Investing in real estate can be a risky business.
Some risks are to be expected. When owning a rental, there’s going to be periods of vacancy. Heck, I just experienced over a 2 month vacancy. There’s also going to be maintenance and repairs that as the owner, you’ll need to budget for. While all rental properties are susceptible to these risks, other risks can be disastrous. Some homes are located in very high risk areas just waiting for a calamity to strike.
Take what happened this past summer for example. The massive Blue Cut wildfire in San Bernandino, California scorched over 25,000 acres and mandated the evacuation of over 34,000 residents. Also, in the wake of record rainfalls in Louisiana, catastrophic flooding ensued causing damage to over 40,000 homes and some 86,000 in need of assistance from FEMA.
These are examples of the kinds of calamities that can literally wipe out one’s investment.
In this post, I want to share 3 risk factors to avoid when investing in rental real estate. These areas will all negatively affect an investor’s returns. Not only that, but once you own rentals in the following areas, there’s really not much as an owner that you can do to mitigate these risks.
Here are 3 pitfalls to look out for when investing in a real estate market.
1. Geographically Risky Areas
Invest in a market where the property is not in a high risk geographical area. What’s considered high risk? Areas that are susceptible to earthquakes, flooding, mudslides, hurricanes, tornadoes, and wildfires.
If you have a property in a designated flood zone that sustains flood damage, then you better have flood insurance. Otherwise, as the owner you may have to foot the entire bill since flood damage is typically not covered in the homeowner’s policy.
If you have a property in a coastal region prone to storm damage from high winds and hurricanes, then expect to pay higher insurance premiums. Why? Well, these areas equate to more risk in the eyes of the insurance company and so your premiums will be much higher. The result, lower cash flow.
Earthquakes you say? I’m not saying that you shouldn’t invest where there’s earthquakes because frankly, that could exclude entire countries like Japan! Just be sure to do your homework and account for any expenses that may be imposed on landlords who provide housing in earthquake prone areas. For instance, a new law in Los Angeles mandates thousands of landlords to retrofit their buildings to better withstand earthquakes. Safer buildings? Check. Tens of thousands of dollars in retrofitting? Double check.
2. Rent Control
Avoid investing in real estate where rent controls are in place. Rent control ordinances typically set limitations on the monthly rent landlords can charge as well as how much rents can increase per year. In some cities, landlords actually need the tenant’s consent to raise the rent! Rent control laws sometimes govern more than just the rental amount, but may regulate the eviction process as well.
Where is there rent control? Well, only a few cities and counties in five states have laws that limit the amount of rent a landlord may charge. Typically, rent control is found in only a few of the largest cities (e.g. Los Angeles, San Francisco, New York City).
Locations where rent control apply include:
- Washington D.C.
- Takoma Park, Maryland
- Newark, New Jersey
- New York
These areas tend to be attractive for real estate investors seeking appreciation rather than cash flow. Should you choose to invest in a rent controlled area, then you absolutely need to familiarize yourself with the current rent control ordinance supplied by the city’s rent control board.
Ultimately, rent controls hurt investor returns by preventing landlords to appropriately respond to the economic demand of an area.
3. Tenant Friendly States
How fast is the eviction process for a non-paying tenant? How many days must a landlord wait before they can legally file for eviction? And how long is the actual eviction process itself?
Consider that an eviction involves scheduling a court hearing, a judgement, and the potential forced removal of a tenant by a sheriff or marshal. The eviction process alone can take several weeks to many months! Not only are we talking about lost rent that can add up to several months, but there’s also court fees, lawyer fees, paying the sheriff, changing locks, cleaning, and possibly repairing the unit.
Several states have different timelines for evictions so it’s critical that as a landlord, your rentals are in states where the laws do NOT favor the tenant. Evictions are a last resort, but when you go this route you want them out as fast as possible.
So for any market, get familiar with the average timeline and process for conducting an eviction in that state. For information on state specific landlord-tenant laws, check out this excellent resource over at Landlordology.
And Watch Those High Property Taxes
Lastly, we have states with very high property taxes.
Properties with overly high taxes can really hurt your cash flow as an investor. Local town, county, and state taxes can really add up. As an out of state investor, the taxes paid on the property go towards funding public services (i.e. schools, roads, etc). While these are essential services, as an investor, the property taxes you pay are only lowering your returns.
In some jurisdictions, the tax rates are even higher for out-of-state investors. Take Indianapolis for example, where the rate is actually higher for a non-resident. Several other states often have tax exemptions available only to in-state residents. So as an out-of-state investor, it’s important when analyzing a potential deal that you assume the correct property tax expense when running your numbers.
I won’t go as far to say you should avoid investing here, because there are actually some great real estate markets such as Texas that is notorious for high property taxes. Just be sure to do your homework.
I hope this post helps you the next time you’re evaluating a new real estate market. Don’t just jump towards what you think is the best location from a desirability standpoint. Step back, uncover those pitfalls, and evaluate the risks.
This post highlighted 3 pitfalls:
- Geographically risky areas (i.e. earthquakes, hurricanes, etc.)
- Areas under rent control
- Tenant Friendly States
What areas are most important to avoid when lowering risk in your real estate investments?
I’d love to hear from you. Leave a comment below.