In the first part of this article, I touched on several reasons real
estate investing is something that many should consider. In the second
part, I will approach the topic from a different perspective and look
at why one should not invest.
In the first part of this article, I touched on several reasons real estate investing is something that many should consider. In the second part, I will approach the topic from a different perspective and look at why one should not invest. There are risks with all investments – including real estate investments. Although real estate has historically created vast amounts of wealth for many, it’s not suitable for everyone. I will highlight some factors of real estate investing that have caused justified hesitation in some investors.
Just as there are people who swear by real estate investing, there are also a few who are not fans. As with any plan, it is important to be objective (consider both pros and cons, and minimize emotional attachment) when exploring all types of opportunities. No matter what the type of investment, ignoring potential drawbacks does not mean the risk elements don’t exist – and don’t be fooled, risk exists in everything, whether you are made aware of it or not. Nor is ignoring risk being objective or prudent. It can lead to participation in opportunities that are inappropriate for you. Ill-prepared investors could experience much frustration simply because they weren’t made aware of potential drawbacks in advance and, therefore, aren’t able prepare for less ideal periods.
Luck aside, there are controllable elements that are crucial for increasing the probability of success. There is a simple formula of which successful investors (and business owners) are always aware. They relate risk to the amount of expertise (often viewed as a combination of knowledge and experience) and time they have available to devote to any venture. Less expertise or time that one has to devote to managing and monitoring usually equals greater risk and vice versa. This simple formula can even be used for other situations like fixing a car, building a bridge or running a business as well as making an investment. Savvy investors know there is always a chance of success even with no preparation, knowledge or experience (also known as speculating). However, if a person does not have the knowledge or experience nor the time to commit to ongoing active participation in the investment, and does not utilize available expertise and time of others, there will be generally a significantly greater exposure to risk.
From this, there are essentially four options available:
- Don’t participate at all and hence you will not be exposed to any risk. (The argument can be made that missing out on a good opportunity is a risk in itself, but that is for another discussion.)
- Just do it anyway. This approach is where one just accepts the increased risk that comes with participating with little knowledge and time involvement. For these individuals, they feel they are at least involved and “you can’t win if you’re not involved at all.”
- Spend the time to acquire the knowledge, gain the experience and actively participate in managing the venture.
- Work with someone (or a company) who has the expertise and systems in place and have them do it for you.
So, what are some risks and concerns to take into consideration when investing in real estate? Here are a few of the more common ones:
Like all investments, real estate markets fluctuate. No one can predict with 100 per cent accuracy or influence how the real estate market will perform, so trying to time the market over the short term is risky. Having a thorough understanding of key indicators that impact the long-term viability of real estate markets – and, of course, knowing where to find this information and having the time to research the topic – can help reduce risk. However it cannot be eliminated altogether.
Generally, it is accepted that real estate is not as liquid as stocks. However, there are real estate instruments that offer some flexibility in this area. Understanding all the real estate investment options available and restrictions associated with your ability to “cash out” is critical. It is important to be clear in prioritizing the importance of this factor. Don’t confuse “must have” with “nice to have,” as it may limit your options.
Risk increases for investors when they invest beyond their means. Close evaluation of the cash flow of the property is important to determine whether or not the investment is suitable for the investor. There are several factors to consider that impact this risk, including vacancy factors, increasing operating expenses, decreases in rent and interest rate fluctuations, to name a few. Budgeting for higher than expected costs and conservative income expectations for a worst-case scenario is an approach that should be considered in order to determine manageability.
Assessing risk should always be from the perspective of difficult time periods and one should plan accordingly to manage risk. Budgeting from an optimistic viewpoint only is not being objective
Like the market, interest rates fluctuate. This can lead to an increase in the cost of borrowing amd affect cash flow performance. Be aware of these ongoing risks with variable rate mortgages and upon renewal of fixed rate mortgages. Choose appropriate financing terms and budget accordingly. Plan for where interest rates may be, not just where they are now. Speaking with a mortgage specialist or an experienced lending officer at a bank is helpful in choosing the right mortgage product to balance cost savings (of lower interest rates) with flexibility in options (pre-payment, provisions for increasing interest rates, etc.).
This is probably the most common concern most people have with real estate investing. Not only does this impact the cash flow, but also it can be a major inconvenience. A few simple strategies that are effective in reducing this risk include:
- taking advantage of vacancy protection programs – also known as proportional profit sharing programs – usually set up by the property management company
- utilizing professional licensed property management companies
- doing your homework! Invest in desirable properties with good quality tenants.
- Nonetheless, budgeting for the eventuality of occasional vacancies is a must.
Managing your investment properties can be very time consuming and frustrating. Inexperience in this area can dramatically affect the return on your investment and even cause more headaches. Using reputable, licensed property management companies can help reduce this risk.
Bad tenants can cause serious damage, resulting in unexpected costs. Although you cannot eliminate this risk, having professional property management companies that have the resources and processes to screen applicants carefully to ensure good tenants occupy the project can minimize this risk by eliminating them before they enter. Professional management companies also know the proper procedures (different in each province) for removing problem tenants without creating further legal issues for property owners.
Managing the improvements or renovations to add value to the property, to increase rental revenue or to reduce ongoing operating expenses can be very frustrating, time consuming and complicated. Making improvements can, however, have a significant contribution to the overall performance of the investment. Knowing where to spend money to maximize returns is a real science and can vary significantly in different markets. Inexperience in this area can prove to be very costly not only financially, but also in terms of the investment
CONTROL AND INVOLVEMENT
Clarity in how much control and involvement the investor wants is important. Investors should be honest with themselves about the amount of time they will commit and the level of expertise they have to navigate what can be, at times, a very complicated and time-consuming world of real estate investing.
There are many real estate investment products available. Each has its unique characteristics, so it is important for investors to educate themselves about the advantages and disadvantages of each and choose the products appropriate to their needs and profile.
Knowledge is power. As with all investments, there is no way to eliminate all risks completely and simply ignoring them is not an option that any successful investor would recommend. Knowing is better than not knowing. There are many strategies and systems successful real estate investors utilize to address the challenges discussed here, and many others. A worthwhile approach to note is to take a moment to prioritize which risks are most important for each individual to address and then focus on ways to reduce them to a more manageable level.
By gaining awareness and knowledge (of both the good and the bad) individuals can participate with more success and confidently take advantage of the tremendous benefits real estate investing has to offer. In turn, they may experience for themselves an avenue of investment that has helped countless ordinary individuals secure a great deal of wealth.
Will Wong is the director at CORE Investment Solutions Inc., a real
estate investment firm based in Vancouver and specializing in helping
individuals and companies build hassle-free real estate portfolios. He
has written a report called The Strategic Real Estate Investing Report,
and if you would like a copy, he can be reached at 604-676-1687 or
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