680: How to Reduce REI Risk in Tough Economic Times

SHOW NOTES FOR EPISODE 680: HOW TO REDUCE REI RISK IN TOUGH ECONOMIC TIMES

Real estate is not without its risks!  They are real enough in their own right.  From bad tenants to bad cash flow to bad contractors to natural disasters.  But how do you reduce risk in a bad economy?  In today’s episode, Bill shares 12 ways to mitigate the risks of real estate investing in today’s economy.

Introduction

As I mentioned a few weeks ago, in these final episodes of 2022, I’m going to try to provide my best content from my own personal experience that will be of the most help in your real estate investing efforts.

I received a review from SC Investor (may be someone from South Carolina) back in May that really hit home for me.  He or she wrote: ”I am 54 and just entering the world of real estate investing.  At our age, risk is something we cannot afford without taking careful consideration.  Your podcast really helps me drive past those fears and concerns.”  Well, thank you for your comment and kind words SC Investor.  I couldn’t agree with you more!  We work a lifetime to build up out assets yet, if we are not careful, we can also lose it overnight, if we are not careful!  You inspired me to put this episode together.

One of the greatest advantages to real estate versus stocks is the predictability of real estate investing returns.

When you buy a rental property, you can generally accurately predict your average annual yield and cash flow. And while I have, for decades, invested in stocks too, they’re as volatile as a bipolar teenager with raging hormones.

Still, real estate is not without its risks!  They are real enough in their own right. From bad tenants to bad cash flow to bad contractors to natural disasters, anyone looking to buy rental properties needs to plan for – and mitigate – common real estate investing risks.

Here are 12 ways to mitigate the risks of real estate investing, to always come out ahead when buying rental properties.

1) Invest for Cash Flow and Appreciation

At the Old Dawg’s REI Network – Cash flow is king!  But, and when I can, I always try to make money the day I buy.  So, in other works, I always try to buy under-market value properties! Far too many investors blindly count on future appreciation in their rental properties but I want to know up front, that I have extra equity already built in.

I don’t like to speculate on any of my investments, but I do like to make money when I spend money!

It’s also smart to purchase properties in emerging markets to hedge your bet but, when ever the word “bet” is involved, you know there is risk.

If you look at nationwide real estate trends, home prices usually go up in value.

Individual properties, neighborhoods, and towns can all experience drops in home values but they eventually go back up. Even on a nationwide level, home prices can fall; look no further than the 27.42% drop in the Case-Shiller Home Index during the Great Recession.

But, that’s why cash flow is king!  Rents prove far more resilient. Even as home prices were in free fall, rents didn’t dip at all during the Great Recession. Don’t believe me? Check the Census Bureau. Instead, rents simply flattened for a couple years, before steep increases during the 2010s.

Cash flow is more predictable. You know the market rent, you know the purchase price and prospective mortgage payment. And you should know your long-term average expenses.

2) Use the Buy ‘n Hold Strategy

The buy and hold strategy is one of the best ways to mitigate risk in your portfolio.

In short, it’s when you buy a property and plan to hold onto it for the long haul, maybe even a lifetime. It is considerably less risky than flipping, wholesaling or buying on speculation because you aren’t relying on market cycles.

Now this doesn’t mean that you don’t ever sell.

The beauty of buy and hold is that you can afford to wait for your property to appreciate. I was fortunate to have bought a property in 2016 for $350,000 that I sold 6 years later for $1.2 million. This is on top of solid cash flow for all 6 of those years.

3) Don’t Buy Just Because it’s Cheap

Low-end rental properties offer tantalizing returns – on paper. In reality, that dream property can become a nightmare overnight!

I should know. In my early days of real estate investing I bought a number of them, and spent years regretting it.

They look good on paper because your cash flow calculations usually don’t account for hidden costs like vandalism, break-ins, professional tenants gaming the system to draw out the eviction process. For that matter, even numbers included in the calculations, such as vacancy rates, maintenance, and property management costs, tend to be wrong because of the high turnover rate and high property damage.

Yes, there’s a niche for buying homes in the hood or becoming a Section 8 landlord. But unless you go to pains to learn that niche by apprenticing under a mentor who specializes in them, avoid low-end rental properties and save yourself a world of pain and unforeseen real estate investing risks. Don’t buy less than B class properties!

4) Focus on Multifamily Rentals

Owning and renting multifamily properties is less risky than single family homes.

With single family homes, if one unit is empty, you’re not getting any rent. You’re under water each month.

On the other hand, if you own a four-plex and one unit is empty, you’re probably still cash flowing a little. And that can be enough to get you through a couple of months until you find your next renter.

Larger apartments are even better!.

5) Make Money When You Buy

One excellent way to mitigate real estate investing risk is to “buy value.” Value investing means finding properties priced below market value. In the single-family rental home market, this could be as straightforward as searching for underpriced properties. But, as it happens, there are several other approaches to think about value. Investing in a rental house with rental rates that are lower compared to the prevalent market rate provides a shot to raise rents and keep your cash flows.

