Real Estate Investment Risks (1) – The Property

In my post “Is Real Estate the New Bitcoin?” I already hinted at some of the risks associated with financing real estate investments. And I voiced the opinion that this topic doesn’t seem to get the exposure it deserves with the current online-hype around investment property in Germany. That’s why I want to go into some more detail regarding the risks you should be aware of when buying and renting out real estate.

As you know, we do invest in real estate ourselves. So I definitely don’t want to advise you against this type of investment. But the more you know, the better able you are to handle the associated risks. And again: we did know a little bit when we first started. But in hindsight, we went about things rather naively overall. And no matter how much you read on the subject, you have have to collect your own experiences.

If you want to read some general information about real estate as an investment, my post “Building Income Streams with Real Estate” might be for you.

The topic of risks around real estate is a bit broader and I don’t want my posts to get too long. That’s why I’ll make it a small series.

One quick note: everything in this series refers to the situation in Germany. A lot will be transferable to other parts of the world  or at least be similar. Always cross-check with rules and regulations appropriate to your country and region, though.

 

Location, Location, Location

Ok, let’s get started. Some of the risks associated with owning real estate concern the property itself. The first is the location.

That’s why there’s the real estate agents adage about the three most important criteria when buying real estate: Location, location, locaction. The location of the property will influence its long-term value and attraction for renters.

“Location” can be broken down into macro and micro location. Macro location refers to the town in which the property is situated and to its surrounding region. Micro location refers to the concrete street and neighbourhood, its infrastructure and the availability of shops, schools, and other services.

It’s important you don’t “blindly” buy an apartment just because the return looks good on paper. Find out whether the town and region have the potential for positive development, e.g. for population growth. You can start your research on this via the internet and use tools such as the Prognos-Zukunftsatlas (Germany only). But make sure to get a live, on-site impression as well. Talk to people who live and work there.

What’s that got to do with risk? You have to be able to get a feeling for the adequate market price, that goes both for the sales price and the rent potential. If the current rent seems rather high in comparison to the sales price, you might have found a great deal. But in most cases a higher return will be a sign of a higher risk. An apartment in an area with a difficult demographic and high levels of vacancy, to give an example.

 

The building

The building itself carries some risks as well. Different ages of construction come with typical problems such as damp basements or insufficient insulation. Major issues can arise from toxic materials like asbestos. If you buy from a developer you might encounter construction defects. But in that case you should at least have some sort of warranty.

With older real estate problems like dry rot or house longhorn beetle would be major. Make sure to include a clause in the sales contract where the seller certifies that he has no knowledge of any such issues. If you’re not a real estate pro yourself, it might sense to have an authorized expert check out the property.

 

A real shocker

But real shockers can crop up way after you bought the property as well. As with the building that houses our first apartment. It was built at the end of the 19th century and the basement was prone to be a bit damp. Which wasn’t a big deal and no problem for the two maisonette-apartments concerned which were tiled in that area.

But a few years ago a young family bought one of the apartments and had wood floors laid in the basement. Some time after there was a mould issue. When the floors were taken up in preparation for refurbishment, a technical expert involved assessed that the foundation was not up to today’s statical regulations.

And – whoops, just like that – we were obliged to have a major restructuring project which runs to over half million Euros for the co-ownership. We will be able to deduct the costs from our earnings for tax purposes, but nevertheless we’ll be stuck with a major part. And there goes the rental return for years.

To be fair, we were still lucky in comparison as the property value has risen substantially since we bought 20 years ago. So this additional cost is really unfortunate, but if we wanted to sell, we’d still be pocketing a nice profit. If in a case like this you bought at peak prices and took out a loan as high as possible, you might run into real trouble if you were trying to get additional financing.

 

Don’t forget maintenance costs

Luckily, if you don’t start off with buying a whole apartment house but with a single apartment, you don’t have to shoulder costs for repairs and refurbishments of the common parts on your own. The co-owners regularly contribute a specified amount to savings for ongoing maintenance. Have a look at how large current savings are when you’re interested in an apartment. And find out which future measures – and potentially one-off contributions – have already been signed off.

When buying an apartment house it’s important to know that you will not be able to take over an existing maintenance fund. So you’ll have to build up your own savings from scratch. But if you’re reading this, I assume you’re starting out small. In fact, we only have single apartments which I consider an advantage as far as diversification is concerned. An my impression is that the “volume discount” you used to get when buying an apartment house versus single apartments doesn’t apply at the moment.

 

Co-ownership

The fact that you are only co-owner of the building when buying an apartment does have advantages as the splitting of costs I talked about above. But there are disadvantages that you have to be aware of as well. You can’t decide on your own if or which improvements of the building are carried out. There might be co-owner who don’t pay their share of the common costs. And there might sometimes be infighting among co-owners.

We haven’t encountered any problems of this kind so far. But – interestingly with the apartment I talked about above – we once had a trustee who embezzled the funds of the co-ownership. That’s not funny either, but probably the disreputable exception.

Always look at past year’s budgets and at the protocols of the co-owners meetings. The meetings should take place once a year. The protocols will list all topics that were discussed and voted on. Like this you can quite a good impression of how things stand in the co-ownership.

There seem to be many people who prefer buying in smaller versus larger co-ownerships. My personal view is just the opposite. I might not go extremely big myself. But my impression is that you will always have a certain base level of running and maintenance costs that is somewhat independent of the size of the building. So – particularly when you hold a smaller apartment – you might end up with not only relatively but absolutely lower costs as well in a larger co-ownership.

Right, so this was Part 1. Part 2 will be about the risks associated with taking out real estate loans. Stay tuned.

Financial Independence Rocks!