Dealing with Risk in Real Estate Investing

One of the questions we often get, especially from new real estate investors is, “How do I deal with risk?” I wish real estate investing were a sure thing, but there is no such thing as a “sure thing.” There is always the possibility of losing money, just like there is always a possibility of making money. It’s true for any business, and it’s true for any investment. The key to dealing with risk in real estate investing is knowing yourself and being diligent in minimizing the risk you are willing to take on. Let me share more.

Know Your Risk Tolerance.

I have been a private lender for almost twenty years. When I tell people what I do, many respond with, “Wow. It’s so risky.” I am sometimes taken aback by that. I don’t think that what I do is unusually fraught with risk, but then again, maybe this is the level of risk I am comfortable with. This is the first key to dealing with risk: know yourself.

If you are a real estate investor who is averse to risk, you may pass on some deals that someone with a higher risk tolerance might find attractive. That is perfectly fine. It means that you will be doing fewer deals. However, your risk of losing money will also be lower than that of those ready to take more risk.

Here is an example within the real estate industry. Let’s say two different flippers are presented with the same opportunity: a distressed property sold at $320,000. Their contractors estimate approximately $60,000 to $70,000 in repairs, and the after-repair comps range between $470,000 and $490,000. One of the investors walks away from the transaction, proclaiming that you cannot make money flipping this home. The other one rubs his hands and says he is about to make $50,000 in profit. Both of them are equally right, but how?

The difference lies within simple math. The risk-averse investor based his numbers on the worst-case scenario. He assumed that it would take $70K to renovate the property, and once renovated, it would sell for $470,000. He also budgeted twelve months to renovate and sell the property.

The other investor took on more risk by assuming the best-case scenario. He budgeted $60,000 for the rehab and estimated that the property would be worth at least $490,000. He also assumed that the process would be so smooth and efficient that it would take him only six months to renovate and sell. Use our hard money calculator to check the numbers for yourself. The transaction is not worth the risk for those with low-risk tolerance. For those willing to risk working for free, it might generate $50,000 in profit if all the stars align.

If you are going to get serious about real estate investmenting, do not make the mistake of avoiding risk. As the saying goes, fortune favors the bold. It’s also important to note that people’s fear of risk can also be an asset for you. Many people hesitate about a good deal because they fear the risk. But if you can handle the risk and have done your best to mitigate it, you can be first to the table and gain leverage that risk-averse people just don’t get.

Being bold does not mean being reckless. That risk-averse investor we’ve discussed might be a grizzled flipper unwilling to bet on the best-case scenario. It takes wisdom, discipline, and experience to walk away from a deal just because you perceive it’s too risky. A frustrated borrower of ours recently lamented that he always gets outbid. “How do these people make money?” he kept asking. Truthfully, many willing to pay the highest price are not making money. They welcome so much risk that they are willing to bet that the real estate prices go up significantly by the time they are ready to sell. There is a chance that they do, of course, but this is not the risk that I personally willing to accept both as a private lender and a real estate investor.

Work to Minimize Your Risk.

Regardless of your risk tolerance, you should always do your best to minimize it. Risk will always be there, but there are things you can do to reduce it. Here are some ways you can do it.

Conduct Due Diligence On the Property Before Purchasing It.

If you are like our risk-loving investor in our earlier example and are willing to assume that everything works just perfectly, you better work hard to ensure it. After all, you don’t have much margin for error. Be aware and investigate any potential red flags that might have even a small chance of increasing your rehab costs or delaying your renovation process. We have an excellent article about the red flags in real estate investing that you can read for further information.

Work With a Trustworthy and Experienced Lender to Find Your Transaction

Working with a reputable private lender can help you close your transaction on time and hassle-free, but it can also do much more. The lender’s interests are aligned with their borrowers. The higher the profit for real estate investors, the safer the transaction is for the lender. The more risk the borrower assumes, the riskier the private hard money loan for the lender. This is why your lender is your best ally in evaluating and managing the risk you are taking in your real estate investments.

Get Accurate Estimates from Your Vendor and Contractors.

Three numbers determine your transaction’s profitability: the property’s purchase price, the renovation budget, and the after-repair value. The first and last numbers are dictated by market forces. Yes, you might be able to negotiate a good discount when buying and then sell at the top price, but overall, these prices will be within the range the market allows.

The renovation budget is different. A first-time real estate investor with no repeat business might have to pay retail, while a seasoned investor with his own crew might pay a portion of that price. If you are a contractor trying to break into real estate investing, you clearly have the advantage: after all, you can set your own labor costs.

So, it might be tempting to set the renovation budget low. After all, on paper, the lower your renovation budget, the higher your profits. But that is on paper. How is it in real life? Let’s assume you’ve selected the contractor giving you the lowest quote. You might be getting a great deal, or the contractor is going to hit you with change orders once the work is underway. The truth is until you work with that contractor on a number of projects, you know little about the accuracy of his estimates or the qualiy of his work. Thankfully, this risk will decrease as you build a relationship with your contractor over time.

Be Present and Be Involved.

From time to time, we have out-of-state borrowers intending to renovate properties in the DC area. They plan to “fly here regularly” or “have an uncle who will supervise the process.” Your uncle might be great, but you are increasing your risk by delegating a crucial part of your project to him. The best way to minimize the risk of your renovation is to be present on-site.

We have a great borrower who flips multiple properties a year. He works fast and typically is able to flip his projects within three to five months. Let me tell you: he is NOT delegating. On the contrary, he told me on many occasions that he is there on a daily basis, sometimes as early as six o’clock in the morning. Truly, when it comes to real estate investing, there are no free lunches.

Know how much risk you are comfortable with. Some people are very comfortable with a high level of risk. Betting the farm is no big deal because they have been through ups and downs and are used to a certain amount of risk. Other people go into shock at the loss of just a few dollars, and these people spend sleepless nights tossing and turning with doubt and fear. Each of us falles somewhere between these two extremes. You need to know how much risk you are willing to tolerate and invest accordingly.

New Funding Resources LLC is a private lender in the Washington DC area. We provide fast and flexible financing to help real estate investors purchase, rehab and sell an investment property in Maryland, DC, and Virginia. Apply today or call us 240.436.2340 .