When jumping into the real estate investment world, it’s easy to get excited about the potential profits and forget the risks. However, your success hinges on your understanding of the risks in real estate investing. For example, entrepreneur, real estate investor, and former equity analyst Joseph Hogue explains to Physician on Fire that at the beginning of his investment journey he quickly gained traction. Yet, he soon depleted all of his life savings after his rentals stopped generating positive cash flow due to his lack of experience. Unfortunately, this is a frequent problem for investors who don’t understand the risks in real estate.
This article will help you anticipate the most common risks when investing in real estate and how to navigate them so you can protect yourself—and your profits—as much as possible.
- Real estate investments can lead to substantial financial losses unless you choose positive cash flow properties and avoid financing investments through risky debt.
- Lawsuits are common in the real estate industry, so know your legal responsibilities and work with a lawyer to limit risk.
- Form an LLC to protect yourself from financial and legal risk.
- Being hasty with the tenant screening process can lead to bad renters that cause costly damage to your property or lead to missed months of rental income.
- Unexpected repairs can turn a profitable investment property into a money pit. Be a proactive homeowner to stay ahead of major issues and always have some money budgeted for maintenance.
4 Risks in Real Estate All Investors Should Consider
1. Financial Risk
While borrowing money for a real estate investment often results in excellent returns, there’s always the chance that unexpected circumstances will make it difficult to repay the loan.
Negative cash flow is one of the most common risk factors for becoming unable to repay a mortgage lender. With a negative cash flow property, operational costs are higher than profits. The property cannot support itself, meaning you’ll need other sources of income to keep the investment afloat.
Negative cash flow can happen for many different reasons. Sometimes, property costs are higher than expected or rental income is lower than hoped. Other times, investors intentionally buy negative cash flow properties, intending to make money over the long term as the property’s value and rental income increase with time.
While some investors manage to stay afloat with negative cash flow, this type of investment is risky. If the cost of maintaining the property increases or other sources of income decrease, you could find yourself unable to pay your mortgage.
How to Limit Financial Risks in Real Estate
- Avoid low cash flow properties: While you can’t always anticipate market downturns, if you invest in real estate properties with a strong cash flow, you’ll be able to cover expenses, even if operation costs rise or rental income slows down.
- Avoid risky debt: It’s difficult to predict if you’ll be able to keep up with payments when you take on risky debt in the form of an adjustable rate loan. Similarly, short-term loans should only be used if you have a guaranteed path for repayment.
- Create an LLC: Forming an LLC for each of your investment properties will protect your personal assets and properties from each other in the event that one of your investments goes under.
2. Legal Risk
Many inexperienced real estate investors don’t take the time to learn all the legal requirements of being a landlord. Lawsuits are one of the most common real estate risks that can impact the profitability of your investment.
It’s critical to understand fair housing laws and treat all tenants and potential tenants fairly to avoid lawsuits. Tenants have a right to sue landlords over housing discrimination. Recent data from the National Fair Housing Alliance shows there were 28,712 fair housing complaints in the U.S. in 2020.
Landlords can also find themselves in litigation for personal injury lawsuits. A tenant could be injured by a frayed electrical wire, trip on an uneven staircase, or cut themselves on glass from a broken window. If you don’t keep your property safe, habitable, and in good condition, tenants can sue you for negligence.
Landlords also need to respect the terms of the lease the tenant signed. Your lease should outline your policies on security deposits, visiting the property, and ending the lease. Violations of the policies stated in the lease can become major legal issues.
Follow These Strategies to Protect Yourself From Lawsuits
- Hire a lawyer: The first time you write a lease, it’s a good idea to have a lawyer read through it to ensure the language provides maximum protection from future legal issues. When facing tricky situations like tenant evictions, you should also consult with a lawyer so you understand your rights and responsibilities.
- Set up an LLC: If you weren’t convinced to set up an LLC for your investment properties to protect yourself from financial issues, you should consider forming an LLC for the legal protection it provides. When your investment property is held by an LLC, any lawsuits that arise will only affect the LLC. You won’t have to worry about a lawsuit impacting your personal assets or your family.
