Ask a real estate investor about risk management and you are likely going to get a long discussion about entities, land trusts, and other vehicles to protect oneself from the potential liabilities of being a housing provider or an investor. While these are critical topics, I believe they miss the most important aspects of risk management in real estate investing.
I break down risk management into three critical areas that any investor should acknowledge to mitigate risk in their own business: Market Cycles, Interest Rate Risk, and Operational Turnover.
As a 20-year vet of real estate investing and someone who can say they have looked at their market nearly every day for two decades, I can tell you without question my market has cycles just like yours has cycles. Market cycles are determined by supply and demand imbalances but can be exacerbated by outside forces like government incentives, historically low interest rates, or tight lending standards.
Understanding where you are in the cycle means you can lower your risk of being caught over-leveraged as many flippers did in the last crash when prices kept falling. All cycles eventually change, and you never see it coming unless you are in your market every day. For example, I remember the day that hedge funds came into my market and bought everything site unseen for list prices; it was crazy and a clear sign the bottom was in. I also remember the wave of inventory hitting the market and daily price drops as others insisted “there’s no problem here.”
It is far better to understand and recognize the top than it is to catch the bottom where bankruptcy looms.
Interest Rate Risk:
For the last 20 years we have been spoiled as the 30-year mortgage rate has generally trended lower with only short-term upticks. This recognition is important because I believe we are about to enter a three- to seven-year period where interest rates generally increase, and that means some real estate has new risks that were not considered before.
For example, did you know that most commercial and multifamily (over five units) carries interest rate risk as you only have three-, five-, or seven-year fixed rate periods? This fact tied to rising interest rates, flat rents in multifamily, and rising cap rates could mean multifamily investing suffers some real pain in the next few years.
In addition to rising interest rate risk, I believe the single-family market and builders might need to change their product type. The past 20 years have been very kind to move-up buyers as they were able to sell their home and buy a bigger, nicer one while also getting a better interest rate. It is far easier to buy a house that is $100K more than your first house when the interest rate is down one percent in five years, and you have great appreciation.
However, what happens to the move-up buyer if they want a house at $100K more and the interest rate is one percent higher than their first mortgage? I suspect most people will see payment shock and decide to stay put. Interest rate is a huge part of payments, which all real estate is based on, and if we have five years of increasing rates, we could see real pain as the move-up buyer decides to stay put.
Did you know landlords have some control over the one thing that can bring the largest profit or loss after acquisition? That one thing is unit turnover.
Turnover is expensive and it can kill all your profit in a single year if you are not careful. That is why I recommend landlords look at their tenants and try and find the great ones. Too many people talk about horror stories of being a landlord. Why not instead talk about the family that paid on time for 12 months straight? Why not celebrate that? Why not reward that?
Too many new landlords would rather focus on the process to remove problem tenants. Instead, I say focus on implementing processes to keep the great ones. The rules to remove a problem tenant are clear, but what are your rules to celebrate a great tenant?
Also, why would you raise rent $25 on a tenant that has paid rent on time for 12 months and has not been an issue? Every rent increase causes families to question whether they want to live there. Never be penny wise and a dollar foolish.
As a real estate investor, you must think about the risks of market cycles, rising interest rates, and turnover as each can crush your dreams quickly.
Michael Zuber worked in the Silicon Valley since graduating from Santa Clara University 20+ years ago. After wasting time and money in his 20s, he began investing buy and hold rental properties and never looked back. Michael grew his rental property portfolio from a single rental house to financial freedom in 15 years. Now that he no longer has a day job, he shares his story via his self-published book and YouTube Channel, both called One Rental at a Time.