Vacancy Risk

The most common risk factor affecting the cash flow of a property is the lack of rental income, whether that is because a unit is vacant or because the tenant is not paying. Losing just a month or two of rents can throw off financial projections significantly, especially for single family homes or smaller multifamily buildings. Nonpayment of rent by a tenant also can incur legal costs for eventual evictions, which can turn a property with a positive cash flow quickly into a property with a negative cash flow. This is much more common in lower graded neighborhoods and buildings, and in looking at financial projections for those types of properties a large vacancy allowance should be built in. When diligencing any property, look at the current and target vacancy rates and make sure you have confidence in each if you are going to base your forecast on the plan being presented.

Unexpected Expenses

Unexpected maintenance costs and capital expenditures (“capex”) can also significantly affect a property’s cash flow, particularly for single family homes or smaller multifamily buildings. A new water heater or boiler, or needing to fix a roof or replace appliances, can be significant expenses compared to rent, especially in lower graded neighborhoods or cities that have low rents. A refrigerator more or less costs the same anywhere, but if a unit is getting $2,000/month in rent, it’s a lesser expense than if a unit is getting $400/month in rent. Similarly, a new roof for a single-family house is going to eat up a larger share of rent than a new roof for a 10-unit building. It is always good to be conservative and underwrite for higher than expected maintenance and capex costs to see if a property still looks promising. If a property only projects well with low or no maintenance and capex costs, chances are it will not work out well in reality.

Third-Party Risk

For crowdfunding projects or any property that is not self-managed, there is a risk that the property management team or sponsor does not do a good job screening tenants or managing costs efficiently. It is imperative before investing in any non self-managed property to vet the management team because they are ultimately going to be a large part of whether a property’s cash flows meet expectations.

Macroeconomic Conditions

Unless you have a property where you can force appreciation, generally there is not much you can do to control the rate of appreciation as that is mostly based on macro factors - the desirability of a city, the desirability of a neighborhood, how the local and national economy is performing, and where interest rates and inflation are. There are certainly places with better chances for appreciation - coastal cities and higher graded neighborhoods are better bets - but there are a lot of uncontrollable risks if you are relying only on appreciation for a potential investment. For example, if interest rates increase, investors will need higher cap rates to justify an investment, which lowers the potential sale price.

Conclusion

The best way to avoid these risks is to invest in higher graded neighborhoods and buildings or to diversify your holdings if investing in riskier neighborhoods or properties. For example, if a portfolio has a hundred single family homes, it is less likely that all of them will need a new roof or have non-paying tenants. It is also helpful to diversify your holdings over several different locations to reduce the risk of stagnant appreciation over your entire portfolio.

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