Last Updated on February 17, 2022 by Mark Ferguson
I am trying to buy as many rental properties as possible because of the great returns they provide. I am also trying to help other investors discover the fantastic world of investing in long-term rentals through my blog. However, I run into a lot of feedback from people who are worried about how risky it is to invest in rental properties. I hear: “my friend went broke investing in real estate” or “my parents had a rental and it was a money pit up until the day they were forced to sell it.” There are many horror stories involving real estate, but I have no doubt whatsoever long-term rentals are a great investment if you do your homework and buy properties right. Most of those horror stories come from people who did not do their homework, turned a personal residence into a rental out of necessity, or were hoping for appreciation. Is investing in rental properties risky and how can you mitigate these risks?
Are rental properties risky?
There are real risks with investing in rental properties. Many people felt the wrath of these risks in the last housing crash. Housing values plummeted and in some areas rents plummeted as well. Interestingly enough, not every area saw lower rental rates. Some areas saw rents increase because there were so many more renters (people who lost their houses) and the demand pushed rents up.
The investors who were hurt the most in the housing crash were those who were breaking even on their properties or losing money each month and hoping prices would increase to make money. When the bottom dropped out, they now had a property that was losing money each month and was worth less than they had bought it for. Many investors allowed these homes to go into foreclosure because they didn’t think they were worth keeping.
Other risks come from rentals when people buy a property and do not have enough cash to maintain the property or hold it when it is vacant. Most banks will require a certain amount of reserves when you get a loan on an investment property. But as soon as the property is purchased there is nothing stopping the owners from spending that reserve money. When you own a rental there will be times when the tenants move out, there can be evictions, and rarely a tenant can destroy a property. We see these situations occur quite often because people love to see drama but for the most part our tenants take care of our rentals and are awesome.
Why invest in rentals with these risks?
Rental properties have made me a ton of money over the last decade. Prices have increased significantly, which is great, but the properties also make money every month, and I always get a great deal on everything I buy which means I build equity on day one. There are many ways to mitigate the risks of rentals and the money I have made from my properties more than makes the risks worth it!
A lot of people will assume that when you are investing in large value assets like real estate and there can be huge returns, that the risk must be through the roof. There are types of real estate that can be very risky. We flip houses as well, and that is a much riskier venture than owning rental properties in my opinion. Development can also be much riskier but again come with huge rewards as well.
I also was an REO broker during the housing crash and I talked to many investors who lost homes. I was able to see why they lost their homes, what they could have done differently, and what happened after they lost their homes. For the most part, they bought houses that did not cash flow or make money every month and when things went bad they lost the motivation to keep paying into them. Losing the houses was also not the end of the world for these investors. Many of them had put little money down thanks to the crazy lending that was happening prior to that last crash. They were also able to keep those houses for quite a while after they stopped making payments. Many investors kept collecting rent during this time period which may or may not have been legal, but it did happen.
Many of those investors got right back in the real estate game after recovering and invested the right way with cash flow!
How can you mitigate the risk from rentals?
Buy below market value
One key to a low-risk rental strategy or any successful real estate strategy is to buy property below market value. Buying a property below market enables you to create instant equity, increase your net worth, and protects against a downturn in the market. One of the investors who was hurt badly during the crash was buying brand new houses and turning them into rentals. The houses were in great shape, but he paid full retail value for them.
When I buy rentals I want to pay at least 20% less than they are worth after considering any repairs are needed. For example:
- A home needs $20,000 in repairs and will be worth $200,000 after those repairs. I want to pay $140,000 or less for that property ($200,000 x .80 – $20k). If I am flipping houses, I need to get an even better deal!
I also usually put about 20% down when I buy rentals which means after the property is repaired I have a loan around $110,000 and a property worth $200,000. Even if prices lost 30%, which is about how much they dropped across the county I am fine.
I consider cash flow the most important factor in my long-term rental strategy. I want every property to make money each month after paying all expenses. Finding these properties that are also a great deal is not easy, but if you want to change your life with massive returns, it is not easy! When I invest I look for a return of 15% cash on cash. That means I make 15% on the money I have invested into the property. These are very high returns and not everyone needs to make this much but it is what I shoot for.
When you have cash flow coming in every month, it does not matter if values decrease because you do not need to sell the property. While it is true that rents can decrease and lower your cash flow, that is very rare and was even very rare in the last housing crash. There were some areas like Florida and Arizona that were massively overbuilt that saw lower rents, but the nation as a whole barely saw any drop.
