Should someone diversify their investment portfolio with rental properties? Perhaps, but like all investments, it has its pros and cons.
Here are some of the risks that come with buying rental properties.
#1: Vacancy Rates
The biggest and most common risk that real estate investors need to consider is high vacancy rates! Tenants will be the primary income source for all your rental properties. So, if you want them to make money, you need to keep your property occupied!
If you want to maximize your returns, you should keep your vacancy rate below 10 percent. But you can still make a good profit with an occupancy rate of 70 to 80 percent. Most banks and lenders will take occupancy rates into consideration when they decide on whether to lend you money. The average occupancy rate accepted by banks is above 70 percent, but some of the more conservative lenders will require an occupancy rate above 80 percent.
While you’re planning your finances, you should come up with an estimate of the expected vacancy rate on your rental properties. You then want to add it as an expense in your calculations. You also want to assume the worst, so you can avoid any unexpected financial disasters because of a vacancy rate that’s higher than you expected.
#2: Bad Locations
Location is everything when it comes to real estate investing. So, you should always take this into consideration before you buy a rental property. Some areas may look like a great choice for a rental property because of low prices and high occupancy rates. But in a lot of cases, these numbers may be because the area is either undeveloped or has a high crime rate.
If you’re only looking at the price, buying properties in an area with a high crime rate may seem like a good idea because it will be lower than what is typically seen in the housing market. They also have a higher occupancy rate because people are more likely to rent homes. The problem is that your rental property is more likely to get vandalized or robbed. This can result in unexpected expenses and repair costs. Not to mention, all the legal matters that can come up because of it.
As you invest in real estate, you always want to choose your location carefully. It may seem like a good idea to invest in a bad neighborhood by purchasing cheap rental properties (especially if it’s showing signs of future development and an improved law enforcement presence). But it most cases, the risks aren’t worth it.
#3: Market Economy
Whether you’re getting into the real estate business as an investor or as a landlord, you always want to stay updated on the market economy. You also want to educate yourself, so you can understand the market and how it works.
The market economy plays a huge role in determining a rental property’s future value. If you buy a rental property while prices are at their peak and it’s time for you to sell the property, you may find that the market has gone down considerably as the market comes down. This could cause you to sell the property at a lower value than what you had originally paid.
It’s a good idea to have a deep understanding of the market economy, so you can at least get an idea of what may happen over the long term. This can help you to determine if it’s worth buying the property at that time.
#4: Negative Cash Flow
The cash flow of a rental property is the amount of profit you have generated after you have covered all your expenses (including taxes and mortgage payments), and it’s usually a lot lower than the property’s rental rate. When you have a positive cash flow, you’re making money on your investments. But if you have a negative cash flow, your expenses (including your taxes and mortgage payments) are higher than your rental income. This will cause you to lose money on that investment over time.
If you want to have a positive cash flow you need to make accurate calculations of the expenses associated with that property before you purchase it. You will also have to estimate any expected and even unexpected costs related to that property. This can include maintenance and repair costs, vacancy rates, as well as any property management fees. You need to be as thorough as possible, because even the smallest expenses can add up to a considerable amount of money over a long period of time.
#5: Bad Tenants
While landlords want their rental properties to be occupied whenever possible, there are some situations where having a higher occupancy rate might not be worth it. Before you rent out to tenants, you want to make sure they won’t give you any extra headaches or even financial losses.
You need to screen prospective tenants who want to rent your property before you even think about giving them the key. Some tenants may have a bad credit score or a history of not paying their rents, which is something you don’t want to deal with. You want to contact any of their previous landlords, because some tenants may have bad habits that can damage your property and lead to higher maintenance costs.
#6: Foreclosure by Lenders
Having a negative cash flow can keep you from making your mortgage payments, which may put your rental property at risk of foreclosure and hurt your chances of getting approved for a bank loan. To keep this from happening, you need to “run the numbers” before you purchase the property. You also want to do the proper risk analysis on each deal, while having a good exit strategy prepared in case something goes wrong.
#7: Rising Property Taxes
If taxes and insurance costs go up faster than your rental income, you will have a decrease in cash flow. Insurance companies will adjust claims in case of a catastrophic event, so it can be seen as one of the downsides of investing in rental properties.
Final Thoughts
The only way to avoid the risks associated with rental properties is to think about each deal you make. Find out if you’re working with a good real estate company that you can trust, and make sure you get any important information (such as market prices) so you can weigh them according to what you prefer as an investor.
If you want more information on how you can make money with real estate investing, be sure to get in touch with Trevor Shakiba at Shakiba Capital.
