Investing creates great opportunities to make great money, but there is always a risk to take along with it.
Is owning real estate a risky investment? In the past decade, real estate has ranked as the top investment pick for the majority (35%) of Americans, according to Gallup’s annual Economy and Personal Finance survey. That puts real estate ahead of stocks and mutual funds (21%), savings accounts and certificates of deposit (CDs) (17%), gold (16%), and bonds (8%) as the most favored investment.1
It may be the top investment pick, but is real estate investing really safe? Just like any investment, real estate investing has risks, and property owners can lose money. Here are seven real estate investment risks to watch out for when you’re thinking about buying an investment property.
- Owning real estate consistently ranks in the top place among Americans as the best investment opportunity.1
- Real estate investing can be lucrative, but it’s important to understand the risks.
- Key risks include bad locations, negative cash flows, high vacancies, and problem tenants.
- Other risks to consider are the lack of liquidity, hidden structural problems, and the unpredictable nature of the real estate market.
- Here, we detail seven such risks.
1. The Real Estate Market Can Be Unpredictable
Real estate has proven resilient during the COVID-19 pandemic, reaching all-time highs in many locations.2 Still, leading up to the 2008 Great Recession, many investors (wrongly) believed that the real estate market could only move in one direction: up. The basic assumption was that if you bought a property today, you could sell it for a lot more later on.3
While real estate values do tend to rise over time, the real estate market is unpredictable—and your investment could depreciate. Supply and demand, the economy, demographics, interest rates, government policies, and unforeseen events all play a role in real estate trends, including prices and rental rates. You can lower the risk of getting caught on the wrong side of a trend through careful research, due diligence, and monitoring of your real estate holdings.
Real estate is not a set-it-and-forget-it investment. You should monitor your investments and adjust your entry and exit strategies as needed.
2. Choosing a Bad Location
Location should always be your first consideration when buying an investment property. After all, you can’t move a house to a more desirable neighborhood—nor can you move a retail building out of an abandoned strip mall.
Location ultimately drives the factors that determine your ability to make a profit—the demand for rental properties, types of properties that are in the highest demand, tenant pool, rental rates, and the potential for appreciation. In general, the best location is the one that will generate the highest return on investment (ROI). However, you have to do some research to find the best locations.
3. Negative Cash Flows
Cash flows on a real estate investment refer to the money that’s left over after paying all expenses, taxes, insurance, and mortgage payments. Negative cash flows happen when the money coming in is less than the money going out—meaning that you’re losing money.
Some common reasons for negative cash flows include:
- High vacancy rates
- Too costly maintenance
- High financing costs on loans
- Not charging enough rent
- Not using the best rental strategy
The best way to reduce the risk of negative cash flow is to do your homework before buying. Take the time to accurately (and realistically) calculate your anticipated income and expenses—and do your due diligence to make sure that the property is in a good location.
4. High Vacancy Rates
Whether you own a single-family house or an office building, you need to fill those units with tenants to generate rental income. Unfortunately, there’s always the risk of a high vacancy rate in real estate investing. High vacancies are especially risky if you count on rental income to pay for the property’s mortgage, insurance, property taxes, maintenance, and the like.
The primary way to avoid the risk of high vacancy rates is to buy an investment property with high demand, in (you guessed it) a good location. You can also lower your vacancy risk if you:
- Price your rental rates within the market range for the area
- Advertise, market, and promote your property, being mindful of where your target tenant might look for property information (e.g., traditional methods? online?)
