5 Tips for Calculating Risk as a Real Estate Investor
According to radio advertisements and popular television shows, anyone with a basic understanding of real estate can make their fortune with an investment. There are ample opportunities for making your fortune, but there’s also risk that you need to understand first.
Many investors go into the real estate market naively expecting rousing success on their first property. They fail to do their homework first, and as it turns out, the risks are greater than the reward.
Don’t go into any investment blindly. Use these expert tips to help you identify risks before any investment.
1. Know Your Cap Rate
Real estate investors use the term “capitalization rate,” usually nicknamed “cap rate,” to determine if it’s worth investing in a certain property. This formula compares your net operating income (NOI) and your property’s current value to indicate the rate of return.
Using a cap rate formula or calculator, you’ll consider your property value, annual gross income, operating expenses, vacancy rate, and annual net income. The final calculation is a percentage. Typically, a sound investment will be 10 percent or higher. However, some areas where properties are in high demand may have a cap rate of 4 percent, which is great for the area. Avoid anything lower than 4 percent as a general rule.
Calculating your cap rate should be simple, but if the concept of cap rates is still confusing to you, check out this in-depth cap rate calculator resource.
2. Research the Market
Much of your risk will be identified as you understand the market in which you’re investing. As any good real estate guru knows, location is the most important factor in real estate, and you need to know how your location of choice performs.
Location can create several risks for investors as it dictates supply and demand. Too much competition can be bad for business. There’s also risk in purchasing a property in areas of high crime or poverty. It increases the likelihood of robberies or vandalization.
As you research good markets for real estate, look at the potential appreciation for your property as well. Low appreciation equals a negative return—you always want your property to be rising in value.
3. Know Your Expenses
Underestimating your property expenses is one of the biggest risks of all, and it’s easily remedied at the beginning. You’ll likely remember the mortgage payment and insurance, but that’s just the tip of the iceberg.
Author and investor Keith Weinhold recommended to the Forbes Real Estate Council using the acronym “VIMTUM,” which stands for vacancy, insurance, maintenance, taxes, utilities, and management. Create a spreadsheet including the potential expenses for each of these categories and include this amount in your cap rate. It will help you recognize whether this is really worth your time.
4. Identify Your Exit Strategy
When you make an investment based on good cap rate numbers, it doesn’t guarantee that the property will be a success. There’s always a chance that the market will take a negative turn, and you’ll experience a major loss.
Before buying a property, it’s smart to always identify an exit strategy. This will protect you if the deal goes south.
For example, you might advertise the property to real estate agents while you’re renting it out to get a list of potential buyers. That way, when you’re ready to get out, you can easily offload the property and avoid major losses.
5. Use Your Experience
Experience is one of the best predictors of risk. After a while in the game, you develop a sixth sense for bad property investment. Oftentimes, you’ll feel uneasy about a property and back out before it’s too late.
Additionally, experience can teach you invaluable lessons about your prospects, including the importance of taking it seriously and removing emotional attachments. You might fall in love with the fireplace in a property, but that’s no reason to bet the farm. Remove your personal tastes and feelings from any purchase and use the facts, numbers, and reliable experience to help you avoid losses.