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How to Mitigate Risk When Buying Rental Property
While there are unique benefits of residential investment properties compared with all other asset classes, when it comes to assessing the risk level of an asset class, that primarily depends on the investor’s level of expertise in that particular space and the extent to which they have cultivated an advantage (legally and ethically, of course) over other investors (i.e. super knowledge, superior networking connections, superior access, etc).
The Maverick business model is predicated on helping our clients attain a built-in advantage when buying rental property. But, even with access to the most 'investor-advantaged' markets, access to unlisted properties that are not available to the public, access to turn-key properties that enable you to buy in the best markets regardless of where you live….you still need to understand the potential downside risks in your rental property investment and strategically mitigate them as much as possible.
Potential "Downside Risks" when Buying Rental Properties (And How to Mitigate Them):
#1) Non-Payment of Rent / Eviction of Tenant
If your tenant defaults on the lease and stops paying the rent, your income is interrupted and you may have to evict the tenant and then replace them with a new tenant, which is a further expense.
- Ensure you are using a high quality property management company that has a thorough tenant screening process with credit background checks and conservative rent-to-income ratio requirements. Review tenant qualifications before authorizing the property management company to sign the lease.
- Purchase higher-end property that commands a higher market rent and attracts higher income earners with more stable employment.
- Some investors prefer purchasing 2-4 unit properties because if the tenant in one unit defaults on the rent, they still have income from the other units so the loss is partially mitigated.
- Insure against tenant default and eviction. You can pay a monthly fee to lock in coverage that protects against tenant default, eviction and malicious tenant damage. (Note: Be sure to factor that expense into your cash flow analysis if you go this route).
Even if your tenant pays the rent as agreed, eventually your tenant will move out and you will have a vacancy period where you will need to "turn" the property—fix it up and re-lease it. During that vacancy period, your income ceases for the duration of the vacancy and your cash flow is disrupted.
- Ensure you are buying in an area with high rental demand so your tenant can be easily replaced and the duration of your vacancy period minimized.
- Ensure you are using high quality property management that is able to incentivize the tenant to renew their lease and stay for longer periods. Reducing tenant turnover and increasing the length of tenancy through great customer service should be one of the top priorities of your property manager.
- Purchasing higher-end properties with higher market rents tend to attract less transient tenants.
- On the other hand, 2-4 unit rental properties can also help mitigate the risk because when one unit goes vacant the others remain rented so all cash flow does not cease at the same time.
- Since vacancy is an inevitable reality in real estate investing, factor a “vacancy estimate” into your cash flow analysis from the beginning so that you have already projected it and accounted for it.
#3) Maintenance / Repairs
Eventually over the life of the property you will have expenses for maintenance and repairs. This is another inevitable reality of real estate investing.
- Ensure that you have a 3rd party independent home inspection performed on the property before you purchase it as part of your due diligence to identify any existing repairs that are needed and potential deferred maintenance items.
- Be sure to include a “maintenance” factor in your cash flow analysis from the beginning so you have accounted for this inevitable expense and are financially prepared for it when it occurs.
- Buying rental property in nicer areas with higher market rents often tends to attract tenants that treat the property better, reducing your overall maintenance expenses.
- Insure against malicious tenant damage
- Consider signing a “lease-with-option-to-buy” or “rent to own” (where allowed by law) as this often creates a “pride of ownership” mentality in the tenant so, whether or not they end up purchasing the property form you down the road, they tend to treat it as if it is their own home while living there.
- Ensure you are using a high quality property management company that is able to conduct repairs efficiently with economies of scale to save you as much money as possible.
#4) Property Declines in Value
If you own property over a long period of time, you will notice that property values move up and down in a fairly predictable “property cycle”. A decline in property value reduces your equity in the property (and thus the amount of profit you would be able to harvest when re-selling it at that point in the property cycle). However, unlike the first 3 downside risks mentioned above, a decline in property value does not create a disruption in cash flow. It does not necessarily correspond with a declining rental market and could even correspond with an increasing rental market that improves your cash flow. These variables are independent and should be analyzed as such.
- Always buy rental properties based on “cash flow fundamentals” and never speculate or rely on price appreciation as your primary profit center. Ensure you are in a strong rental market with job growth and population influx where there is high rental demand for the type of property you own. Ensure your real estate investment analysis makes sense so that your cash flow can remain steady regardless of any future home price fluctuations.
- Buy at the right stage in the property cycle. If you buy at the late stage of a contraction cycle or the early to mid stage of an expansion cycle, not only do you have upside appreciation potential in case you decide to sell near the top of the expansion cycle, but you have a stable buffer if you want to hold the property through the next contraction cycle and continue collecting your cash flow, taking your depreciation, etc.
Obviously there is the off chance that your property could burn down or have something else happen to it.
- Insurance. Get the right rental property insurance. Policies terms for rental properties can vary and your policy terms, like all other insurance, can be customized to your comfort level.
- Don't Buy in Highly Hazardous Areas. Be prudent when you purchase property to ensure you are not in a major flood zone, a common hurricane path, on a tectonic fault line, next to a nuclear waste site, etc.
In today's litigious society, it is always possible that you could get sued for something, whether frivolous or not.
- Insurance. Most rental property insurance policies will also give you an option to attain liability insurance as well.
- Encumbering. Debt secured against your property can actually be an effective form of asset protection. If you are using financing on your property, the lender probably has a 1st position lien on the property. That means that the lender has the first right to foreclose on the property to have their interest protected so a third party is typically not able to take the property from you.
- Entity Structure. More sophisticated investors often choose to create a separate legal entity, most commonly a Limited Liability Company (LLC), to hold their properties. There is even a "Series LLC" structure where you can just create new "cells" in the series to hold all your different properties instead of starting new entities for each property you buy. You will need to consult with your own advisors about whether this is advisable and cost-effective for you. Maverick can introduce you to asset protection specialists who can consult with you directly about these matters if you wish to learn more.
There are always downside risks when buying a rental property, including others that are not on this list and it is impossible to eliminate them all. Factors like vacancy and maintenance are inevitable components to real estate investing. Smart investors take them into account from the very beginning and build them into their overall evaluation of the rental property investment. Then, they make strategic decisions to mitigate the downside risk as much as possible.