Summary: I often hear the comment, “Owning rentals is risky.” While this may be true for those who don’t know what they’re doing, for experienced investors, investing in rentals is considerably less risky than other investments. Why? The reason for this is that they are actively taking steps to mitigate risk in their real estate portfolio. In this article, we list the top ten ways that you can mitigate risk when investing in rental properties.
Lately, I’ve found myself discussing risk with a lot with people.
A lot of it stems from our 401K liquidation article. People feel that real estate investing is far riskier than putting their money in the stock market.
These conversations got me thinking about the ways we mitigate risk in our real estate portfolio.
It turns out, there’s a lot you can do to mitigate your risk. In this article, I list 10 risk mitigation strategies that you can use to ensure that your real estate portfolio is profitable and growing for many years to come.
[Author’s note: In this article, when we talk about real estate investing, we are specifically referring to direct-ownership of rental properties.]
1) Use the buy and hold strategy
The buy and hold strategy is one of the best ways to mitigate risk in your portfolio. We covered this strategy in detail in a prior post.
In short, it’s when you buy a property and plan to hold onto it for the long haul, maybe even a lifetime. It is considerably less risky than flipping or buying for appreciation because you aren’t relying on market cycles.
For example, when you combine this strategy with #2 and #3 below (buying cashflowing multifamily properties), you can continue to receive a healthy return on your investment (we aim for 10% cash-on-cash return) without relying on appreciation.
Now this doesn’t mean that you don’t ever sell.
The beauty of buy and hold is that you can afford to wait for your property to appreciate. For us, we’ve been fortunate to have bought during a crazy run of appreciation between 2015 and 2019. In fact, we are selling one property we bought for $160,000 for $235,000 or a 47% appreciation in two years. This is on top of cashflowing 10% each year.
2) Focus on multifamily rentals
Owning and renting multifamily properties is less risky than single family homes.
With single family homes, if one unit is empty, you’re not getting any rent. You’re under water each month.
On the other hand, if you own a four-plex and one unit is empty, you’re probably still cashflowing a little. And that can be enough to get you through a couple of months until you find your next renter.
Commercial properties, which house retail, are also usually higher risk due to the high cost of vacancy. Same goes with office space.
Everyone needs a place to live. Focus on providing housing, not commercial space, and you mitigate your risk.
3) Aim for a certain minimum of cashflow
When buying rental properties, be sure to “buy it right.”
What does this mean? It means that every time you buy a property, you have pre-defined criteria and only buy properties that meet that criteria. Never compromise.
One of the most important criteria is the cashflow that a property generates.
As mentioned above, we like to use a threshold of 10% cash-on-cash return. If a property brings in less than that, we generally won’t buy the property. There are of course exceptions to this rule. For example, if a property has a considerable amount of untapped hidden value.
By ensuring a certain minimum level of cashflow, you are mitigating your risk. Even if rents drop slightly in the next downturn, you’ll have some cushion to be able to absorb a drop.
4) Buy the types of properties that people will live in during the recession
We don’t buy “A” properties.
What is an A property? Think, the modern apartment building covered in glass with the dog park or pool, or the sweet Tudor house with a back yard in a neighborhood. These are the properties that rent for $2,500 dollars and above. And these are not our rentals.
We buy “B” and “C+” properties. Why?
Think about what will happen to a person who is living above their means in an “A” property and who loses their job during the next downturn.
Where does that person go? They will be moving into our B or C+ property.
Likewise, if there’s an upswing in the market and everyone has jobs, the people in the D and C class go up to the B class.
We believe the sweet spot for rentals is in the middle. That way you can benefit from an upswing and weather a storm during a downturn.
5) Focus on smaller units, especially two bedrooms
What happens when there is a recession and people can no longer afford their current housing? As mentioned above, they move into a cheaper place (e.g., move from B to C properties). Not only that, they also tend to downsize.
This is where the two bedroom unit comes into play.
The two bedroom, in my opinion, is the most versatile of all of the rental unit sizes for people living on tight budgets and looking to downsize. It is affordable but still has space for a family with one, two, or even three children. It can work for a single person or a couple who wants an extra room for an office. It can house a single person and a roommate.
When you have a desirable product that is in high demand, your risk goes down.
6) Make your property the nicest on the block
In a downturn, vacancies tend to go up and the options for housing increase significantly.
So how do you ensure that your house isn’t the one that sits vacant during a downturn? How about making it the nicest on the block?
The great thing about making your property the nicest on the block is that during good economic times, you can demand premium rents.
I’m not saying you need to go crazy with stainless steel refrigerators and granite. But a little upkeep and slightly higher finishes above your community norm is a great way to mitigate risk for the long term.
7) Use 30-year loans
This one is always an open debate on multiple online real estate communities.
People want to pay off their loans as soon as possible, so they often choose the 15-year mortgage.
But this can be a risky proposition.
Let’s say you own a duplex and one of the two units is vacant for a prolonged period for whatever reason.
Which of the following scenarios do you want? Would you rather be forced to come out of pocket every month until the vacancy is filled or make a little bit of cashflow or at worst be cashflow neutral?
From a risk standpoint, the 30-year mortgage is less risky.
With the 30-year loan, you can always choose to pay it off in 15 years. And it also preserves your flexibility to NOT pay it back in 15 years if there is a downturn or something happens that lowers you monthly income. The flexibility that comes with a 30-year loan instead of a 15-year (or a 5-year adjustable rate mortgage!) is risk mitigation.
8) Put properties in LLCs
As with any business, owning rental properties opens your up to the possibility of being sued.
The key is separating the rentals from each other AND from your personal finances. You do this buy putting each property in its own LLC (or in a series LLC). And then you treat each LLC as its own business. You get separate EIN numbers. You get separate bank accounts.
Is it a lot of work? Yes it is.
Is it a pain in the ass? Yes it is.
But isn’t it more painful to have a renter sue you, take all your properties and your personal residence and garnish your wages? I’ll leave that one for you to answer.
9) Get good insurance
Although the LLC gives you some protection, you’ll also want to have good insurance coverage.
You’ll want to not only get adequate coverage for the property itself; you’ll also want to get good umbrella insurance to cover anything above what the property insurance covers.
10) Buy in multiple states/locations
This is one of the main ways that Kenji and I decided to further mitigate our risk early on in our investment career. When we thought about how to lower our risk from natural disasters and extreme market shifts, we realized that diversifying into other markets was a way to minimize the chances that our whole portfolio could go down at once. Therefore we spread our money through several areas of Washington as well as venturing out into new states.
Think of other ways to mitigate risk besides those listed here?