You’ve seen the infomercials, listened to radio hype and read in numerous wealth-building manuals that real estate investing is the best way to build your fortune. The gurus even tell you that you don’t need money – using “other people’s money” is the best way to get started. But there are some downsides that the gurus don’t tell you about, but that any beginning investor should consider before banking on real estate investments to fund their retirement.
Land is an excellent long-term investment, so long as the property is located in an area attractive to buyers. But what happens if you purchase a piece of property, and then find yourself cash-strapped? How easily can you sell this newly-acquired property?
Despite rising real estate prices overall, there are locations where the demand for housing is diminishing and property values are dropping. Two notable examples are Detroit and Indianapolis. Local economic conditions play a large part in this; as corporate headquarters relocate or companies close up shop, the people who are most likely to own homes or to “trade up” to larger properties relocate with their jobs or go elsewhere in order to start over. As a result, there are housing developments teeming with “For Sale” signs. Most of the properties available are in good condition, but are being sold at or below market value. This market is great for buyers, but
sellers are anxiously awaiting any good offers, all the while being required to pay a property manager or realtor to maintain the property while it sits on the market.
A rule of thumb in any real estate purchase is that the property owner needs to allocate 10% of the purchase price annually for routine maintenance. For example, a $50,000 home will require an average of $5,000 per year to maintain it. These maintenance costs cover things such as lawn care, painting, repairs and services such as carpet cleaning, furnace and air conditioner inspections and other recurrent costs. However, there may be some not-so-routine maintenance situations that come up that need immediate attention, and that drain cash on hand.
A recent example of this came in the form of subzero temperatures combined with a blizzard. The weather conditions cut off electricity to many residences. This meant that there was no heat coming into homes, which led to many frozen – and subsequently burst – water pipes. Residents had to have their main water turned off, relocate to shelters, and then try to get plumbing repairs done on an emergency basis. Emergencies cost substantially more than routine, easily scheduled work and homeowners insurance may not cover the damages that many of these situations bring about.
There was a news story recently about a couple who did everything right in terms of real estate investing, built a small fortune, but are now facing bankruptcy. The reason: their twenty rental properties, as well as their own home, were all located in New Orleans. They had covered all of their properties with both property and casualty insurance and purchased the maximum amount of government-issued flood insurance available as well, which was $200,000. The couple’s properties were worth over $1,000,000, but property insurers aren’t paying a penny, alleging the damages their properties suffered were from the flooding rather than the wind. Flood insurance has paid the $200,000 claim, leaving the couple with an $800.000 deficit. The five years of tax deductions this couple will be allowed don’t compensate for the fact that they currently have no positive cash flow. Their tenants want to return to their respective properties, but the property owners have no resources with which to make needed repairs. The tenants are homeless, but at least they have the opportunity to move elsewhere; the property owners are hamstrung with mortgage payments on untenantable homes.
Hurricane Katrina was an aberration, but frankly, aberrations happen. Hurricanes are a reality for any homeowner on the eastern seaboard, tornadoes regularly rip through midwestern and plains states, and earthquakes, wildfires and mudslides are California’s claims to fame. Before investing, be aware that any property carries with it some weather-related risk, and that risk can occur at any time. And in the case of Katrina, insurance may not cover all of the losses.
The government isn’t always the friend of property owners, and there are times when pleasant sounding, politically correct legislation can have adverse consequences to real estate investors. The most egregious example is the Supreme Court’s latest ruling on eminent domain. Every property owner is at risk, but properties that are especially vulnerable are rentals located in urban areas that may be targeted for “renewal.” In this situation, any developer promising to install a five-star restaurant, hotel, casino or retail store in one of these areas can ask the city to take possession of those properties, with little or no remuneration to the owners. In short, the property owner no longer has anything they can rent or sell, and the payment offered to them for their inconvenience may not cover their expenses of ownership.
Another example of laws adverse to property owners is “anti-discrimination” legislation being enacted throughout the country. In Indianapolis, for instance, gay rights advocates lobbied successfully for a law banning housing discrimination against homosexuals. No reasonable human wants to see overt discrimination against another reasonable human being, regardless of his or her lifestyle. However, what if a tenant – who happens to be gay – is a nuisance? There would be no argument about evicting a heterosexual if they clearly were causing problems with neighbors or other tenants, but if someone with an alternative lifestyle alleges the eviction came about due to some level of “homophobia,” the property owner may be in for a bumpy ride through civil rights litigation. This puts the property owner in a double-bind situation; either they have to ignore the gay tenant’s bad behavior and risk offending the other tenants, or they evict the gay tenant and risk dealing with allegations of bigotry and discrimination. In either case, the property owner loses.
What makes any of these situations a minefield for real estate investors who have used the “no money down” methods touted by infomercial salespeople is that creative financing throws the investor into massive debt.
Whether their investment doesn’t yield the cash flow they anticipated, becomes a money pit due to unplanned maintenance costs, is tied up in legal wrangling or is destroyed due to an act of God, the debts are still due.
Potential real estate investors need to ask themselves how much they can afford to lose, and what cash they have available to work with in the event any unforeseen disaster happens, before they quit their jobs and plunge into that first deal. Investors need to ensure they have hedged all of their risk. Otherwise, the path they believed would lead to financial freedom could become the biggest bear trap they’ve ever stepped into.