Interested in buying an investment property, but worried about the risk involved?
Real estate comes with many advantages, and chief among them is your ability to forecast returns and mitigate risk. You also have far more control over your risk and returns with real estate investments, compared to investments like stocks and bonds.
As you explore buying your next property, keep these risks in mind — and mitigate each one of them.
Risk: Negative Cash Flow
When you buy a rental property, you run the risk of it losing you money each year, rather than earning income.
I’ve owned properties that lost money year in and year out, and it’s not fun. Things get even worse if you overpaid or overimproved the property, and find yourself upside-down on it. That makes it hard to unload without taking a loss at settlement.
How to Mitigate Negative Cash Flow
You can mitigate the risk of negative cash flow in several ways.
First, learn how to accurately calculate cash flow for any rental property. That means not just including obvious expenses like the monthly mortgage payment, property taxes, and insurance, but also irregular expenses such as repairs, maintenance, vacancy rate, and property management fees to screen and sign lease agreements with new tenants. You have to take the long-term average of these expenses, rather than just looking at a typical month’s recurring expenses.
No investors like hearing it, but substantial down payments also help here. The more you borrow for a loan, the higher your mortgage payment of course, and the greater the risk of negative cash flow.
You also need to estimate the market rent accurately. If you forecast that the property will rent for $1,500, but you only rent it for $1,350, your monthly cash flow drops by $150. That can put you in negative cash flow territory.
Finally, look for ways to reduce tenant turnovers, as most landlord expenses happen then. Focus on retaining your good tenants, and leasing to new tenants who will likely stay for many years.
Risk: Rent Defaults
Not every tenant pays their rent on time, or at all. When your tenants stop paying the rent, you still need to make your mortgage payments, pay property taxes, pay your insurance premium, and pay for repairs and maintenance.
In other words, you’re stuck with the check if the tenant stops paying.
How to Mitigate Rent Defaults
First and foremost, screen all tenants thoroughly. That includes tenant background checks such as credit reports, criminal checks, and eviction history reports, but tenant screening goes far beyond background checks.
You should also verify their income with pay stubs and tax returns, and by speaking with their employer. While speaking with their employer, confirm how long they’ve worked there, and their odds of continued employment. Also ask about what kind of worker they are: do they show up on time consistently, do they work well with others, are they conscientious? That gives you insights into what kind of tenant they’ll be.
Call both their current and former landlords, to ask about their performance as renters. Did they pay the rent on time every single month? How did they treat the property? Did they violate any other lease agreement rules? Note that while current landlords might say anything to get rid of bad tenants, former landlords have no vested interest and will tell you the truth.
If you can, also visit their current home to see how they treat it.
You can also purchase rent default insurance, which kicks in and pays you the rent if your tenant stops paying. Price it out, as it’s often worth the peace of mind.
Finally, accept online rent payments, and encourage your tenants to set up recurring automated payments. Some platforms even report rent payments to the credit bureaus, such as SparkRental’s online rent collection service. That further incentivizes on-time payments.
Risk: Tenant Damage
Even if your tenants pay the rent on time, they can still damage your property.
That could include scratching up your beautiful hardwood floors, spilling red wine all over your new carpets, or their children coloring all over the freshly-painted walls. Or it could be more malicious — I’ve had tenants punch through every single kitchen cabinet door out of spite before.
How to Mitigate Tenant Damage
Tenant screening helps you avoid high-impact tenants who don’t care for their homes. Speaking with previous landlords and visiting their current homes can help you spot applicants who don’t treat their homes with respect.
The security deposit also helps of course. But you can usually only collect one-to-two months’ rent as a security deposit, which won’t necessarily cover the cost of all tenant damage. Aim to charge as much as the market and local regulations will allow.
However you should think defensively when you plan rental renovations. Aim for indestructible flooring — I prefer LVT (luxury vinyl tile) over hardwood or carpets, because it resists water damage, scratching, and stains. I also aim for semi-gloss or glossy paint on the walls, to more easily wipe away scuffs than flat paint. Try to “tenant-proof” your property as much as possible.
Risk: Higher than Expected Repair Costs
Investors don’t always understand the full scope of the repairs needed on a property. They may buy a property, only to discover mold behind the walls, or some other hidden nightmare.
Even when you know the full extent of the needed repairs, you can underestimate the renovation costs. Or, for that matter, simply fall prey to unethical contractors who look for excuses to raise the price on your halfway through the job.
How to Mitigate Expensive Repairs
First of all, always conduct a home inspection before buying any property. In most cases, they find and document every single repair problem with the home.
But you also need to choose your contractors carefully. Incompetent contractors can cause even more damage, and unscrupulous ones will lowball you when pricing the job, only to find excuses to charge you more at every turn throughout the job. Follow these rules when hiring and managing contractors.
Speaking of managing them, keep a close eye on your contractors’ work. Try to visit the job site every single day to check on progress, ask questions, and verify both the progress and the quality of work. If you see anything you don’t understand, or anything that concerns you, question the contractor. This not only finds problems early, but it also prevents them, as contractors pay more attention when they see you paying more attention.
Tenants love to sue landlords. Real estate investors make easy targets for lawsuits in general, given the high value of the assets involved, and the inability to move them.
How to Mitigate Lawsuits
As a real estate investor, you can gain some basic protection by owning your properties under business entities rather than your personal name. If someone sues you and wins, they can go after your personal assets — such as your home, car, and personal savings — if you own properties under your personal name.
But beware: if you commingle funds between your business accounts and your personal accounts, you lose the protection afforded by legal entities such as LLCs.
Read up on ways to protect your assets as you scale your property portfolio.
Finally, use a landlord-protective lease agreement. It should include clauses that put as much liability as possible on the tenant, rather than on your as a landlord. Also include clauses that protect your property from common threats, such as scratched flooring. For example, our lease agreement includes a clause requiring felt pads on the bottoms of all tenant furniture.
Real estate investors have many options available to reduce the risk in their investments. But it requires foresight and work on your part to mitigate these risks.
As a parting thought, aim for the best quality tenants you can manage. That starts as you scout neighborhoods for investing — buy in better neighborhoods to attract higher quality tenants. High quality tenants come with lower risk of rent defaults, more respect for your property, and more financial stability in general.
Even after you purchase a property, you can still position it to attract better quality renters. Explore renovations to attract the best tenants possible in your neighborhood.
Unlike stock investing, rental investing is not 100% passive. You have better control over your returns on rental properties, but it requires effort and attention on your part to maximize your returns while minimizing risk.