By Aniket Bose. Edited by Arjun Chandrasekar.
According to Gallup’s annual Economy and Personal Finance survey conducted in early April 2020, since 2013, real estate has emerged as the top investment choice for the majority of Americans at 35%. This puts real estate investing favored over investment types such as stocks and mutual funds (21%), savings accounts (17%), and bonds (8%) as the most popular investment types in the USA.
Real estate investing can be very lucrative to new investors, but it is important to be careful in each step. The key risks to real estate can include but are not limited to: bad locations, negative cash flow, high vacancies, and problems with tenants. Four main risks are associated with real estate investing: choosing a bad location, negative cash flow, high vacancy rates, and problems with tenants. Let’s learn more about each risk in more detail!
Choosing a Bad Location
When investors are looking to invest in a real estate property, the location is always the first thing they take into consideration. The main reason is that you can’t move a house into a more desirable neighborhood, nor can you move a retail building out of an abandoned shopping complex. The location ultimately drives the other factors that determine the investor’s ability to make a profit through the demand for rental properties, properties that are in high demand, tenant pools, rental rates, and the potential for the property to gain appreciation. For most real estate investments, the properties with the best location are the ones that will generate the highest return on investment (ROI) for the investors.
Negative Cash Flow
Cash flow is one of the most important factors in a real estate investment. This is because it’s the money left over after the payments for all expenses, taxes, and mortgage payments have been fulfilled. Negative cash flow occurs when the money that is coming in for the real estate property is less than the money going out of the property, which in simpler terms means that the investors are losing money. The main reasons for negative cash flow to occur in a real estate investment include high vacancy, too much maintenance, high financing costs, charging low rent, and not using the best rental strategies. The most efficient way to reduce negative cash flow is to research the rental property before deciding on purchasing it.
High Vacancy Rates
Whether investors own a single-family house or an office building, they need to be able to fill in those units with tenants to generate rental income which would eventually help in generating a profit. However, in real estate investing there is always the risk of high vacancy rates. These high vacancy rates can prove to be especially risky if the investor tends to rely heavily on the rental income to pay for the property’s mortgage payment, insurance, property taxes, etc. The easiest way to avoid high vacancy rates is to choose a property that is a good location that has a high demand. This high demand will lead to competition between potential clients, which could result in the investor receiving more rent than they anticipated.
Problems with Tenants
For investors to avoid a potential vacancy risk, they tend to keep their investment profiles filled with tenants, however, this could lead to another risk which would be having bad tenants. A bad tenant can end up being much more of a financial plan for an investor compared to not having a tenant at all. The common problems that are associated with bad tenants are not paying rent on time, trashing the property, not reporting maintenance issues on time, hosting extra roommates, and ignoring their responsibilities as a tenant. Investors and property owners need to run a credit and criminal check on every potential tenant so that they can avoid having bad tenants and fewer problems. It is also recommended for property owners to investigate a potential tenant’s work history because it is necessary for them to have a steady salary that can reasonably cover rent and their living expenses.
Real estate investing has traditionally been considered a sound investment, where investors can enjoy a passive income, excellent returns, advantages with tax, and the opportunity to build wealth. However, like any form of investing, real estate investing can also be risky at times. Investors and property owners can limit their risks by being diligent and conducting a thorough real estate market and rental property research and analysis.