Many investors choose to avoid real estate due to a perception of risk. They think it’s simply too risky. As a result, people considering this field frequently ask me how to reduce risk in real estate investing.
This is a loaded question, as every real estate investment has risk. But, you reduce risk through clear goals and experience. Clear goals come with a clear investing strategy. And, experience comes with mistakes. The most common ones I see are overvaluing property and underestimating rehab costs.
I’ll use the rest of the article to explain ways to reduce risk in real estate investing. Specifically, I’ll dive into the following topics:
- An Overview of Risk in Real Estate Investing
- Real Estate Risk of Overvaluing Properties
- Real Estate Risk of Underestimating Repairs
- Reducing Risk through Wholesaling
- Final Thoughts
How To Reduce Risk in Real Estate Investing
As stated, every real estate investment includes some level of risk. And, as with all investments, real estate risk typically relates directly to returns. In other words, the more risk you assume, the more reward potential in a deal. For instance, commercial real estate development from the ground up offers some of the highest returns in the industry. But, successfully taking a property from a patch of dirt to a stabilized commercial property comes with massive risks, as well.
On the other hand, you can limit your risk (not eliminate) by purchasing a turnkey rental property. With these deals, you buy a ready-to-occupy home—typically at retail—and a management company handles all aspects of the deal (placing tenants, operating the property, maintenance, etc.). But, this approach also significantly cuts into your returns, both due to the retail purchase price and monthly management fees.
For investors committed to a fix & flip strategy, you cannot avoid certain risks central to this approach. For instance, some primary risks include:
- Purchase risk: Buying a place for too much, which cuts into your profit.
- Rehab risk: Rehab period not going according to time and budget.
- Deal risk: Rehab period falling apart completely, leading to a need to sell an unfinished property to recoup some costs.
- Resale risk: Finished property selling for less than planned, which cuts into your profit.
While you can’t eliminate these risks, you can reduce their potential impact. With more experience, you can better analyze and spot good deals. However, gaining experience takes time—and typically a few mistakes. I’ve found that new investors make two major mistakes in fix & flip deals: overvaluing properties and underestimating repair costs. As a result, if investors can avoid these two mistakes, which I’ll discuss in detail below, they can significantly reduce their real estate investing risk.
Real Estate Risk of Overvaluing Properties
I often see fix & flip investors make this mistake, and it can absolutely crush a deal’s profitability. And, new investors often make it on both the front- and back-end of the deal. That is, they A) pay too much for the initial property, thinking it’s worth more than it currently is, and B) estimate too high of an after-rehab value (ARV), which inflates their budgeted sales price.
To mitigate this risk, investors must understand how to value properties. However, accurately valuing properties hinges on access to current, reliable data about sales comps in your market. Simply put, you need to know what similar places have recently sold for in order to determine the value of your property.
Without access to the Multiple Listing Service (MLS), investors can struggle to find this information. We understand this reality, and we’ve created our Investor’s Edge software to solve the problem. This program aggregates data from MLS around the country, providing investors access to over 160 million property records. Armed with this data, you can pull the most recent sales comps for your market. These comps let you accurately estimate property values—and therefore reduce the risk of overvaluing a property during your deal analysis.
Real Estate Risk of Underestimating Repairs
The next major mistake new investors make involves repairs. More precisely, they tend to drastically underestimate repair costs and timelines. Often, this results from working with a bad contractor, someone who underbids a job then continuously submits cost overruns.
Say, for example, that a contractor bids $30,000 on a rehab but then submits another $15,000 in cost overruns. If your deal budget initially projected a $20,000 profit, that swing brings it down to $5,000. And, if the contractor also needs more time, your increased holding costs (loan interest, taxes, insurance, etc.) may completely eliminate your profit.
To avoid this mistake, investors should get multiple bids from different contractors (a minimum of two). This lets you confirm an accurate, fair value pricing bid. And, as part of this process, you’ll need to complete a detailed scope of work and services contract with your selected contractor. This ensures you’re both on the same page in terms of A) work to be completed, B) cost of that work, and C) associated timeline.
But, we also understand that working with a contractor can overwhelm and challenge new real estate investors. As such, The Investor's Edge team supports all of our members with experienced project managers (PMs). These PMs will work with you through the entire deal, from initial contractor bidding through rehab and sale of the property. These professionals will mentor and guide you through this entire process, helping you avoid the mistake of underestimating your rehab costs. And, in doing so, you’ll significantly reduce your investing risk.
Reducing Risk through Wholesaling
Lastly, investors can reduce their risk by changing strategy completely. Instead of a fix & flip approach, they can pursue a wholesaling strategy.
With wholesaling, investors don’t actually buy, rehab, and sell properties. Instead, they find the sorts of properties that fit the needs of fix & flip investors. Broadly speaking, the strategy works like this:
- Find a distressed property: Wholesalers look for a property in need of repair, typically at a deep discount, that would support a fix & flip investor’s purchase criteria.
- Put the property under contract: Once they find a property, wholesalers put it under contract with the seller. But, the contract should explicitly allow for assignment.
- Assign the contract: Next, wholesalers assign—or give the rights to—the contract to a third-party investor. And, they do this for a fee. For instance, say you put a property under contract for $100,000. If you assign it to a fix & flip investor for $110,000, you net a $10,000 profit on the deal.
With this approach, investors avoid a tremendous amount of risk. They don’t need to A) qualify for loans, B) rehab the property, or C) sell the renovated home, all of which reduces risk. Instead, the investors to whom you assign the contracts assume all this risk, as they’re the ones who ultimately close on the purchases.
But, while wholesaling reduces risk, it also requires a ton of work to find properties. Wholesalers generally need to find even better deals than fix & flip investors, as the numbers need to support both their profit and the fix & flip profit. Once again, Investor’s Edge can help you find these deals.
Final Thoughts
While you can’t eliminate real estate investing risk, you can certainly reduce it with experience. And, for new investors still building this experience, you can help yourself by avoiding these two key mistakes: don’t overvalue properties, and don’t underestimate repair costs.
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