Monday, November 27, 2006
Real Estate Not Always a Rock Solid Investment
(MS) - Conventional wisdom suggests real estate is a can't-miss investment strategy. So long as you have the available initial capital to invest, theoretically real estate is a lock to earn money, right? While that's a comforting notion, it's also untrue.
Like all investments, real estate comes with an element of risk. Unlike some investments, the risk involved with real estate can be great, as the initial capital you'll need is often greater than that with other, safer investments. For those looking at real estate purely as an investment strategy, it's easy to get burned. Consider the following potential pitfalls, each of which can turn a seemingly sound investment into a nightmare.
The Neighborhood
Neighborhoods are a big part of the risk element when it comes to investing in real estate. A change in neighborhood can make or break a property, which can make or break an investor. Consider the following scenario: you purchase a house with the intention of renting it out. With maintenance and property taxes, you likely won't see a significant increase in your cash-flow. In fact, you'll more than likely break even. This shouldn't come as a surprise, as the home and property's value rests in the re-sale value down the road.
However, if the neighborhood begins to decline, you're stuck on a multitude of levels. The market value of the property is certainly going to drop as the neighborhood continues to decline, lining you up to take a loss. In addition, as the neighborhood declines, you'll more than likely need to lower the rents, again costing you money and possibly costing you the property should you find yourself unable to make the mortgage payments.
Where most people find themselves in trouble is overestimating the gentrification efforts of depressed neighborhoods. Gentrification does not happen overnight and it's certainly not a guarantee. If it works out, you've made a very sound and potentially very rewarding investment. However, if gentrification efforts stall or fail, you're going to take a hit, one that could prove very damaging. The best thing to do to avoid such a fate is to heavily research any neighborhood you're planning on investing in. Oftentimes, severely depressed neighborhoods are best avoided by those new to the real estate game or those without the ability to endure a substantial hit.
Tenants
Another big risk to consider before investing in real estate is who your potential partners will be. Teaming up with a relative or friend or business associate is one thing. However, investing in a property is also a partnership with potential tenants. This can be a great unknown.
Your tenants are akin to partners because you'll be relying on them to make your mortgage payments. Any veteran landlord will tell you good tenants who consistently pay on time and treat the property well are hard to find. Particularly if you'll be investing in a property that is in a depressed neighborhood (with the hope of the area being gentrified), you're likely to find less reliable tenants. A bad tenant can be a nightmare, as laws often favor the tenant and removal is almost always a difficult, not to mention stressful, endeavor.
On top of that, should a neighborhood begin to decline or should unforeseen circumstances arise, it could be hard to find tenants. For example, beachfront property owners are often at the mercy of conditions beyond their control. Heightened ocean pollution or negative weather forecasts have been known to keep potential tenants away from the beach, forcing landlords to take a season-long hit or lower rents. Neither of those options is desirable and both could end up costing investors substantial amounts of money.
A good way to combat potential tenant problems is to always get first and last months' rent up front (and possibly a security deposit as well) and plan ahead for any scenarios in which your tenant could leave you in the dust.
Interest Rates
Hopefully, anyone considering investing in real estate understands the differences between interest rates. If you don't, learn the differences before you think of investing so much as a dime in any property.
Low-rate mortgages often seem too good to be true. And that's often because they are. Interest rates fluctuate, and anyone investing in real estate needs to be prepared. For example, if you borrowed $100,000 on an interest-only 4-percent loan, you'll pay $4,000 per year. With an adjustable-rate mortgage, however, your interest rate might climb to 10 percent, meaning you're now on the hook for $10,000 per year. That's an additional $6,000 per year you might not have planned on needing. Finding money to cover that interest-rate hike can be tough, as you likely won't be able to pass it on to your tenants. That makes planning ahead for potential interest rate hikes a key element to investing in real estate.
While real estate is often looked at as a high reward investment, for those considering making the investment, let it be known it's also high-risk, one that requires deep pockets to begin with.
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