Top Risks of Real Estate Investing
Paul Kondakos | Posted on Saturday, December 8, 2012 at 5:21PM
Although the real estate market can be a tremendous investment vehicle providing regular cash flow and wealth creation, it has also been responsible for wiping out entire fortunes and forcing many into bankruptcy as evidenced in the late 80's.
The multi-unit residential market is one real estate segment that has done extremely well over the past decade throughout Canada. This is especially true in the larger urban centres such as Toronto, Vancouver, Calgary and Edmonton where market cap compression has resulted in cap rates as low at 4% . This recent success however means that investors need to be even more cautious and pay closer attention to the fundamentals and risks associated with this segment before investing.
The three main risks that need to assessed include (1) Economic Risk, (2) Political Risk and (3) Property Specific Risk. As previously mentioned, every investment carries risk. As an investor, you need to assess and try to mitigate those risks. A such, the goal of this article will be to review each of the aforementioned risks and offer strategies to help mitigate them where possible.
ECONOMIC RISK
Generally speaking, Canadians are in an extremely enviable position economically. Our real estate market has not only survived, but thrived, while other markets have collapsed around us. Even though foreign dollars are investing in Canadian real estate as a safe haven, investing can still be a risky proposition.
Interest Rates - What goes up must come down (and vice versa)
I intentionally began with the interest rate risk as it is the number one perceived risk by prospective investors. As Canadians, we have witnessed interest rates at historic lows for a prolonged period of time. As recently as Dec 4th Mark Carney and the Bank of Canada, for the 18th consecutive time, kept the benchmark interest rate at 1%. While these historically low interest rates present great opportunity, at the same time they present a great perceived risk. The thinking goes like this; If rates rise too quickly, a once positive cash-flow property will turn into a negative cash-flow property.
Mitigate: There are two potential ways to help mitigate interest rate volatility. The first is to simply take the volatility out of the picture by locking into long term financing anywhere between a 5 to 10 year term. This will provide investors with a prolonged period of predictable cash flow and mortgage pay down. A second option would be to buy CMHC insurance on the property. CMHC insurance typically means discounts as high as 1% off interest rates for the life of the mortgage. Combine these two strategies and you can get 10 year financing as cheap as 3-4%. It doesn't get much safer or more predictable than that.
Vacancy Rate Risk
Landlords have been enjoying historically low vacancy rates across Canada. According to a CMHC report issued on June 12th; "The average rental apartment vacancy rate in Canada's 35 major centres decreased slightly to 2.3 per cent in April 2012, from 2.5 per cent in April 2011". Once again, the same type of perceived risk applies here as it did to the interest rate section above. Investors are concerned that vacancy rates have nowhere to go but up which can significantly impact a property's cash flow.
Mitigate: The best way for investors to mitigate this potential risk is to buy in areas where key economic metrics point towards low future vacancy rates. These metrics include, but are not limited to; low unemployment, population growth, GDP growth, large scale construction/development, inmigration and currently low vacancy rates. Investing in economically sound areas will help to mitigate vacancy rate risk in times of economic downturn.
POLITICAL RISK
Canadians are very fortunate to live in a country that has very little political risk. Apart from some left and right leaning skirmishes, our real estate sector and property rights are very stable and secure.
Rent Control Risk
Rent control risk varies from Province to Province. For example, British Columbia, Manitoba, Ontario and PEI have rent control legislation allowing landlords to only raise rents according to their respective Provincial guidelines. Until recently, Ontario landlords were allowed to raise rents based on the Ontario Consumer Price Index (CPI). However, for 2013, the maximum increase has been capped at 2.5%. It wasn't so long ago that Ontario landlords were limited with the amount they could raise rents even when the units were vacant. The main point here is that rent control legislation is an active risk that can appear at any time.
Mitigate - Knowledge is the key here. Ensure that you are familiar with your Province's current and historical legislation on rent control, if any. Right wing governments tend to avoid rent control legislation whereas left wing governments tend to embrace it. Also get familiar with any grassroots political movements focused on introducing new rent control legislation or placing new caps on rent control.
Licensing Risk
Licensing risk varies from city to city. It has been a hotly contested issue in a number of Ontario cities including Waterloo, Toronto and Hamilton. In Waterloo, a rental housing licensing bylaw was recently enacted imposing new fees on landlords. In Hamilton, landlords are hotly contesting a draft bylaw to regulate buildings with between one and six rental units. Licensing at the end of the day ultimately leads to new expenses for the landlord affecting cash flow. It also makes investors less likely to invest in cities that are heavily regulated thus affecting real estate prices in those cities.
Mitigate - Once again, knowledge is the key. Become familiar with the political landscape in any city your are considering for your investment dollars. All other things being equal, look to invest where legislation favors the landlord.
PROPERTY SPECIFIC RISK
Property Selection Risk
Property selection can be a very risky endeavour. In fact, this can be the riskiest stage for investors as a poorly selected investment property can lead to perpetual negative cash flow and eventually force a sale. A "Negative Cash-Flow Investment" is one oxy-moron real estate investors should aim to avoid (yes, there are situations where a negative-cash flow investment property can be turned around, but I wouldn't recommend it for the novice). Risks in property selection include, but are not limited to; insufficient cash flow, imminent capital expenditures, rental rates above market, legally non-conforming property, poor tenant profile, environmental issues, structural issues and understated expenses. Buying an investment property without being fully apprised of what makes a good investment property may be the biggest risk of all.
Mitigate - Knowledge once again is the key. Become educated on what makes a great investment property. Read books, join real estate groups/networks, surf the web, find a mentor. Successful investors know from the outset if their investment will be successful because they have crunched the numbers and accounted for any potential risks.
Vacancy Risk
Although already addressed under Economic Risks, Vacancy Risk can also be property specific. High vacancies can adversely affect a property' cash flow and in turn, affect the value. In some cases, high vacancy rates are not a function of the economy, but are specific property. A poor tenant profile will lead to weak cash flow and higher expenses.
Mitigate - The 2 best ways to ensure that a property is either at or below the areas average vacancy rate is to (1) ensure the property is properly maintained and (2) ensure that all new tenants are screened properly which includes running a credit check, verifying employment, checking past references and verifying ID. Both of these initiatives will help to lower tenant turnover.
Unknown/Unexpected Expenses Risk
The unknown and unexpected are always a scary prospect for real estate investors. Given that properties usually run on tight budgets, an unexpected cost can quickly make a cash flow positive property cash flow negative.
Mitigate - When first buying an investment property, always have a professional inspector give it the once over to ensure that there are no serious issues. It also provides the investor with recourse if the inspector missed something major. With respect to unexpected expenses ... welcome to real estate investing. Unfortunately, it happens all the time, but as long as you are prepared for it, it won't be a big shock. Set aside a contingency fund that you contribute to every month from the property' cash flow to address potential surprises such as a leaky roof or new boiler.
While not an exhaustive list of the potential risks associated with real estate investing, this article has outlined some of the major considerations to be investigated before purchasing any investment property.
ARTICLE PUBLISHED IN CANADIAN REAL ESTATE WEALTH
Author: Paul Kondakos, BA, LL.B, MBA - Professional Real Estate Investor
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Licensing at the end of the day ultimately leads to new expenses for the landlord affecting cash flow. It also makes investors less likely to invest in cities that are heavily regulated thus affecting real estate prices in those cities.