Real estate investments are risky by nature, but there are ways to mitigate your risk and reap the rewards that can be realized. Those who invest in real estate wisely can potentially find additional passive income as well as financial freedom and independence.
While the lure of passive income may sound appealing, real estate isn’t as hands-off as it sounds. There are real estate investment risks that investors should research and be aware of before jumping into the real estate industry. We’ve compiled a list of some of the top risks that any prospective investor should consider before they jump in feet-first.
Figuring out what kind of investment property to purchase is only half the battle when it comes to determining your real estate investment risk. Thankfully, if you understand the most common risks and what to look for beforehand, you can minimize your losses. Here are some of the most common real estate investment risks to be aware of in today’s market.
Unpredictability
The market for real estate investments has strong connections to how well the economy is performing at any given time. Because of the unpredictability of the real estate market, it’s important for investors to do some research on the market before they purchase a property. The last few years have been especially good for investors who currently own residential income properties, as the housing market has continually grown. However, it’s important to do your research as a new investor because if you purchase when the demand is high, and the economy is good, you may end up having to sell when the economy slows and lose money on the sale of the property.
Keeping up with market trends and understanding the dynamics of the real estate industry is vital for investors looking to lower their real estate investment risk. Understanding the risk before you buy can help you determine if you are purchasing a property at the right time, or if you should wait.
Bad Location
The most important aspect to take into consideration when determining if a property is a good real estate investment risk is the location. Supply and demand dictate the value of a property. If you purchase a property in an area with too many rental properties, poor job market, or low population growth, you will find it more difficult keep tenants in rental properties. Do your homework before you purchase a property and look for areas that have a growing job market, and an increasing population.
Choosing to purchase properties in high-crime areas is another real estate investment risk. Properties in high-crime areas may be attractive due to higher potential cash flow, but tend to have low appreciation rates, and are difficult to sell. However, because of the crime rate, these properties tend to be cheaper to purchase, and high-crime areas also have higher rental rates because fewer people are buying homes in high-crime neighborhoods. Even if the initial property price is low and you have a good opportunity to rent in a high-crime location, that doesn't mean you’re getting a good deal. If you find an investment property with a lower purchase price than similar properties on the market, look at the reason the price is low and find out if you’re really getting a good deal on the property. Don’t make the mistake of automatically equating a low price and higher rent with a good investment.
Bad Tenants
After you’ve done your research and found a great location for your property, you’ll need tenants to turn a profit. While you may not think it matters who you rent to, it can cost you much more money and time if you have bad tenants than if you had no tenants. Bad tenants don’t pay rent, destroy property, and leave you scrambling to pay the mortgage and take care of the repair bills.
Sometimes the only option to deal with bad tenants is to evict them. However, the eviction process wastes a lot of time and money on your side as well, and you may not recover the funds that you’ve lost from a tenant who refused to pay their rent.
The best way to minimize this real estate investment risk is to thoroughly screen tenants before you approve them to live in your housing. The tenant screening process typically involves getting references from previous landlords and performing credit checks on potential tenants to make sure they are responsible renters.
Negative Cash Flow
After all the bills have been covered, you’ll need to make sure you actually have some profit from your property. Many investors fall into the trap of negative cash flow, which is when expenses equal more than the revenue you receive from your rental property. It’s not a good situation to be in, and this real estate investment risk can be mitigated by conducting a real estate market analysis before you purchase the property.
Take some time to sit down and figure out how much your income will be from each of your rental properties and how much the monthly and yearly expenses will be. Keep in mind that even small expenses can add up over time. An investment property should help you increase your income, not drain it. The advisors at FGG can assist you to complete an analysis of your investment properties.
Paying Capital Gains Tax
When it comes time to sell your investment property, you may end up having to pay capital gains taxes on any appreciation of the property value plus depreciation benefits. Capital gains taxes apply whenever you have an asset that appreciates in value during the time that you are in possession of the asset. For example, if you purchased a rental property home for $150,000 and sold it for $200,000, your appreciation would be $50,000, and you may be eligible to be taxed on that amount. You may also be required to pay 25% tax on applicable depreciation benefits plus a 3.8% Net Investment Tax. Total taxes owed at time of sale can reduce your net proceeds by as much as one third or even more.
However, there are ways to defer and potentially avoid these taxes, especially if you're planning to use the funds from the sale of your current investment property to purchase a new investment property. In this case, a 1031 Exchange with the help of our advisors at First Guardian Group can help you potentially keep more of your money from in the sale of your investments.
Reduce Your Risk
In general, the more responsibility you take on as a real estate investor, the greater your risk. The common approach that we see among our clients to mitigating risk is to seek out properties in growing locations that have experienced in-place management and perform thorough due diligence, usually with aid of a qualified real estate professional, before making an investment.
Delaware Statutory Trust (DST) Options
To reduce risks, many of our clients seek out investments in properties structured as a Delaware Statutory Trust which can offer the following:
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Opportunity to diversify among multiple properties due to typical investment minimums as low as $25,000 for cash investments and $100,000 for 1031 Exchange investments.
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Typically, larger, institutional grade properties, that have been evaluated by experienced real estate firms.
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Substantial due diligence information and risk disclosures provided in offering documents.
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Availability of third-party reports and appraisals to provide added information on the property.
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Information on background and track record of the manager/trustee.
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Loan liability is solely the responsibility of the manager/trustee.
Nothing can prepare you to handle real estate investment risks like talking to the right people and getting good advice. With over 16 years of experience, the professionals at First Guardian Group can help you find suitable investment properties. We know how to help investors save money and make the most of the real estate investment risks they’ve taken. Call us at 408 392-8822 or email at info@FirstGuardianGroup.com to learn more.
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