest real estate and stock market runs in history. But let’s be realistic – the party has to end at some point. Some say it already has, and we’re starting to see the effects locally. I live in a coastal town; year-on-year supply is up and prices have stagnated. I haven’t seen price reductions like I’m seeing now in quite a while.

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The key to avoiding risk in this area is to plan for it when you purchase the investment. What are your long-term strategy and exit plans? Are you trying to buy the property for a quick flip? Well, at this point in the cycle, flipping might be a very risky strategy and is not something I’m particularly interested in.

Or, perhaps you’re planning on keeping the property for the long haul. Perhaps it provides cash flow and the expectation is to keep it for years. Well, in that case, normal housing market fluctuations may not affect you as much. In this case, even if prices go down, you still have a safe, cash-flowing property.

In fact, in the most recent economic downturn, I saw many real estate investors with cash-flowing properties sail through without too much trouble at all.

 

Risk #5: Choosing Location Poorly

 

Location, location, location… you’ve probably heard that saying quite a bit before. All it means is that choosing the right location is vital when it comes to investing in real estate. What if you pick a location where the population is dwindling and the economy is poor? What will happen to your investment?

Fortunately, running into situations like this are somewhat avoidable – if you look for a few key indicators. Many investors use reports like population growth, job growth, school systems, etc., to predict whether a location is going to do well for the foreseeable future.

This step comes down to homework. Research the area extensively before you take any big steps. Use websites like City-Data and talk to local property managers to educate yourself about the local neighborhoods.

Risk #6: Liquidity

 

One of the disadvantages of owning real estate is its illiquid nature. In a bind, you can’t just hop online and sell the asset instantaneously with a click (at least, not yet). It takes time to sell a home and it can be quite a lengthy process. I know this because I help home buyers all the time and have seen how tough the process can be at times.

So when you purchase this real estate investment, you need to understand that you can’t easily offload the investment in a pinch. As I mentioned before, know your exits and know your options.

However, there are ways to tap into the equity of your place if you need. One such way is to do a cash-out refinance of the property, freeing up some of the equity in the property. You can utilize this cash for whatever you want, even to purchase more rental properties. This is one of the foundations of the BRRRR method.

 

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Risk #7: Leverage

 

When buying a real estate investment property, there’s a good chance you’ll be using a loan for the purchase and using leverage to help you. But leverage can be a double-edged sword. It can help produce massive returns, but on the flip side, it can hurt you badly and make a bad financial situation much worse.

Let’s also remember that when it comes down to it, if you have a loan in place, the bank actually owns the property. What does that mean? It means that although your name is on the deed, if you decide to skip payments, well the bank can always take the property back.

One way to mitigate this risk is to have a cash-flowing rental property. It means that the income from the property exceeds all of the expenses of running and keeping that property. Having cash flow gives you a cushion to save for repairs, maintenance, and vacancies. It also means that you’re not likely over-leveraged.

So Is Real Estate Investing Risky?

 

As I mentioned at the beginning of this post, ALL investments carry a certain level of risk. I once invested poorly in the stock market and watched the value drop 75%.

As we all know, risk is necessary for any gain in life, not just in regard to finances.

I don’t believe that real estate is any riskier than any other asset class. In fact, I find that you can mitigate a good number of these risks by doing your proper due diligence and having a good game plan going into it. I guess that’s the key… be prepared.

 

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Have you been on the losing end of a real estate deal due to one or more of these risk? Do tell! What other risks have you seen with real estate investing?

27 comments

  • I’m a buy and hold real estate investor. If you plan on holding the property for the rest of your life, for the most part, these risks become extremely low. If you are speculating with real estate, such as flipping, these risks can become very severe.

    Dr. Cory S. Fawcett
    Prescription for Financial Success

    • hdo

      Curious what you think about John T Reed’s argument in _Best Practices for the Intelligent Real Estate Investor_ that the longer you hold property, the more the probability of adverse events approaches 100% (lawsuits, bad tenants, government decisions resulting in declining local values). Therefore, unless you can get a massive cash flow like >=10% cap rate, you’re actually safest with the strategy of buying property at a deep discount and/or upgrading its value massively and then getting it off your hands ASAP before something can go wrong.

      • Of course something will go wrong. But the consequences are always over stated. You could say the same about buying mutual funds. The longer you own the fund, the more likely it will experience a drop in value. So you should sell the mutual fund as soon as it goes up so you wont have to go through one of those awful down markets. But you can count on that drop happening. Both the ups and the downs are part of investing. Over the years, the trend is up and almost all of the bad things get compensated.

        Dr. Cory S. Fawcett
        Prescription for Financial Success

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  • As someone who has tilted his portfolio way into the real estate section for the past 2 years these points are definitely taken to heart.

    That is why I am inclined to forgo some of the profit by assuming a more passive stance and let people who are professionals in the field find, vet, and present deals via syndication. Of course that carries some risk as well (the syndicator has to be trustworthy, dependable, and do due diligence as well), but when you find a syndicator that you are comfortable with, it can truly feel like “mailbox money.”