Another wise course of action would be to find a property that, with little inexpensive improvements or more up-to-date services, would elevate the property’s value or tenant appeal (or both). Ultimately, keeping a close eye on future developments and buying in areas before housing prices start to climb can also be great ways to always make certain that your investment can offer you stable returns many years from now.

6)  Set Your Investment Criteria and Stick with It!

When buying rental properties, be sure to “buy it right.”

What does this mean? It means that every time you buy a property, you have pre-defined criteria and only buy properties that meet that criteria. Never compromise.

One of the most important criteria is the cashflow!

I like to use a threshold of 10% cash-on-cash return. If a property brings in less than that, I generally won’t buy the property. There are, of course, exceptions to this rule. For example, if a property has a considerable amount of untapped hidden value.

By ensuring a certain minimum level of cashflow, you are mitigating your risk. Even if rents drop slightly in the next downturn, you’ll have some cushion to be able to absorb a drop.

7) Buy the Types of Properties People Will Live in During a Recession

I don’t buy “A” properties.

What is an A property? Think, the modern apartment building covered in glass with the dog park or pool, or the sweet Tudor house with a back yard in a neighborhood. These are the properties that rent for $2,500 dollars and above. And these are not our rentals.

I buy “B” and “C+” properties. Why?

Think about what will happen to a person who is living above their means in an “A” property and who loses their job during the next downturn.

Where does that person go? They will be moving into our B or C+ property.

Likewise, if there’s an upswing in the market and everyone has jobs, the people in the D and C class go up to the B class.

We believe the sweet spot for rentals is in the middle. That way you can benefit from an upswing and weather a storm during a downturn.

8) Focus on Smaller Units, Especially Two-Bedrooms

What happens when there is a recession and people can no longer afford their current housing? As mentioned above, they move into a cheaper place (e.g., move from B to C properties). Not only that, they also tend to downsize.

This is where the two bedroom unit comes into play.

The two bedroom, in my opinion, is the most versatile of all of the rental unit sizes for people living on tight budgets and looking to downsize. It is affordable but still has space for a family with one, two, or even three children. It can work for a single person or a couple who wants an extra room for an office. It can house a single person and a roommate.

When you have a desirable product that is in high demand, your risk goes down.

9) Make Your Property the Nicest on the Block

In a downturn, vacancies tend to go up and the options for housing increase significantly.

So how do you ensure that your house isn’t the one that sits vacant during a downturn? How about making it the nicest on the block?

The great thing about making your property the nicest on the block is that during good economic times, you can demand premium rents.

I’m not saying you need to go crazy with stainless steel refrigerators and granite. But a little upkeep and slightly higher finishes above your community norm is a great way to mitigate risk for the long term.

10) Put Properties in LLCs

As with any business, owning rental properties opens your up to the possibility of being sued.

The key is separating the rentals from each other AND from your personal finances. You do this by putting each property in its own LLC (or in a series LLC). And then you treat each LLC as its own business. You get separate EIN numbers. You get separate bank accounts.

I would also recommend that your LLCs be held by another LLC in a state such as Delaware, Nevada or Wyoming that allow for anonymous ownership

Is it a lot of work? Yes it is.

Is it a pain? Yes it is.

But isn’t it more painful to have a renter sue you, take all your properties and your personal residence and garnish your wages? I’ll leave that one for you to answer.

11) Get Good Insurance

Although the LLC gives you some protection, you’ll also want to have good insurance coverage.

Paying a little extra for good coverage, that also covers natural disasters, is key.

You’ll want to not only get adequate coverage for the property itself; you’ll also want to get good umbrella insurance policy (of at least $1 million) to protect you from frivolous lawsuits and to cover anything above what the property insurance covers.

 12) Buy in Multiple States/Locations

This is one of the main ways that I decided to further mitigate my risk early on in my investment career. When I thought about how to lower my risk from natural disasters and extreme market shifts, I realized that diversifying into other markets was a way to minimize the chances that my whole portfolio could go down at once. Therefore, I spread my investments through several states and markets

In Conclusion

Real estate is a massive asset class and its popularity with investors is well-deserved. An investor who exercises prudence and diligence prior to investing, as outlined above, can benefit from the safety, security, and low volatility of this asset class while avoiding undue risk.

While most investors aspire to own a real asset as a foundation of their investment portfolio, it is important to evaluate the underlying risks before making the investment. If you invest in real estate with the right knowledge and perspective and give your investment the time to perform that it deserves, it could be not only a fruitful investment but also an enjoyable journey combined with the pleasure of ownership of a hard, tangible asset that no other asset class can match.

If all that sounds like a lot, well, at least you have control over your real estate investing returns, by being able to lower your risks. How much control do you have over your stock returns?

Remember, if you’re not able to accurately predict your rental property returns, you’re doing it wrong. Follow the tactics mentioned to reduce your real estate investing risks, and enjoy ongoing high-yield rental income for years to come

 

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