Investors often purchase an investment property without having a solid handle on exactly how or if it will be profitable. To be fair, none of us were given instruction manuals when we started learning how to invest, so it makes sense that so many people dive in without fully grasping the fundamentals of determining whether a property will become profitable or not.
Adding to the problem of not having an instruction manual, we also don’t know what we don’t know, which makes it hard to succeed with a property.
Fortunately, while the information can feel abstract, there are simple things you can learn that will greatly help you increase your chances of success with a property you’ve been eyeballing as a possible investment.
Whether you’re buying a rental property, flipping, or investing in a commercial building, no matter what strategy you’re using, there are three questions you can ask yourself that may dramatically change the fate of your investment.
Before you learn the three questions, I want to clarify two specific instances where you should apply this checklist of questions:
- With your real estate investment strategy
- With each specific property you consider
If you can answer each of these three questions as you begin to pursue an investment strategy, you will be in a much stronger position to better understand what properties to focus on and how to manage your overall investing experience in a way where you secure your chance for success with it. Then, when you begin to shop for properties, ask yourself each of these questions to help ensure that the property will do its best to support your success.
Now, get ready to take notes and keep these questions on hand to use them every time you’re about to say yes to an investment.
- Question #1: How do I plan to profit?
- Question #2: What are the specific risks involved?
- Question #3: What specific risk mitigations can I implement to minimize risk?
Now that you have those written down, I’m going to help you better understand each one and how best to answer it.
Question #1: How Do I Plan to Profit?
This is a common place for new investors to falter. Too often, I see people dive into an investment without having a thorough understanding of how they expect to profit from it.
On the strategy side, it’s easy to have a general understanding of the process, but not understanding the intricacies of a process can create some gaps in the path to success.
For example, say you want to be a BRRRR investor. The process is spelled out in the name: Buy – Rehab – Rent – Refinance – Repeat. That’s pretty easy to understand. BRRRR means BRRRR. But how do you conduct each of those steps in a way that will achieve a profit?
Using this example, ask yourself what makes for a successful BRRRR versus an unsuccessful BRRRR. You’ll need to understand exactly what needs to happen or what needs to be in place during each of those steps to create a profitable investment compared to one that will end up costing you money.
Similarly, when looking at prospective properties to purchase within your strategy, you must again understand the specifics of the process rather than just the basic process.
For example, say you want to buy a rental property. Rental properties are pretty straightforward: buy a property, collect rent from the tenant, keep what’s left over after the expenses, and collect appreciation along the way.
Generally speaking, that’s precisely how a rental property profits. But what do you need to know about each step to ensure you set yourself up for a profit?
- What price do you need to buy a property for it to be profitable?
- How do you run the numbers to determine the cash flow?
- When should you expect to gain from appreciation, and how much? What if appreciation doesn’t happen? Will you still be profitable?
- How do you know if you’re getting a good deal?
Those are examples of a more detailed level of understanding you will need if you expect to know how to profit from a rental property.
When thinking about being able to explain how you expect to profit from a particular real estate investment strategy or from a specific property that fits into that strategy, treat it like you need to convince someone it’s going to be profitable. When you have to convince someone of something, you use more knowledgeable and concrete facts to help better your argument. In the case of investing, assume you are one of those people who needs to be convinced of the deal and give yourself all of those answers!
Question #2: What are the Specific Risks Involved?
You can run numbers and understand the detailed specifics of how an investment will be profitable all day long, but at the end of the day, none of those things matter if a major risk factor comes into play and wipes your profit clean off the table.
For example, you plan to flip a property. You’ve run all the numbers, bought the property, and the contractors head in to start the rehab work. Suddenly, there’s an unexpected foundation issue that will cost an additional $30,000 to fix (and it’s so bad that you can’t avoid fixing it). Now, you’re $30,000 over budget, and maybe you were only anticipating a $20,000 profit on the flip. You’re going to be $10,000 in the hole after all is said and done. Whoops!
Rehab overages happen all the time in real estate. You can’t pretend they never happen because if you do, you may end up in this exact situation.
Every real estate investment strategy comes with different risks, and every property you consider will come with risks.
While not a comprehensive list, here are some examples of major risk factors to rental properties and flipping strategies to give you an idea of what kinds of things you should look for:
Rental property risk factors
- Unexpected repairs
- Bad tenants
- Extended vacancy periods
- Declining appreciation due to external factors (i.e., the local market or neighborhood)
Flipping risk factors
- Rehab overages
- Rehab delays
- Property not appraising for expected after-repair value (ARV)
- Market slowdown or crash causing a significant drop to the ARV
To understand some of the risks specific to individual properties, I’ll use rental properties as an example. Here are risks that can negatively impact the bottom line for the investor:
- Limited tenant pool, causing the possibility of extended vacancy periods and having to lower rent
- A lower-quality neighborhood increases the risk of bad tenants
- Poor property condition that forces excess repair and maintenance expenses
- Cash flow numbers are tight, meaning there’s more reliance on appreciation
You should not move forward on an investment strategy or a specific property without understanding exactly what the risk factors are for that strategy or property. If you have no idea what could be looming around the corner in the shadows, you won’t be able to see it coming until it’s too late, and you may not recover from the loss it causes. However, if you’re aware of things that can happen, you can more adequately take steps to help prevent the loss as best as you can.
Question #3: What Specific Risk Mitigations Can I Implement to Minimize Risk?
Unfortunately, there’s no fool-proof, 100% solution that allows investors to avoid every possible risk that may hit an investment property. The best any of us can do is put as many risk mitigations in place as possible so that we’re simply minimizing our chances.
For example, if one of the greatest risks to rental properties is bad tenants who cause a lot of damage, don’t pay rent, and run up eviction costs, an easy mitigation is to try to increase our chances of attracting higher-quality tenants. How can we do this? Invest in nicer properties in nicer neighborhoods. Better properties in better areas can still end up with a bad tenant, but the chances of it happening are lower.
Does this example mean we should never invest in properties in rougher neighborhoods? Not at all! There are a lot of investors who specifically focus on properties in high-risk areas. The trick here is to go back through all of these questions we’re talking about, identify the risks specific to high-risk properties, and figure out how to help mitigate those.
For instance, one of the most effective ways of handling bad tenants comes down to how they are managed, whether by the investor or a property manager. Many property management companies specialize in bad neighborhoods. They have developed systems that are especially effective with challenging tenants and use those methods to help overcome the risk of ongoing expenses.
The first step is studying your strategy and property analysis to understand the risks. After that, you want to make sure you have appropriate risk mitigations in place. While risk mitigations won’t necessarily solve all possible problems, again, it’s about decreasing your chances of undue expenses as best as you can.
Applying the Questions to Your Investing
There’s absolutely no wrong answer when choosing an investment strategy as long as you’re willing to dive deep into how to make that strategy work, both in the processes and with the specific properties you may acquire. Fortunately, diving deep isn’t an extensive process! As long as you understand how you’re going to profit, what the risks specific to what you’re doing are, and how to mitigate those risks best, you’re going to be miles ahead of most.
Remember, even if you identify every risk and implement every risk mitigation option available to you, there’s no guarantee that something won’t still negatively impact your investment along the way. Sometimes things happen, and that’s just part of the game. Your job then, as a successful real estate investor, is to learn how to manage challenges and pivot whatever you need to so you can resume your path to profitability. It can be frustrating, but it’s the on-the-job training that’s inherent to being a real estate investor!
What specific criteria do you focus on for your chosen strategy and when analyzing properties that support it in hopes that it sets you up for the greatest chance of success?
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.