    My best investment ever was because of real estate, getting on the ground floor of a medical building I practice in which just got sold last month. Received the biggest check I have ever in my life (and likely for the rest of it) and it has essentially fast forwarded my FI time line by probably 4 or more years.

    Conversely people have lost their shirts in real estate but those stories are often because of speculative type investments or trying to emulate TV shows and flip homes.

    • Xrayvsn, syndicated realestate deals don’t remove any of the risks, they just hide them better. Since the partners don’t know what’s going on, they do see any of these things happen.

      Dr. Cory S. Fawcett
      Prescription for Financial Success

    • Harjot

      So true! I have reviewed a few of these, and tried due diligence on my own to be in real estate passively and it never seemed to work.
      BTW. I think two more points are in order –
      8. How much time would spend managing real estate? Is it worth it?
      9. Bad property managers- they can eat away all the margins or worse

      • Harjot, I managed 65 units when I was a full time surgeon. Took 10-15 hours a month. Watch for my next book this fall, the Doctors Guide to Real Estate Investing for Busy Professionals to learn how to efficiently manage it yourself or to have a manager do it.

        Dr. Cory S. Fawcett
        Prescription for Financial Success

        • duke33

          Need some info on the “truly” passive options such as the syndicate deals, crowdfunding etc that allowable favorable tax implications such as depreciation and possible 1031 exchanges. I dont think most full time docs want to manage any properties or be landlords for the most part.

        • Harjot

          Cory, I had read material from John Reed, especially after he had debunked fairy-tales of Robert Kiyosaki. I have avoided sure disasters because of his teaching. I look forward to your book as a resource- if not for me, for others because I have too many irons in the fire right now.
          However, mentorship from someone like you maybe very valuable.
          We, in Physician world, are not used to paying for knowledge, or coaching, or mentoring. That’s why Physicians fall in the traps and are constantly sold things. An example is in order – there was an agricultural land deal being sold at 14k per acre. A multinational did due diligence and could not make it work, their people had decades of experience, and already owned similar land. Guess who bought the land at 18 k per acre- a Physician crowdfunded group- all sold on complicated promises of tax schemes etc.

        • Duke33, you can make your own real estate be “truly”passive if you want. In a syndication, you give the money to a manager and he takes care of it and sends you the checks. You can do that with your own property by hiring a management company. Same thing, but you keep all the benefits. Just because you own it doesn’t meen you have to manage it. I’ve only been home 4 weeks this year, I turned all my property over to a manager so I could travel. I was active for 12 years, now I’m passive.

          Harjot, I have seen physicians invest in stuff they know nothing about. It often turns out poorly. We need to stop doing that.

          Dr. Cory S. Fawcett
          Prescription for Financial Success

    • I’m super-leery of these syndication deals. I don’t believe they’re worth the risk. You have ZERO control over anything. And on many of them, you’re only getting your “guaranteed” % return… not the huge upside if the value of the property sky-rockets.

      And if the deal you invested in fails (you lose your investment), the people syndicating have many other deals for themselves.

      It will take 10 more years or so, but I think people are going to lose more often than not in these deals.

      I’m not saying the idea of “pooling” money to buy real estate can’t work, but you want to be at the top of the deal with upside on everything… not at the bottom simply getting an 8/10/12+ percent return.

  • All important risks to point out. If you don’t do your homework and invest blindly, you could pay a heavy price.

    I always recommend seeking out a mentor to help guide you through your first one or two acquisitions. Oh, and find a strong realtor who’s more interested in finding a good house for you than chalking up a quick sale.

  • Wow, I considered myself great with real estate but you managed a 65 unit building yourself. That’s amazing! My head would have exploded.

    Having said that I’ve always considered the biggest risk is ‘surprise expenses’ and being able to fund them. It’s the only asset that really has this issue (I think) and people don’t plan for it well.

    You kind of touched on it in liquidity but when your AC breaks in the summer you better be able to shell out the couple thousand dollars of cash to fix it quickly. Stack up a few repairs and maybe some vacancy it the short term cash flow can get very negative.

    Don’t pay those bills and things can get hairy quickly.

    It’s these surprises that cause the most problems in my eyes. You just need a big fund to draw on to cover them but if you don’t plan for it you’re in trouble!

    • Leif, I managed 65 units that were spread out in 5 apartment complexes. Most “surprise” expenses are not surprises. Just like in your own home you have to keep some cash to handle repairs. But a lot of people don’t have any funds for repairs and then call it a surprise when something breaks. I have 65 A/C units so I know some of them will need replacing every year. If the life of a unit is 10 years, then I expect to replace 6 units this summer. It’s not a surprise. I set aside money to take care of those things. I have 65 water heaters so I know some of them will leak this year, it is not a surprise. It is true that I don’t know what day it might happen, but I know it will happen. This stuff is normal maintenence, not surprises. I did have a true surprise this year, someone drove their car through the wall of a unit. Fortunately I prepared for that surprise by having insurance. Sometimes stuff happens, so just be ready.