- Research all relevant laws in your city and state: Many cities and states have landlord-tenant laws specific to the area. The best way to avoid a lawsuit is to stay up-to-date on all the requirements of landlords.
- Get a liability insurance policy: Ultimately, any landlord can make mistakes and end up with a lawsuit on their hands. For total risk protection, find a good liability insurance provider to ensure a legal issue doesn’t ruin the success of your business.
3. Maintenance and Repairs Risk
Every home requires maintenance to keep it in good condition, but a home with too many maintenance needs can quickly become a money pit. Hopefully, your home inspector will catch most major issues with the home before you buy it. But things can be missed during home inspections, and new problems can develop—especially if the home is older.
Jennifer Beeston, a mortgage lender from California, was on the hunt for the perfect property for three years. When she found her dream property, the only way to get her offer accepted in the incredibly competitive market she was in was to remove all contingencies, including the inspection. Unfortunately, the first time it rained, Beeston discovered the roof was leaking into nearly every room in the house.
The average cost of a roof replacement is $7,211. An expense like that can be a huge setback after you’ve put a big chunk of cash toward down payments, realtor fees, or moving expenses. Other home issues like foundation cracks, electrical rewiring, or plumbing issues can become a huge financial burden.
That’s why Beeston believes it’s critical for homebuyers to get thorough home inspections before purchasing a property. In a video posted to her YouTube channel, she says: “There is stuff with houses that can go wrong. And a lot of it is not apparent to the naked eye, and it can be very expensive.”
While a home inspection can protect you from certain unexpected costs, you should always have money set aside for repairs. Experts recommend annually budgeting 1–3% of the value of the home for maintenance. Be as proactive as possible with maintenance to catch small problems before they become major concerns.
Take These Steps to Minimize Maintenance and Repairs Risk
- Be proactive with maintenance.
- Keep a budget for maintenance and include some emergency savings in case larger expenses arise.
- Choose a high-quality home insurance policy.
4. Bad Renters Risk
Many landlords work hard to avoid the financial loss of vacancies by replacing tenants as quickly as possible. But rushing to fill vacancies can increase your risk of dealing with difficult tenants. Often, a bad tenant is ultimately more expensive than taking your time to fill vacancies.
Real estate agent and investor Graham Stephen bought his first rental property in 2011. Being anxious to begin earning rental income, he moved quickly to find tenants and accepted the first tenant application he received without any screening process.
Within a few months, Stephen discovered the tenant was operating an illegal drug business out of the garage of his property. Although Stephen took action to evict the tenant, the process took months, and he received no rental income during the ordeal. When the tenant finally vacated the property, he left behind $10,000 worth of damage.
“Anytime you’re investing in real estate with the intention of becoming a landlord, you have to be very careful with who you pick as a tenant, you have to take your time, and you should not rush into these things,” Stephen says. “But I also really believe that with careful due diligence and planning ahead of time, all of these mistakes are easily avoidable.”
Although Stephen’s first experience as a landlord was challenging, he hasn’t had a bad tenant since then because he follows an extensive screening process. A good screening process can bring your risk of bad renters down to nearly zero. He recommends minimizing the risk of bad renters by including the following things in the tenant screening process:
- Run a credit report.
- Get a photo ID.
- Request proof of income and employment history.
- Speak to references and previous landlords.
- Verify the identity of all references.
So, Is Real Estate Investing Safe?
The main risks of real estate investing are financial loss, legal trouble, unexpected maintenance, and bad tenants. If you prepare for each of these risks, you can significantly lower your risk and ensure profitability in your investments.
When you take all necessary precautions to protect yourself from the risks in real estate investing, you set yourself on a reliable path toward financial independence. Residential real estate investors see average returns of 10.6%, while commercial real estate investors see average returns of 9.5%. While there is investment risk in any industry, real estate is historically one of the most stable investments you can make.
To find out whether you should start your investment journey, check out: “Is Real Estate a Good Investment in 2022?“
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