People often ask me how investors should measure real estate risk? Great question, as you shouldn’t view any investment without considering its associated risks – including real estate.
With stocks, investors can look at the historic volatility of a particular company’s shares to assess risk. With bonds, investors can review credit ratings associated with a specific offering for a similar assessment.
But, with real estate, that same uniform standard of risk assessment does not exist. As such, investors need to understand a variety of different types of risk – and how to mitigate those risks.
In this article, I’ll discuss the different types of real estate investment risk factors faced by investors and the steps they can take to mitigate them.
Different Investment Strategies, Different Risks
Levels of risk in property investment inherently relate to the type of real estate investment. In other words, different investing strategies include different sorts of risk.
For example, an investor buying subject-to properties may face risks of lenders executing due-on-sale clauses, while investors deciding between a BRRR or flip approach need to weigh their own set of risks.
Consequently, I can’t provide a straightforward answer to the question about measuring risk in real estate, as each niche in the extremely broad real estate industry entails its own unique pros and cons, risks and rewards.
Recognizing this reality, I’ll discuss risk in the context of two of the more common investing strategies we use at The Investor's Edge in the below article – wholesaling and flipping.
Wholesaling – Low Risk Real Estate Investment Strategy
Investors typically consider real estate wholesaling a low risk investment strategy due to the inherent hedging that it involves. Broadly speaking, the strategy entails buying with the intention to immediately sell, and it follows these four steps:
- Find a property: The wholesaler finds a deeply discounted property that fits the parameters of an effective house flip.
- Find a buyer: The wholesaler then finds a motivated buyer interested in purchasing the property and actually conducting the renovation and subsequent sale.
- Negotiating the deal: The wholesaler next needs to negotiate with both the buyer and seller to reach agreed upon terms.
- Closing the deal: The wholesaler assigns the contract to the buyer, and the buyer and seller close the deal, with the wholesaler receiving a commission for finding and securing the property on the buyer’s behalf.
As stated, wholesaling entails an inherent hedging mechanism, that is, if you can’t line up a buyer, you just don’t buy the property, significantly reducing the risk associated with this strategy.
House Flipping – A Higher Risk Strategy
While wholesaling entails less risk, it also commands less reward. House flipping, on the other hand, entails a higher level of risk with a higher potential for reward if done correctly.
Every house flip includes unique characteristics, but, in general, the strategy includes the following steps:
- Buy an undervalued property: Investors likely will not find these sorts of deals on the MLS but will instead need to find off-market properties undervalued due to significant renovation needs.
- Renovate the property: Investors next renovate the property to a level that it both A) appraises for a higher valuation than the combined purchase price and rehab costs, and B) appeals to potential buyers.
- Sell the property: Lastly, house flippers sell the renovated property. If done correctly, the sale proceeds will include a significant profit margin for the investor.
With this strategy, investors assume far more risk than wholesalers do, as they assume both the risks of completing necessary repairs and selling the property.
The following six investment risks relate to house flipping, and each associated mitigation technique provides investors a proven method of coping with this inherent risk.
Risk 1: Overestimating Valuation Projections
When investors develop a house flipping plan, they project an after repair value, or ARV. This value serves as the budgeted exit price, that is, the cash investors will receive when they sell a property following the rehab process.
Often house flippers, and particularly inexperienced ones, drastically overestimate their ARVs. This poses tremendous risk.
For example, if an investor purchases a property for $50,000, budgets an additional $50,000 for rehab/holding costs, and projects a $150,000 ARV, he or she has a forecasted profit of $50,000. In this scenario, the investor assumes the risk of the actual ARV coming up short, that is, the final property selling for less than $150,000. If, for instance, the budgeted rehab/holding costs remain accurate but the property sells for $90,000, the deal swings from a $50,000 profit to a $10,000 loss.
While this scenario may seem drastic, overestimating ARVs remains a major risk for investors.
Risk Mitigation Technique
At a basic level, investors mitigate the above risk with in-depth market research. With experience and a solid understanding of sales comps and your local market, you can ensure projected ARVs remain as close to reality as possible.
However, sometimes ARVs fall short of projections for reasons outside of the investor’s control, like a recession (e.g. Great Recession collapsing valuations). In these dramatic situations, investors use time to mitigate inflated projections.
Investors don’t realize losses until they actually sell. So, if in the midst of a rehab, values plummet, investors can change strategies to a long-term buy-and-hold approach. That way, a tenant’s rent payments cover holding costs, and the investor can sell the property in the future once values recover.
Risk 2: Underestimating Rehab Costs
On the opposite side of the above coin, investors also face the real estate risk of underestimating rehab costs, that is, thinking the entire renovation and holding period will cost them far less than it actually will.
Let’s use the above example. Assume a $50,000 purchase and as-planned $150,000 ARV. But, this time, the investor blew the rehab budget by $60,000. In this scenario, the projected $50,000 profit also swung to a $10,000 loss, but this time due to a poorly projected rehab budget.
These above risks cannot be separated from human nature. In general, investors tend to be overly optimistic about both how much they’ll receive exiting a deal (i.e. selling a property) and how little they’ll spend during the deal (i.e. actually renovating the property). And, television shows unfortunately exacerbate this problem. When new investors watch one of the seemingly dozens of TV shows about flipping houses, they often think, well that’s pretty easy.
In reality, a 30-minute television show cannot show all of the actual work that goes into a successful home flip. Typically, viewers only see the purchase, a quick snapshot of some repairs, and a shiny finished product. This structure – while entertaining television – sets new investors up for failure by dramatically limiting how much work goes into a successful rehab, which leads to this risk of underestimated rehab costs.
