Risk Management

Apr 20

Photo by Loic Leray on Unsplash

Risk is inherently part of life and any investment. Real estate investing is no different. However, there are ways to significantly reduce certain investment risks, which is the subject of this article.

NOTICE: I am not an attorney, insurance agent, property manager, or financial advisor. Seek competent authority before making any decisions.

Risk Factors

I divide real estate investment risks into the following categories:

Compliance risk - Many laws and regulations govern renting properties. If you violate any federal, state, county, or local regulation, even accidentally, you can face serious (and expensive) litigation.
Litigation risk: A tenant sues you.
Price risk - you pay too much for a property relative to the rent and cannot make a profit.
Vacancy and rent rate risk - You are unable to rent the property at a profitable price now or in the foreseeable future.
Renovation risk: You expected to spend \$2,000 on the renovation, but the total is now looking much higher.
Maintenance risk: You budgeted for \$300/Yr in repairs, and it's February, and you've already spent \$9,000.
Non-performing tenant risk - A tenant stops paying rent.

I will go through each of the above risks and explain how you can minimize them.

Compliance Risk

Complying with all the federal, state, county, or local regulation regulations is not easy. The best way to protect yourself from making a mistake that could cost you tens of thousands in legal fees and fines is to use a property manager. Compliance is a huge risk that you cannot ignore.

Litigation Risk

The concern here is that a tenant or another party sues you. One way to protect yourself is to put each property into a separate LLC. The state of Nevada has a DIY site for setting up an LLC. Nevada offers a Series LLC, enabling you to create a separate LLC for each property at no additional cost.

Also, landlord insurance may offer some protection. Check your policy so you know in advance what is covered and what is not covered.

We also have a few clients who purchased umbrella policies. I know little about insurance, so you will want to check with an insurance agent. Umbrella insurance is insurance that provides protection beyond existing limits and coverages of other policies. Umbrella insurance can provide coverage for injuries, property damage, certain lawsuits, and personal liability protection.

Price Risk

You pay too much for a property compared to market value. Over-paying is the easiest risk to manage because you decide how much to offer. However, as long as you buy in a good location, all but the worst mistakes will be corrected over time through appreciation. However, if you buy in a market where rents and prices do not exceed inflation, you have a problem with no good solution.

If you are financing the property, you have an additional safeguard. Lenders require appraisals, and they will not loan more than what the property is worth. If the appraisal comes in below the contract price, depending on the terms in the contract, you may be able to renegotiate the purchase price.

Financial Risk

If you can't rent the property at a profit, you may have the nightmare of a cash sink. If you purchased in a location where the rent is increasing faster than inflation, time will correct all but the worst mistakes. If you buy in a location where rents do not exceed inflation, there is little you can do after the fact. Only:

Only buy properties in locations where rents and prices are increasing faster than the rate of inflation.
Work with an experienced and proven investment team. A lot of knowledge and skills are needed to find a property and put it into production. You cannot do it all yourself.

Renovation Risk

If you do not work through a good investment team or do not follow their recommendations, renovation can be high-risk. A few items to be aware of.

Do not be deceived by a pretty face - Never make the mistake of thinking that just because the cosmetics of the property look updated, the plumbing, foundation, electrical, structural, and roof are in good order. Cosmetics are inexpensive compare to the various systems. For example, installing granite countertops in a kitchen with an under-mount sink and faucet costs between \$2,000 and \$3,000 for a typical house. The cost to replace the sewer line between the property and the main is between \$5,500 and \$8,500. Re-plumbing costs between \$7,000 and \$15,000 for most properties. A composition roof for a 1,500SF single-story house is between \$6,000 and \$10,000. Do not fall in love with a "pretty face."
Property inspection - A good property inspector is critical if you want to avoid a costly mistake. They have the experience to evaluate things that you might not even know existed. The property inspector we work with has saved us many times from a disastrous purchase.
Remodeling to taste - Too many first-time investors want to remodel a property to match their personal taste. This is almost always a costly mistake. Find the best property manager you can (they will not be the cheapest!) and do what they recommend and only what they recommend.
Do not be trendy - You will hold the property for many years while fashion trends come and go every year. Today's trendy colors and styles will make the property difficult to rent in just a few years. At that point, your choice will be to reduce the rent, rent to bad tenants (much worse), or renovate the property (again). You can not afford any of these options. Listen to your property manager.

Maintenance Risk

The only way to keep maintenance costs low is to not buy a property that will require a lot of maintenance. Below are some considerations:

Older properties require more maintenance than newer properties.
Composition roofs require more maintenance than tile roofs.
Properties in climates with hard freezes require more maintenance than properties in mild climates.
Properties in locations with a lot of moisture require more maintenance than properties in dryer climates.
Wood siding requires more maintenance than aluminum or stucco siding.
Properties with lush vegetation require more maintenance than properties with little or no vegetation.
Locations with high termite activity levels will require more maintenance than areas with little or no termite activity.

When I owned properties in Houston, I was constantly replacing roofs (composition), siding, wood-framed windows, and dealing with wood rot, pest control, termites, and landscaping. The properties were all older, so plumbing, electrical, termite, and foundation issues were also significant and costly issues. On paper, the cash flow was outstanding. However, I barely broke even after all the maintenance expenses plus tenant turns, skips, and evictions. Consider all the costs, not just the paper profits, before you buy a property. Especially maintenance cost.

Non-Performing Tenant Risk

Where you decide to invest is critical. Landlords have little rights in some locations, and it is almost impossible to remove a non-performing tenant. As a reality check, watch the 1990 movie Pacific Heights.

The only way I know to minimize the chances of having your own "Pacific Heights" situation is as follows:

Only buy in a state/location where the laws favor the landlord. It can take a year or more in some locations and cost thousands of dollars to evict a non-performing tenant in some states or locations.
Do your homework and pick a credit-based tenant pool. Once you have a clear understanding of your target tenant pool, only buy properties that your target tenant pool is willing and able to rent.
Never manage your properties. You will lose a lot of money plus, you may find yourself in a far worse situation. Again, see the movie Pacific Heights to get a good understanding of what can happen. In this movie, the property is managed by the owners to save money. The nightmare tenant sought out such a property because they know they will never pass even an initial screening by a good property manager. What are the odds of getting into such a nightmare situation? Low, but so is your chance of getting cancer.

In Conclusion

The best way to minimize risk is not to put yourself into a high-risk situation. The major things you can do to protect yourself include:

Work with a good investment team.
Only buy in a location where prices and rents are increasing at a rate greater than the rate of inflation.
Only buy in landlord-friendly states.

If you follow these three guidelines, your odds of having a serious problem are low.

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