What’s happening in the Long Island real estate market should make investors take notice. In 2018, house flippers there managed an average return of just 3.2% after expenses.
The fact is: While savvy investors can achieve gains of 15–20% (or more), many flippers are losing money. This has occurred for a number of reasons, from overbidding initially to not factoring in carrying costs.
After all, construction expenses, mortgage payments, utility bills, and more add up. It eats into profits over time.
How can you deal with the capital risk of real estate investments?
Quite frankly, you need the right strategy.
First, you must buy right. Do your due diligence, don’t overbid just to win the deal, and buy properties with wide potential buyer pools.
Second, have a renovation plan that you can execute quickly. That entails having permits ready, construction costs dialed in, and experienced contractors already scheduled.
Third, begin marketing and presale as quickly as possible. This earlier you begin this process, the more time you have to achieve your end goals.
In the rest of this article, we’ll go into greater detail on how you can successfully manage capital risk in real estate investments. This way, you are always in the best position throughout all phases of the investment.
Want to learn more about real estate risk management? Check out our other articles in our series on Risk.
Internal Risk Management
External Risk Management
Avoid the most common mistakes with capital risk management
If you don’t want to lose out on your investment, you must do your due diligence and analysis. You have to analyze your deal with conservative numbers and you can’t think everything will be best-case scenario. This ensures you prepare yourself well.
When managing capital risk, keep in mind the common mistakes investors make. These include:
- Underestimating the renovation budget
- Note: Underestimating the cost of renovation could lead you to overpay for a property. The 70% rule says that an investor should have the goal of paying no more than 70% of a home’s after-repair value (ARV). So if a multi-family property costs $300,000 but needs $50,000 in upgrades, you should aim to pay no more than $160,000.
- Mis-analyzing your as-is and ARV values (don’t simply trust real estate brokers and wholesalers)
- Only obtaining one bid for your renovation budget, or not even obtaining bids (read over this guide on hiring a general contractor)
- Expecting appreciation and market improvement
- Warning! Don’t get caught in market hysteria, like what we saw before the 2008 housing crisis.
- Assuming that a higher-end home will fit into a lower-end neighborhood
- Using only the best sales comps
- Note: While you should use tools to determine a property’s value and analyze similar homes, make sure you get the whole picture. There’s no guarantee you’ll sell your home at the highest price.
Know what you can afford
The number one reason real estate investment deals fail is because they’re undercapitalized. This typically happens due to a lack of capital planning. Investors don’t review all the capital risks throughout the investment and either take a short-sighted approach, or they disregard the long-term capital needs of a given project.
“Investors must plan for all phases of the investment: acquisition; re-position; disposition; and re-capitalization. When an investor doesn’t have adequate capital for any stage, a deal can go awry,” states Nathan Trunfio, President of Direct Lending Partners.
Simply put, investors can’t make the mistake of simply planning for the acquisition. You have to have funds for all phases of the real estate investment.
So, what’s the solution?
You should begin by knowing the amount of leverage you can get. Don’t have unrealistic expectations here. When you look at deals, get preapproved before you bid on properties. This way, you’ll know exactly how much the lender can give and how much you need to bring.
“Identify the cash you need to close. When managing capital risk, you must have a good estimate of all costs that come with closing the deal and overseeing the property. We’ve seen too many deals when the operator nears closing and we find out they don’t have the capital to fund the entire project and relevant holding costs. You must have an accurate idea of the capital you need,” adds Trunfio.
On their end, investors must work to mitigate deal risks so that you don’t make mistakes (paying too much, misjudging cash flow, neglecting due diligence, etc). Account for external risks that could impact your investment too, such as market conditions and liquidity risk. This ensures more accurate projections of the cash you’ll need throughout the investment.
To avoid the pitfall of being under-capitalized, diligently plan for all investment phases. Running out of money, or not allocating enough for future expenses, can get you trapped into a tough investment situation.
Find a reliable capital partner
As a real estate investor, you rely on a capital partner to be there every time at the closing table. This way, you don’t lose deals.
While traditional financing with banks offers advantages, such as lower interest rates, it could cause you to miss out on potentially lucrative deals. This is why traditional loans suit those personal residences and more long-term residences.
If you plan to flip homes, build to sell, buy a rental property, refinance or cash out, or need a bridge loan, know that you’re in a time-sensitive game. And time-sensitive loans require fast appraisal and approval so that you don’t miss the right deals.
With traditional banks, having to wait several weeks, if not months, to get loan approval could damage your returns. You can’t take that risk.
Therefore, short-term loan providers of real estate investors are the best way to manage capital risk. Investors can get the funding they need within a week. This ensures they don’t lose out on good investment opportunities that can disappear as quickly as they present themselves.
For example, at Direct Lending Partners, we can close loans extremely quickly, as we fund all deals directly. We’ve helped investors close in as little as five days. Typically, we lend 80–90% of the total purchase price and renovation costs, and up to 70% of the after-repair value. This means that borrowers are expected to bring 10–20% of the total project cost to the table.
When you partner with a lender, look for the team that’s focused on your success. They will help you handle capital risks and navigate the entire investment.
The best lenders make certain you have enough equity for your deals and can scale with the resources you have. They see if you have funds for additional expenses, such as closing costs and capital needed for upgrades. They analyze holding costs throughout a deal, such as debt service, HOA fees, and taxes.
It is important that you have money set aside for repositioning and renovation. And you should have additional capital to deal with unknown problems that rear their ugly heads after closing.
“If you don’t know how much money you’re going to need, how can you go bid on a deal? At DLP, we want to ensure you’re well capitalized to navigate through your entire business strategy. We want to make sure that you have all the money needed from acquisition to disposition, and we also encourage you to have contingency monies or reserves in order to fund the unexpected. Overall, don’t cut corners and think that you can ‘figure it out later.’ This will only lead to issues, stress, and potential bad decisions,” attests Trunfio.
Maximizing return through effective capital risk management
Success in real estate investing depends on your ability to manage risk, especially capital risk. Thinking through all phases of your investment not only ensures you don’t lose out on deals or suffer bad returns (or losses), but it also puts you in a position of strength.
Proper capital risk management with real estate investments can boost your returns and give you momentum to scale your operation. With the right process, you can achieve success over and over again. Then, your potential will be limitless.
Of course, you must ensure your deal has sufficient funds. That means doing what you can on your end to meet cash needs, as well as partnering with a reliable capital partner. Start handling capital risk by getting funds from someone you can trust: