While I believe real estate investing is the easiest form of investing to get into, it does not come without risks. But by knowing the risks ahead of time, you can avoid them. For example, one huge risk is the chance of being sued. But you can protect against that by using an LLC umbrella policy (read more about that here). Here are some other risks:
Problem Tenants: Tenants can be your biggest issue in real estate investing. If they aren’t taking care of your properties or paying rent, you have a problem.
- Go see where they currently live. Most management companies miss this! But to me, this is more important than calling their previous landlord. You actually see how they take care of property!
- Call two previous landlords.
- Use a detailed rental application.
- Check all references thoroughly.
- Get a credit report and criminal history.
- Use a printed lease that complies with your state laws.
- Address delinquent rents immediately. You cannot compromise on people paying their rent. Yes, sometimes people go through difficult times and you want to find ways to help them. It just shouldn’t be out of the rents that you owe—especially if you’re paying mortgages with those rents. You can get into a dangerous area of creating a co-dependent relationship with your tenant if you aren’t careful here.
- Enforce policies immediately. If it’s no pets, it’s no pets. This isn’t an enjoyable experience, but I’ve had it happen many times and survived. We find a pet and immediately ask them to remove the pet from the property. That can be heartbreaking. But they knew before you caught them that they couldn’t have a pet! If you cover all of these issues in detail and they sign off, then you are in the green light to enforce policies. Make sure you don’t build a weak reputation!
- Require security deposit and first and last months’ rent. I like to see that the tenant is able to pay this so that I know they won’t move out randomly.
- Complete a Statement of Condition and have the tenant sign. This is an addendum to the lease. Basically, I go through the property and inspect everything’s condition. I list out the condition, and list out possible damages the tenant could cause. Then I put an average cost for those repairs on the Statement of Condition. If a toilet costs me $75 to unclog, then I put that on there for the tenant to see. Many tenants will expect you to fix it, but I put it as what’s called rent due. If the tenant needs a repair, then you collect the money for that repair the the next month. If they do not pay it, then you can proceed with an eviction.
- Check the property once a month. Your managers should check your property once a month and provide you with an inspection report.
- If you are an out-of-state investor, you should inspect the property every 90 days. A lot of out-of-state investors miss this. Go and inspect the outside and inside of your property every 90 days. If you have a tenant that’s not taking care of your properties, then you need to talk about your managers about getting that tenant out.
Refinance: I’m a big advocate of refinancing property if it’s appreciated properly. In 12-36 months you can refi, pull cash out and then purchase another property. But, unfortunately a lot of investors miss the pre-payment penalty.
- A Pre-Payment Penalty is when you refi a property within 12-36 months and the lender charges you a very high rate. This pre-payment penalty is sometimes 2-3% of the loan amount that you have to pay out if you want to either sell or refinance the property. In most cases, for a real estate investor, it is much wiser to pay a little higher rate and to completely avoid the pre-payment penalty. New real estate investors become obsessed with the interest rate. Now no one should pay higher than they should, but there are times when it makes good business sense. You lose your flexibility to refinance and cash out of your properties if you have a high pre-payment penalty. So don’t be concerned to pay the higher interest rate if it’s not extreme. Go up to half a point higher and run your numbers. Be careful about signing agreements with pre-payment penalties in them. Know what you’re doing.
Long Term Costs of Owning Property: I personally loved holding real estate in my prime. I enjoyed setting up management companies and the like. But it wasn’t always easy.
- Holding real estate takes money. There are going to be times when you have vacancies. You are going to have unexpected repairs and unpaid rent. These things just happen. It’s part of the real estate risk. I’ve known people who have had vacancies and repairs up to 30% of their rents! That’s not great cash flow. You must handle your property prudently and make sure your managers are being thorough.
- Vacancies: 5% is your target. Ensure that your manager is being aggressive about filling your vacancies.
- Unexpected Repairs: 5% is your target. Remember to build predictable repairs into your Statement of Condition so this doesn’t happen too often.
- Unpaid Rent: 0% is your target. Always, always be strong on this issue!
Despite these risks, I still advise anyone who is looking to make passive income to try out real estate investing. It’s relatively easy to understand and control compared to other investments. For every bad tenant, there’s a wonderful tenant. When done properly, you can truly build wealth through real estate investing.
What risk are you most afraid of and why?
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