How to Reduce Real Estate Investment Risk
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How to Reduce Real Estate Investment Risk

wealth-buildingBy Andrew Waite

In 2011, HomeVestors with Local Market Monitor ranked The Best Markets To Invest in Rental Property. This list began by calculating the cost difference between renting and owning and by gauging overall rental demand. These calculations and the resulting list of “best rental markets to….” bring us back to how a real estate investor should judge the risks and rewards of buying a particular house in a particular neighborhood in a particular town. This is like “stock picking” for houses.

For much of the country, the biggest fear in real estate investing is paying more today than the property will be worth tomorrow. During the run-up prior to 2007, this would not have even been a consideration. Since 2007, we have all learned that housing values can fall. The problem, however, is who calculates reasonable housing values and for what audience is the result intended?  Using retail price data intended for homebuyers is only one measure for investors, and then only for about the 10 percent of investors who are qualified to do “fix and flips.”

The real test is whether your investment will pay off if the home is bought, renovated and rented out over the long term. So the risk/reward measure ultimately should be: will the net yield (after ALL expenses) be worth the investment?

Seasoned investors do not consider appreciation to be the basis of a decision, but rather a bonus that occurs after a wise decision. The guru’s pitch this first, as appreciation from a fast sale is more beguiling than rental returns over the longer term.

Costs and expenses mean buying the property, any renovation costs needed to bring the property to a retail sale or rental state, and then any expenses needed to keep the property tenanted over the long term. Real estate investing is ultimately about “getting (really) rich slowly.”

Cheap May Be the Most Expensive

The biggest mistake we see novice real estate investors make is paying more than the property is worth TODAY in neighborhoods that offer no exit opportunity if a glut of rental properties occurs.

One turnkey real estate vendor sells properties 20 percent to 30 percent over market in C and D neighborhoods to novice investors, hoping this will never catch up to them. Unfortunately, a continuing FHA investigation is asking why the highest appreciation in this vendor’s preferred cities is occurring in the worst neighborhoods, with high crime rates and low performing school districts? The answer is that many of these homes are being sold to out-of-state investors who seldom see what they have bought.

Fundamentals are Fundamental

Before purchasing any investment property, make sure you understand the after-repaired value (ARV), true purchase cost, the repairs needed on the property, the renovation and holding costs to make the property ready to rent or sell. After all your initial costs, will there still be some profit left if you were to sell it?

Next, consider your plan for the property. If you are going to rent the property, will the rent cover the service on the debt, including maintenance reserves for repairs and an allowance for vacancies?  Do not omit other non-recurring fees such as lease-up fees (typically one month’s rent to a for-fee property manager) and carrying costs of a vacancy.

Appreciation is a historic fact in residential real estate. Even the biggest skeptic will tell you that real estate values increase over the long term at around 4 percent to 5 percent a year, even counting down years!  Dr. Robert Shiller of the Case Shiller Housing Index can only argue that the stock market is a better place for money by ignoring mortgage leverage for the average homeowner or mortgages and any rental income in the case of an investment property.

The lesson here is to buy residential properties on an ultra-conservative retail or rental model. Plan for a worst-case scenario and work toward a best-case outcome. If it’s good enough for Wall Street funds to be pouring billions into the residential market, it must be good enough for you, provided you adopt strict analysis.

Resources:

Wall Street buys using fundamental standards outlined in “Professional Real Estate Investment Analysis Standards” at https://thinkrealty.com/personal-real-estate-investment-analysis-standards/

The industry-leading analysis is available free. For more information: https://thinkrealty.com/free-tools/

Then go to the Apple App store and download the FREE iPad or iPhone version.