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SHOW NOTES FOR EPISODE 206: HOW TO REDUCE THE TOP FIVE RENTAL PROPERTY RISKS
A rental property is one of the most popular choices of real estate investors looking to invest in new opportunities. Sure there are flippers, wholesalers, builders, speculators and more, but rental property is something most people who have ever owned a home can easily grasp and understand. However, like all real estate investments, it also has it’s risks. In this podcast, Bill discusses five key rental property risks that all investors should be aware of and carefully seek to alleviate.
Introduction
A rental property is one of the most popular choices picked by real estate investors looking to invest in new opportunities. Sure there are flippers, wholesalers, builders, speculators and more, but rental property is something most people who have ever owned a home can easily grasp and understand.
There are also several benefits of owning a rental property, such as earning a steady monthly cash flow from rental income, fantastic tax benefits, securing a long term source of profit, a means of leverage to grow your investment portfolio and a solid investment that historically increases in value over time.
However, despite rental properties being one of the least risky options for investing in real estate, there are a few risks that are associated with owning a rental property that every real estate investor and landlord should know about if he/she wants to find success in his/her investment.
From having a high vacancy rate, through getting stuck with negative cash flow, to renting out the property to the wrong type of tenants, these are some of the most common risks associated with owning a rental property.
In this podcast, I want to zero in on five key rental property risks and how you can reduce the risks from occuring.
Risk #1: Vacancy Rate
The biggest and most common risk that real estate investors and landlords usually consider is the risk of high vacancy rates. Naturally, since your tenants are the source of income from your rental property, in order for you to be earning money from your investment, you need your investment property to be fully occupied by tenants for a good portion of the year.
Typically, in an optimal situation, you will want your vacancy rate to be below 10% in order to achieve maximum returns. However, it is still possible to earn a good profit on your rental property with an occupancy rate of 70%-80%. More importantly, most banks and lenders take occupancy rate into consideration when deciding whether to lend you money or not, and the average accepted occupancy rate by most banks is either above 70%, or above 80% for some of the more conservative lenders out there. Commercial renters want to see at least 90 days of 90% occupancy levels.
When planning your finances, you should always make sure to calculate an estimate of the expected vacancy rate on your rental property and add it as an expense in your calculations, and you should also assume the worst in order to avoid any unexpected financial or local or national economic disasters.
Risk #2: Bad Location
In real estate investing, location is everything – Right? Whether you’re buying a rental property or any other type of real estate property, you should always take the location of the property into consideration.
Some locations might seem like a great choice for a rental property due to lower prices and higher occupancy rates. But, in many cases, these numbers might indicate that the area is either underdeveloped or that it has a relatively higher crime rate. Purchasing a rental property in a neighborhood that has a higher crime rate might seem like a good idea if you’re only looking at the price of the property, as it will most probably be lower than the average price in the housing market. These areas also have a higher occupancy rate as people tend to rent homes instead of buying them.
The risk, however, lies in the high chances of your rental property getting vandalized or robbed, which might lead to unexpected expenses and repair costs, in addition to the complications of legal matters that might arise due to these acts.
Always choose your location carefully in real estate. While in some cases it might be a good idea to invest in a bad neighborhood by purchasing a cheap investment property, especially if that neighborhood is showing signs of future development and an improved presence of the law, in most cases the risks are not worth it.
Risk #3: Market Economy
If you’re getting into the real estate business as an investor or as a landlord, you should always keep yourself up-to-date on the local and national market economy, and you also need to educate yourself to understand the market and how it functions based on the different factors that matter.
The market economy plays a huge role in affecting a rental property’s future value. For example, if you buy a rental property during peak times at property prices, even if this property results in considerable profits through its rental income, when the time comes for selling the property, you might find that its value has gone down drastically as the market moves away from its peak price time, resulting in you selling the property for a lower value. This might even cost you more money than you’ve earned during the period of renting the property out.
For this reason, it’s usually a good idea to have a deep understanding of the market’s economy and to be able to at least have a forecast of the future in the long term, with various worse care senarios, to determine whether buying the investment property at this time is a good idea or not.
Risk #4: Negative Cash Flow
The cash flow of a rental property is the amount of profit that you earn from that property after paying off all expenses, taxes, and mortgage payments. The cash flow is normally much lower than the rental rate of the property. A positive cash flow means that you’re actually earning money on your investment, while a negative cash flow means that your expenses, taxes, and mortgage payments are higher than your rental income, resulting in you losing money on your investment over time.
In order to achieve a positive cash flow and avoid a negative one, it is crucial to have accurate calculations of your rental property’s expenses and costs before moving forward with purchasing it. This includes estimating all the different expected and unexpected costs related to your investment, such as maintenance and repair costs, vacancy rate, capital expenditures and property management. It is very important to be as thorough as possible, as even the smallest expenses might add up to a considerable amount over a long period, so they should all be included in your calculations.
Risk #5: Bad Tenants
While a landlord would typically want his/her investment property to be occupied whenever the opportunity arises, in some cases, the slight increase in the occupancy rate might not be worth the while. Before renting out his/her property to any tenants, a landlord should make sure that the tenants who are going to stay in the property will not cause any additional headaches, or even cause financial losses to the landlord.
It is crucial to screen the prospective tenants who are applying to rent the property before even considering handing them the key. Some tenants might have a bad credit score or a bad history of not being able to pay their rents, or even criminal records or a history of violence, which is not something that you will want to deal with as a landlord.
Additionally, you should contact any previous landlords who have dealt with the tenants to ask them for reviews. Some tenants might have bad habits that might cause damages to your property, which might result in additional maintenance costs for you.
To Sum Up
While rental properties are an excellent real estate investment for generating passive income, and while they typically have a low rate of risk when compared to other types of investments, it’s important that you consider all possible risks before making your final investment. Look at worse case scenarios and make sure you have a plan to deal with each scenario and how it will affect your bottom line.
It’s just makes good business sense to carefully and methodically develop a strategic real estate investment plan that takes into account and tries to reduce all potential risks.
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