Is real estate a risky investment? Since 2013, real estate has ranked as the top investment pick for the majority (35%) of Americans, according to Gallup's annual Economy and Personal Finance survey, conducted in early April 2020. That puts real estate ahead of stocks and mutual funds (21%), savings accounts (17%), gold (16%), and bonds (8%) as the most favored investment.
It may be the top investment pick, but is real estate investing safe? Just like any investment, real estate investing has risks. Here are seven real estate investment risks to watch out for when you're thinking about buying an investment property.
- Real estate investing can be lucrative, but it's important to understand the risks.
- Key risks include bad locations, negative cash flow, high vacancies, and problem tenants.
- Other risks to consider are the lack of liquidity, hidden structural problems, and the unpredictable nature of the real estate market.
1. The Real Estate Market Is Unpredictable
Leading up to the 2008 Great Recession, many investors (wrongly) believed the real estate market could only move in one direction—up. The basic assumption was that if you bought a property today, you could sell it for a lot more later on.
While real estate values do tend to rise over time, the real estate market is unpredictable—and your investment could depreciate. Supply and demand, the economy, demographics, interest rates, government policies, and unforeseen events all play a role in real estate trends, including prices and rental rates. You can lower the risk of getting caught on the wrong side of a trend through careful research, due diligence, and monitoring of your real estate holdings.
Real estate is not a set-it-and-forget-it investment. You should monitor your investments and adjust your entry and exit strategies as needed.
2. Choosing a Bad Location
The location should always be your first consideration when buying an investment property. After all, you can't move a house to a more desirable neighborhood—nor can you move a retail building out of an abandoned strip mall.
Location ultimately drives the factors that determine your ability to make a profit—the demand for rental properties, types of properties that are in the highest demand, tenant pool, rental rates, and the potential for appreciation. In general, the best location is the one that will generate the highest return on investment. You have to do some research to find the best locations, however.
3. Negative Cash Flow
Cash flow on a real estate investment is the money that's left after paying all expenses, taxes, and mortgage payments. Negative cash flow happens when the money coming in is less than the money going out—meaning, you're losing money.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
The top reasons for negative cash flow include:
- High vacancy
- Too much maintenance
- High financing costs
- Not charging enough rent
- Not using the best rental strategy
The best way to reduce the risk of negative cash flow is to do your homework before buying. Take the time to accurately (and realistically) calculate your anticipated income and expenses—and do your due diligence to make sure the property is in a good location.
4. High Vacancy Rates
Whether you own a single-family house or an office building, you need to fill those units with tenants to generate rental income. Unfortunately, there's always the risk of a high vacancy rate in real estate investing. High vacancies are especially risky if you count on rental income to pay for the property's mortgage, insurance, property taxes, maintenance, and the like.
The primary way to avoid the risk of high vacancy rates is to buy an investment property with high demand, in (you guessed it) a good location. You can also lower your vacancy risk if you:
- Price your rental rates within the market range for the area
- Advertise, market, and promote your property, being mindful of where your target tenant might look for property information (e.g., traditional methods? online?)
- Start looking for new tenants as soon as a current one gives notice they are moving out
- Make sure your property is clean, tidy, and well-maintained
- Offer incentives and rewards to keep tenants happy
- List your property with a real estate professional
- Develop a reputation for being nice and renting quality properties (think: Airbnb reviews)
5. Problem Tenants
To avoid vacancy risk, you want to keep your investment properties filled with tenants. But that can create another risk: problem tenants. A bad tenant can end up being more of a financial drain (and a headache) than having no tenant at all. Common problems with tenants include those who:
- Don't pay on time, or don't pay at all (which could lead to a lengthy/costly eviction process)
- Trash the property
- Don't report maintenance issues until it's too late
- Host extra roommates (human or animals)
- Ignore their tenant responsibilities
While it's impossible to eliminate the risk of having a problem tenant, you can protect yourself by implementing a thorough tenant screening process. Be sure to run a credit check and criminal background check on every applicant. Also, contact each applicant's previous landlords to look for red flags like late payments, property damage, and evictions.
Be sure you and your investment properties are adequately insured against losses and liability.
It's also recommended that you investigate a potential tenant's work history. Make sure they have a steady salary that can reasonably cover rent and living expenses. It's also a good idea to pay attention to scattered work history. An applicant who bounces from job to job may have trouble paying the rent and may be more likely to relocate in the middle of a lease.
6. Hidden Structural Problems
One sure way to lose money on an investment is to underestimate the costs of repairs and maintenance. For a typical single-family home, for example, you could be looking at as much as $12,000 to repair a foundation or $16,000 to fix the siding. Structural repairs, or remediation for mold or asbestos, could easily cost tens of thousands of dollars for commercial buildings.
Thankfully, you can lower this risk if you thoroughly inspect the property before you buy it. Don't skimp on hiring a qualified and reputable property inspector, contractor, mold inspector, and pest control specialist to "look under the hood" and uncover any hidden problems. If a problem is discovered, find out how much it will cost to fix and either work that cost into your deal or walk away if it would prevent you from making a reasonable profit.
7. Lack of Liquidity
If you own stocks, it's easy to sell them if you need money or just want to cash out. That's not usually the case with real estate investments. Because of the lack of liquidity, you could end up selling below market or at a loss if you need to unload your property quickly.
While there's not much that you can do to lower this risk, there are ways to tap into your property's equity if you need cash. For example, you can take out a home equity loan (for residential rental properties), do a cash-out-refinance—or, for commercial properties, take out a commercial equity loan or equity line of credit.
The Bottom Line
Real estate has traditionally been considered a sound investment, and savvy investors can enjoy a passive income, excellent returns, tax advantages, diversification, and the opportunity to build wealth. Just as with other types of investments, however, real estate investing can be risky.
You can limit your risks by doing your due diligence and conducting a thorough real estate market and rental property analysis. Also, be sure to hire pros to inspect the property, screen potential tenants, and learn everything you can about the real estate market.
Keep in mind that there are plenty of ways to invest in real estate without owning, financing, and operating physical properties. Options include real estate investment trusts (REITs), real estate stocks, real estate crowdfunding, and real estate partnerships.
You might also consider investing in yourself by learning a new skill or getting a new license. Many real estate investors, for example, become licensed real estate agents or brokers, not necessarily to work as one, but to take advantage of the benefits, such as multiple listing service (MLS) access, networking, and the commissions.