My family and I love watching Shark Tank. You know, the show where experienced (and rich) entrepreneurs assess and potentially invest in other entrepreneurs. Shark Tank has given entrepreneurship a place in the national spotlight. It has also allowed people to see examples of what can be done to accumulate generation impacting wealth. For example, I once read that the average “shark” on the show has 8 different cash flow streams, meaning that their income is being generated by eight independent sources.
Many entrepreneurs attempt to diversify their cash streams by acquiring income-producing-properties (aka IPPs). Many look to the fact that historically speaking (the recession of 2007 notwithstanding), real estate has been a safe place to invest and gain value. An IPP is even better in that it throws off cash to service debt or repay the owner for their investment. Some people see IPPs as a form of passive income, meaning that the amount of effort required is much less than other forms of income. When analyzing if investing in an IPP is right for you, I would challenge you to define your goal for the investment. Some investors seek to increase their net worth as the value of the IPP increases. For example, the investor that purchased an IPP for $100,000 and then four years later sold it for $150,000. If this is your goal, you must be willing to hold the IPP for a long time. If 2007 taught us anything, it is that the price of real estate can decrease and that you may not be able to cash out right away. Another goal may be cash flow (or a monthly check from your rental property) may be more important than increased property value. If so, then you will need to conduct a thorough review of the ongoing and potential costs associated with your property, not only to help you determine how big a check you are going to get each month, but also if that amount is worth it. For example, if you had to invest (either through cash or debt) $500,000 to obtain an IPP but only received $100 each month after all expenses, you should ask yourself if this is the best return that your $500,000 can get. The reality is that most entrepreneurs seek a combination of these 2 objectives, but it is important to know where you stand before you lay your cash on the line.
In a future post, I will walk through the financial analysis that I guide my entrepreneurs through when considering the purchase of an IPP. But now I want to discuss the top four risks associated with an IPP investment.
Vacancy Risk: This is the single biggest risk associated with an IPP investment. An IPP that does not produce income is very unattractive to most entrepreneurs. Local property management professionals should be able to give you a good idea of what the rental market is like (i.e. how long a vacant unit takes to be rented and the trending lease price). As protection against this type of risk, you should have some cash in reserve to cover any expenses that will be incurred while the property is not producing income and/or ensure that your other cash streams are strong enough to carry the property until it is rented again.
Turnover Risk: Turnover risk is closely related to vacancy risk and applies specifically to IPPs that have more than one rental unit. For example, imagine you have a residential IPP that has four units. You would not want the lease in all four units to end on the same day (or even the same month). It would be better to have the lease maturities staggered throughout the year so that if one tenant leaves when the lease is up, you will have time to clean, repair, and lease that unit before the next unit lease matures.
Repair Risk: While catastrophic repairs (hail, fire, wind, flood, etc.) are best covered through a proper insurance policy, every IPP is going to suffer from normal wear and tear that necessitates repairs paid by the property owner. I recommend to the entrepreneurs that I work with to have at least $10,000 per unit (depending upon the age, size, and amenities of the unit) in cash set aside in a repair emergency fund. It is also wise to consider repairs that you may be liable for that are not part of your property, i.e. common area maintenance (CAM) fees that are assessed to owners of condominiums, townhomes, or private subdivisions. On a side note, if your property is part of a property owners association, I would recommend that you speak to the treasure of the board and ask to see the financials prior to investing. There is nothing worse than buying an IPP and then 6 months later getting hit with a $15,000 assessment to repair common areas.
Tennant Risk: Not every landlord wants to deal with their tenants, especially if there is an issue or dispute. Personally, I would not want to receive a call at 2am telling me that the guest toilet is overflowing and that an emergency plumber needs to come right away. Additionally, many “passive” investors don’t want to hear each month why the rent was late, again. I have yet to meet an owner that looks forward to the eviction process when a tenant has not met their end of the lease agreement and must be forcefully removed from the property. Many IPP owners mitigate tenant risk by conducting background checks and financial history inquiries, but many chose to hire a professional property management company that handles these issues for them. Of course, this service is not free and costs between 10% – 15% of the rental income received each month, so the cost must be weighted against the benefit and the cashflow of the property.
Not everyone is cut out to be a landlord, and passive income is at times, not so passive. If you are looking to diversify your assets and cash streams, an IPP may be right for you. But you must know what you want to achieve from the investment, the potential risks associated with the investment, and what steps you are going to take to protect yourself from those risks.
Being an entrepreneur is one of the most difficult and demanding things you can do. The good news is that entrepreneurship today is a team sport. Hit the connect button on LinkedIn or Facebook NOW and together we will start maximizing your profit, strengthening your leadership skills, controlling your business finances and using your bank as a strategic advantage. When we connect, tell me if you own any income producing properties or if you are thinking about investing in real estate.
Greg Martin is an entrepreneur’s insider to the banking industry and passionately believes that every person was uniquely designed for a higher purpose and calling. Greg guides entrepreneurs in defining and achieving their purpose and calling. His deepest passion is living life with his wife of 17 years and their wonderful son.
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