My cash flow calculator can help you figure the real income on rentals.
Type of property
The older the property, the better the chance of a major repair needing to be done. I have enough cash flow coming in to account for major repairs, but homes over 100 years old can have issues come up that could wipe out all equity. It is rare, but a foundation or structural problem can make a property uninhabitable and cost tens of thousands of dollars to repair. By purchasing newer properties, I lessen the chances of running into repairs that could wipe out my profit for a year or even two.
Multifamily and commercial real estate can also carry more risk. Those types of properties are more complicated and have fewer buyers. I also buy multifamily and commercial properties but I am very careful what I buy and understand there will most likely be way more costs and exposure if the market changes.
If you buy properties that need a ton of work that can add to the risk as well. On my flips and rentals, the worst deals I have done were properties that needed massive remodels. It takes so much time, so many resources, and there is so much that can go wrong. It can also be risky trying to do all of that work yourself!
One of the most important things to have when investing in real estate is cash! If you buy rentals or flips that can be expensive at times. It is very important to set aside cash to take care of the problems that might come up. When I figure my cash flow I set aside money for vacancies and repairs. You need to have cash set aside in case something goes wrong and this is one of the biggest mistakes landlords make is not having cash around.
Ironically, getting a loan allows investors to have more cash in many cases. Paying down the mortgage early or trying to pay it off with all your extra cash can leave you in a bad situation. If you do pay a property off and need to access that money in an emergency it can be hard to get to without selling.
Another way to have problems with your rentals is to manage them poorly. Many people have no idea how to manage a rental but decide they can do it on their own. They choose a bad tenant after not screening them, then never check on the property, and are surprised when it gets trashed. If you are going to manage rentals on your own you have to take the time to learn how to manage them. You have to screen tenants, and keep tabs on the properties!
If you don’t want to manage them yourself, you can hire a property manager as well. It takes time to find a good property manager and this is where it takes from work from the landlord as well. Again, no one said owning rentals was easy, but there are many ways to make them a great investment if you are willing to put in the work.
Liability and damage
Another risk that comes with rental properties is natural disasters or liability from accidents. People can get hurt and can sue tenants or tornados can wipe your property off the earth. Both instances are rare, but they happen. To mitigate the liability side you can put your properties in an LLC or make sure you have the property insurance coverage like a landlord and umbrella policy. With these policies, if you have a tenant destroy property or need to be evicted, they can help cover those costs as well! Putting a property in an LLC can help with getting sued but is not foolproof.
It is important to make sure your insurance agent knows you are using the property as a rental so you have the right coverage. It might be cheaper to leave homeowners insurance on the property if you used to live there but that can cause problems down the road.
Risks that are tough to mitigate
There are some cases where a landlord does everything right but still has a massive loss. These are rare but can happen and just about any investment or simply living life comes with risks.
- Meth or drug house: If someone is cooking meth or using meth in your house it can cause damage that insurance will not cover. You may have to make major repairs depending on how bad it is. These risks can be alleviated by good tenant screening and checking on the properties often. It is not always the case, but many drug houses we see have cameras all over. That can be a sign to check the house out more if you see cameras on your rental.
- Floods: Not all floods are covered by insurance. You often need an additional rider or flood coverage. If you are in a flood zone the lender will require the additional coverage but if you pay cash or use private money you may not be required to have it. There is also the risk of a flood outside a flood zone. If the property has a risk of flooding it is important to talk to your insurance agent about additional coverage.
Why does everyone say rentals are risky?
I won’t tell you it is impossible to lose money investing in long-term rentals. It can easily happen if you don’t have a plan, have reserves, or are impatient. It is not easy to buy properties below market value with great cash flow. If it were easy investing in long-term rentals, everyone would be investing in real estate.
The reason so many people think rentals are risky is that they hear anecdotal stories. Stories are good for entertainment and drama but they don’t give the entire picture. “my cousins, aunts, friend, lost all their money when their rental was trashed!” They failed to tell us the person self-managed a property they used to live in from 4 states away and never once talked to the tenant in 3 years. Then they were surprised it was trashed. There are all kinds of stories but usually, you can find one of the main reasons above for why people lose money on rentals. Overall, real estate is one of the best ways to build wealth!
Don’t be scared to invest in rental properties
There are many people who have gotten rich and retired early by investing in long-term rentals. There is a lot of opportunity and many advantages to investing in real estate. Just because you can have some great rewards does not mean there is a massive risk. Some risk? Yes of course and the less you pay attention to your investment the riskier it will get!