- Start looking for new tenants as soon as a current one gives notice that they are moving out
- Make sure your property is clean, tidy, and well-maintained
- Offer incentives and rewards to keep tenants happy
- List your property with a real estate professional
- Develop a reputation for being nice and renting quality properties (think: Airbnb reviews)
5. Problem Tenants
To avoid vacancy risk, you want to keep your investment properties filled with tenants. But that can create another risk: problem tenants. A bad tenant can end up being more of a financial drain (and a headache) than having no tenant at all. Common problems with tenants include those who:
- Don’t pay on time—or don’t pay at all (which could lead to a lengthy/costly eviction process)
- Trash the property
- Don’t report maintenance issues until it’s too late
- Host extra roommates (humans or animals)
- Ignore their tenant responsibilities
While it’s impossible to eliminate the risk of having a problem tenant, you can protect yourself by implementing a thorough tenant screening process. Be sure to run a credit check and criminal background check on every applicant. Also, contact each applicant’s previous landlords to look for red flags like late payments, property damage, and evictions.
It’s also recommended that you investigate a potential tenant’s work history. Make sure they have a steady salary that can reasonably cover rent and living expenses. It’s also a good idea to pay attention to scattered work history. An applicant who bounces from job to job may have trouble paying the rent and may be more likely to relocate in the middle of a lease.
Be sure that you and your investment properties are adequately insured against losses and liability.
6. Hidden Structural Problems
One sure way to lose money on an investment is to underestimate the costs of repairs and maintenance. For a typical single-family home, for example, you could be looking at as much as $12,000 to repair a foundation or $16,000 to fix the siding. Structural repairs, or remediation for mold or asbestos, could easily cost tens of thousands of dollars for commercial buildings.4
Thankfully, you can lower this risk if you thoroughly inspect the property before you buy it. Don’t skimp on hiring a qualified and reputable property inspector, contractor, mold inspector, and pest control specialist to “look under the hood” and uncover any hidden problems. If a problem is discovered, find out how much it will cost to fix and either work that cost into your deal or walk away if it would prevent you from making a reasonable profit.
7. Lack of Liquidity
If you own stocks, it’s easy to sell them if you need money or just want to cash out. That’s not usually the case with real estate investments. Because of the lack of liquidity, you could end up selling below market or at a loss if you need to unload your property quickly.
While there’s not much you can do to lower this risk, there are ways to tap into your property’s equity if you need cash. For example, you can take out a home equity loan (for residential rental properties), do a cash-out-refinance—or, for commercial properties, take out a commercial equity loan or equity line of credit.
What are some ways to diversify real estate investing?
Diversification is often the best way to reduce risks. Since directly owning several properties may be out of many investors’ budgets, buying shares in real estate investment trusts (REITs) can provide broad exposure to geographically dispersed properties of different types (e.g., residential, commercial, etc.).
How can one minimize the risks of being a landlord?
There are several ways to keep your property costs down over the long run, including paying attention to regular maintenance and upkeep. Relatively small expenses today can save you from large costs down the road. To minimize the chances of problem tenants, run a credit report and check on tenants’ references, including asking their prior landlords how they were as tenants. Finally, choose a good location that will be less likely to either witness crime or have low occupancy rates.
How high can a landlord raise rent?
A landlord is allowed to increase the rent depending on local and state laws, and pursuant to language that exists in the lease. In places without rent controls, there may be no legal limit to how high the rent can be increased.
The Bottom Line
Real estate has traditionally been considered a sound investment, and savvy investors can enjoy a passive income, excellent returns, tax advantages, diversification, and the opportunity to build wealth. Just as with other types of investments, however, real estate investing can be risky.
You can limit your risks by doing your due diligence and conducting a thorough real estate market and rental property analysis. Also, be sure to hire pros to inspect the property, screen potential tenants, and learn everything you can about the real estate market.
Keep in mind that there are plenty of ways to invest in real estate without owning, financing, and operating physical properties. Options include REITs, real estate stocks, real estate crowdfunding, and real estate partnerships.
You also might consider investing in yourself by learning a new skill or getting a new license. Many real estate investors, for example, become licensed real estate agents or brokers—not necessarily to work as one, but to take advantage of the benefits, such as multiple listing service (MLS) access, networking, and the commissions earned on sales and rentals.
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