Risk Mitigation Technique 2
Unfortunately, new investors likely can’t mitigate the above risk themselves (unless they’re experienced general contractors).
Instead, house flippers can mitigate the risk of an underestimated rehab budget by having a deal’s project manager cover in-depth plans with the rehab general contractor. Specifically, these key players need to discuss both industry standards for renovations and the unique challenges of a given property – not simply throw together some “back-of-the-napkin” numbers.
This means that, for example, rather than looking at a property and making a quick ballpark guess – looks like we’ll need about $2,000 of electrical repairs – project managers and general contractors actually do a no-kidding, industry standard estimate of projected electrical costs for a given property.
With this level of planning, investors can view their renovation budgets with confidence, eliminating a major type of risk to flipping.
Risk 3: New or Previously Undiscovered Damage
Unfortunately, even the best plans and budgets can crumble in the face of unexpected challenges.
When a project manager and general contractor build a rehab budget, they build it for the current situation. Unfortunately, during the rehab process, new damage can occur or come to their attention (e.g. a water heater breaks, an attic ceiling collapses, the contractor finds faulty wiring not originally identified – and budgeted for, etc).
Any one of the above scenarios could quickly lead to a busted rehab budget – and slashed profit – a real risk investors need to consider.
Risk Mitigation Technique 3
Some new damage simply can’t be avoided, regardless of how thoroughly an investor and his or her team plan the renovation. But, two basic tools can go a long way towards mitigating this sort of risk:
- Thorough inspection: Prior to actually purchasing a house, an investor should conduct a thorough inspection of the property. Even when inventory moves quickly in a market, savvy investors need to ensure they know what sort of work the target property actually needs. Without this level of knowledge, even the most experienced investor can’t develop an accurate rehab budget.
- Insurance: Nobody likes paying insurance, but flippers need this protection to mitigate the risk of new damage during the rehab process. If a house burns down during the holding period, insurance will help the investor recoup some costs. Without insurance, investors roll the dice, keeping their fingers crossed that nothing goes wrong while assuming tremendous risk.
Risk 4: A Longer Than Expected Rehab Period
This risk relates somewhat to underestimating rehab costs. When investors hire third-party general contractors to renovate a property, these contractors have their own competing priorities, often leading to blown rehab timelines.
In a house flip, investors incur significant holding costs, that is, costs associated with simply owning a property, not actually doing any rehab. These include utilities, property taxes, insurance, loan interest etc, and they can add up quickly.
When a general contractor fails to adhere to a planned timeline, investors assume the risk of these increased holding costs cutting into – or erasing – a deal’s profit margin.
Risk Mitigation Technique 4
I’ve mentioned it a few times, but the key to staying on schedule centers on a competent project manager (PM). This could be the investor if experienced, or, if not (or too busy), a designated member of the investor’s team.
Bottom line, a good project manager handles the day-to-day interactions with the general contractor and ensures that renovations occur on time and on budget. Consequently, new investors need to find solid PMs to mitigate the risk of a rehab breaking schedule.
Risk 5: Using Emotion Instead of Logic
Conflating emotion and investing constitutes risk in all sorts of investments, but particularly so with real estate.
When you purchase a property, you have an extremely tangible reminder of the money you invested, that is, the actual house. Consequently, when a deal goes sour, investors often develop a disgust with that tangible product and say to themselves, I just want to get rid of this house and never see it again.
Unfortunately, taking this approach creates the risk of realizing a loss because of an emotional rationale when a logic-based one would actually solve your problem.
Risk Mitigation Technique 5
So how do you tackle emotion-based investing? While I can’t tell you how to get rid of your emotions, I do know that you can mitigate their negative effects on investing by following a plan.
When you establish – and follow – a plan, you ensure that, no matter what unexpected obstacles arise during a rehab, you make decisions based on logic and a thorough analysis of the best path forward to maximize your return on investment.
Without a solid plan, you’ll inevitably fall victim to the risks of emotion-based instead of profit-maximizing decision making.
Risk 6: Liquidity Shortfalls
Finally, I need to discuss real estate finance and investments risks. Specifically, I mean the risk of liquidity shortfalls, or, simply put, running out of cash during a rehab.
Intricately connected with all of the above scenarios, investors always need to deal with the risk of running out of cash before completing a rehab.
For example, assume that, after purchasing a property, an investor secures a $100,000 hard money loan to conduct the actual renovations. If any number of negative scenarios arise (new damage, longer-than-expected holding period, previously-undiscovered damage, etc), the investor can blow through that $100,000 budget.
If an investor runs out of cash, two options exist (both likely bad):
- Sell the property in its current state, likely receiving far less than the projected ARV.
- Secure another hard money loan, driving up your interest-related holding costs and overall budget.
Risk Mitigation Technique 6
So what steps should new investors take to not run out of cash?
As with basic personal finance, house flippers need to build a reserve into their budgets. Whether you call it a contingency line item or a reserve, investors need to retain some percentage of their total liquidity (either cash or a drawable line of credit) for unexpected situations.
With this buffer established, investors can take comfort knowing that they’ve mitigated the inherent liquidity risk of flipping houses.
With any investment, you can mitigate risk, but you can never completely eliminate it.
And, as discussed, while wholesaling may limit an investor’s risk, it also limits the profit potential of a given deal.
For investors who consider the above risks and decide they still want to follow a house flipping strategy, mitigating risk – in addition to the above techniques – largely centers on following proven strategies.
Learn how to make money flipping properties with us by attending our next webinar.