5.0 Risk


Congratulations, you have done a lot of work to purchase the best possible investment property. Now you just need to do whatever repairs and remodeling work pronto so you can get a tenant in there to cover those expenses and generate income.

Time to get the required utilities such as water, sewer, garbage, and electrify switched on. Since the house is vacant, you can leave off the telephone and cable plus anything else not essential. Your contractor friend can hopefully jump on the project to complete it as soon as possible. Be aware, he may not be able to start for two to three weeks until they have the required permits. I hope you scheduled that time in. You can advertise the space as ready in a few weeks to see if you can get somebody lined up to rent.


5.1 Management Risk

Management risk is exactly what it sounds like, the risk that management will mess things up. You are the management for your project. The risk is basically you. Knowing how to properly manage a project takes time and experience. If you have never managed a project before, you should pick up a book on project management to give you some basic skills and concepts. If you are new to renovation, construction, and sales, speak to someone with some experience in one or more areas to give you some pointers. Here we are going to cover two specific issues in management that relate to you.

If renovating a project, unknown issues will arise. Nobody can ever know what hides behind the walls until they are opened, and no seller is going to let you demolish parts of the home during due diligence. Even the inspector will not be able to guarantee that nothing lurks unseen somewhere. So eventually, there will be an unexpected issue on a project. The contractor will call you and ask "What do you want me to do?". You'll feel a bit cross since you figured the contractor is supposed to know what to do ("Why are you asking me?"), but you're in charge. No doubt all the solutions to the problem come with a higher cost than what you had modeled in the pro forma. If you put a 5-percent contingency in the budget for unforeseen incidents such as this, you may already be covered. If you don't have the cash set aside to solve the issue, you will need to find it. In any event, you are in a bind. You need to put up more cash and the project will take longer to complete - you are losing money.

"What does this have to do with management?" Everything. Anyone can manage a project that is running smoothly. It's like riding your bike with no hands, you just need momentum and a straight sidewalk. However, when things get bumpy you need to grab the handle bars and take control. Taking control is keeping the bike from crashing and staying on the sidewalk. You can't blame the bike for not anticipating the bumps (you chose the route), nor does screaming at the bike avoid any crashes. You gain control and keep moving on toward your destination. It is the same with your project.

A good strategy for success when a problem arises is to always ask those working for you (realtor, contractor, etc., depending on the issue) for different solutions to try. Listen to the advise that is being offered, and if you feel you have all the information you need - make a decision. Time is money, but taking an hour or so to let your brain ponder the problem is not such a bad thing. It is better to lose a day than make a costly mistake. During this process of solution discovery, you may feel the urge to lash out at those you feel are responsible. Whether or not they truly deserve a severe tongue lashing, you are a professional and demand those you work with also conduct themselves in such a manner. You solve the problem, keep the peace, take the blame, and get the project back on track as much as possible (act like one of the Hollywood versions of a mobster - just business). Solve the problem - finger pointing wastes time and money. You have to get rid of this property as soon as possible. If you truly feel bad judgment from one of your folks caused the issue, simply use somebody else on the next project.

"What can I do to prevent the project from falling behind schedule?" Your project should be fairly simple. Just some paint and minor repairs. Simply stopping by the property and tracking progress may be enough. Let the contractor's do their jobs, but feel free to remind them about the schedule they agreed to in their contract (hint, hint). If you pad your schedule with an extra week or two you should generally be alright.

This leads into probably one of the biggest schedule destroyers for the renovation portion of the project - you. When you met with the contractor to put a renovation budget together, the work to be done was agreed upon; the scope of work. Based upon the scope of work, the contractor developed a budget and schedule. Depending on where the project is, the local building department may require design drawings to be submitted for permit that could take a few weeks. Needless to say, a lot of work may already be happening behind the scenes that you may or may not be aware. If you change your mind about something - it all stops.

Once the contractor gets the designers started, any change or revision you make is going to delay the project. If you make a change during the design stage it is not the end of the world; you are probably only going to lose a week or two. Make a change during the permit submittal, you could be required to resubmit and have to restart the review process. You could lose a month or more. The ultimate schedule killer is if you decide to make a change during construction. A change during construction has the potential to bring everything to a standstill for a significant period of time. If the change requires a revision to the permit, new drawings will need to be done and submitted for approval. Sub-contractors may stop working and move on to other projects. Potentially, you'll have to wait until they are done with the other project before they come back to finish yours. The cost of the time delay can be significant even if the direct costs of the renovation are negligible; the loan payments still need to be made as well as additional expenses. To save yourself from yourself, just accept the fact that unless it is life or death - no changes to the project once the process starts (at design). The buyer is probably going to change whatever you did anyway. You can make a design statement or a profit.

Managing the property during the holding period is where you either make or lose money. Tenants must be screened to insure you are not inviting trouble into your property. Rent must be collected on time, and the property needs to be maintained. There are several good books on the subject, and we cannot stress enough that you should explore this subject in depth. You need to understand your local laws and legal requirements for noticing late paying tenants to how you can evict. There are books for specific states that lay out the do's and don'ts when it comes to tenants. Law's change with respect to handicap access and other issues you can become liable for. If all this is too much for you to handle, you can hire a property management company. But unless you understand what is going on, how do you know if they are doing a good job? Be smart and get educated.

When you are ready, the sales process is basically the reverse of the purchase, except you are wearing the seller's shoes trying to get top dollar. Now you are several months from where you started and the market may be getting better or worse. As offers come in, you can plug the price into your pro forma to see what the returns would be. Even if the offer is a bit less than what you had expected, you still may be able to post a reasonable profit. Now the question becomes one of taking the offer in hand (obviously you negotiated the best offer), or risking a better offer will come along soon. You know as time passes your expense payments pile up. Is it better to lock in a profit or hope for a better offer to come along? Well, it depends on your appetite for risk. In many cases taking a profitable offer and moving on to the next project might be the best move. The longer you stay on the market the longer you are exposed to market risks. Luckly you do have a tenant (hopefully) unless you had to evict them to sell. What would you do?


5.2 Market Risk

With all of your hard work, your future estimate of the market can be wrong. People are fairly bad at forecasting future events, and our emotions tend to get the best of us. In fact, each piece of information you used in the pro forma may be in error due to a positive bias. You are being overly optimistic. Even if your acquisition and renovations estimates are exact, your rental growth and future sale projection can be wildly off. "Why?" The future cannot be predicted. All you can really do is attempt to limit your exposure to market risks.

The market is the tide that raises all boats or sinks them. Because income properties are held for several years, they have a greater exposure to a negative market movement. If you are lucky you may be able to ride out a market downturn without much loss.

"How do I limit market risk?" Believe it or not, there are ways to limit the risk of negative market movement by hedging your project with property derivatives. Without hedging, the best way to limit your exposure is through sound management.

This too is a risky business.



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