      Dr. Cory S. Fawcett
      Prescription for Financial Success

      • Fair, planning is the right thing to do. I suppose when you have 65 units things average out nicer than I’m used to. Means I just need more houses 😛

        This year at around the same time (same storm) I had two houses get wind storm damage (each below my deductible) and another get a leaky roof which I didn’t really ‘plan’ for. I had a pool of repair money so it was ok but it was definitely an unwelcome repair which depleted my surprise repair fund.

        When you have 65 units you can likely just assume one weird thing like that will come every year.

        I’m still very impressed by your 65 units. Kudos!

  • I love the real estate focused tilt to your FIRE strategy, and will be doing the same via single family home rentals. I’m not sure I’ll ever hit 65 with that strategy, but perhaps a few 1031 exchanges down the road…. we’ll see.

    I also am leery of syndications, like some of these commenters. But I’m sure there are good ones out there.

    Any strategy can end well with good due diligence and luck.

    — TDD

    • TDD,
      Instead of single family homes, why not try a small apartment like 6-10 units? Way more efficient.

      Dr. Cory S. Fawcett
      Prescription for Financial Success

      • Cory, thanks for this. I do foresee something like this down the road. However, I’m starting with single family homes because of the low barrier of entry. It’s an easy proof of concept for $25k, rather than a larger investment into an apartment building that may need a commercial loan.

        So absolutely, I’d bet that within the next 5-10 years I’ll move into multi family.

        I look forward to your book to hear about your experiences in this arena.

        — TDD

  • I think in general point #7 is vastly underrated by just about everyone.

    Changing a normal asset allocation to one with a massive risk exposure vis a vis real estate and a huge short debt exposure is not diversifying risk; its adding a ton of risk.

    Leverage to amplify returns is awesome in boom times but leads to cataclysm in poor ones.

  • carlos

    The biggest risk of real estate investing is lack of knowledge.
    It is a vast field with many niches and submarkets/locations.
    Like a doctor, a knowledgeable experienced RE investor will make money with anything, and the fool (maybe a doctor) will be parted from his money faster than lightning.
    It is also one of the fasted and surest way to become not only FI but wealthy.
    The biggest source of wealth from RE is leverage through loans.
    That’s when being a doctor comes in handy. The banks look very favorably at doctors for their lending needs. It’s called credit, and credit is a financial thing but also a trust thing: doctors are usually very reliable in their income and their mental stability. Something quite rare in the investment world.

  • We actually just updated our trust this year–we had created it years ago, but since then a lot has changed, including having another child, selling our house and buying another one, and the couple that we had designated as guardians getting a divorce–so it was definitely time. The relief of having it all up-to-date now is huge.

  • Hello, Need some info on the “truly” passive options such as the syndicate deals, crowdfunding etc that allowable favorable tax implications such as depreciation and possible 1031 exchanges. I dont think most full time docs want to manage any properties or be landlords for the most part.

  • duke33

    Agree with Prestige, as much as I know this limits some upside and control.

  • While these are all good points, I have to bring up the fact that people mistakenly believe if they have a Will they avoid Probate. They do not. A Will just names who you would like to be in charge of your estate, guardians and conservators for your kids, and states who you would like to receive your assets (really only an issue if you’re not leaving it to your heirs at law). The Will still has to be probated, and attorneys’ fees and court costs paid based on the size of the estate. Please do yourself and your family a favor and consult with a trusted, experienced estate planning attorney and discuss nonprobate transfers in addition to a health care directive, etc.

  • I love this article – so many important points to consider! I also agree with what Anonymous posted above. A will is a good start, but isn’t enough to avoid probate (which will be a royal pain for your kids when you die – regardless of how much money you have). A better option is a living trust that will avoid probate and also give parents the ability to control when your kids receive an inheritance. With a will, kids get the inheritance at 18 automatically. (That is a scary thought, I can only imagine what I would have bought at 18…) A trust allows parents to determine an appropriate age for their kids to receive an inheritance (21?, 25? 30?). Prior to receiving the inheritance, the Successor Trustee will act as a “gatekeeper” for the kids’ money so that the kids can still have $$ for football, piano lessons, a car, college, etc). It is a great solution. For those commenters looking for a good reference – I used Easy Legal Planning online. They are the perfect hybrid between online services and personalized attention – and it wasn’t too expensive. $495 for a full estate planning package (trust, will, financial and medical powers of attorney and a health care directive). It was easy and inexpensive – a great solution for families! Full disclosure – I work for them now and love it! =)

  • lisa

    The key is to know your investments, since no one particular one is worst than another. For most people, real estate is easier to understand because they see the asset and can better foresee risks. For others, stocks are a better way to go because information about it is actually more readily available.Real Estate Text Marketing

  • I agree with this list of risks of REI, but will say, like some of the other comments, that the vast majority of these risks can be reduced or eliminated just by performing thorough due-dilligence, not succumbing to “shiny object syndrome”, and by targeting a buy and hold strategy. Food for thought.

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