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  • Writer's pictureNicholas Pihl

When real estate is risky

One key principle of good wealth management is to store your money in things that hold their value. This is good investing advice as well, I think. The best solution, in my mind, is to spread your wealth across a broad range of high quality investments, don't take too much risk, and avoid situations where a single bad event can ruin your financial future.

Does buying an investment property pass these tests? I don't think so. At least, not for most people with less than $5,000,000 of assets.

First, for most people, the minimum purchase price for these investments will represent a large percentage of their net worth. When your goal is to preserve your wealth, such concentration is ill-advised because it amplifies your exposure to that risk. If something big and negative were to happen to that property, it could have a ruinous impact on your finances.

Natural disasters are high on that list of "big and negative things that can happen to your property." Worse still, many of the most devastating natural (and unnatural) disasters aren't covered by insurance companies. Commonly excluded "perils" include wildfires, flooding, earthquakes, and landslides.

If you're like me, living in the Pacific Northwest, those are exactly the risks to your property that keep you up at night. You have virtually no control over these events, and stand to lose a LOT if one of them were to happen. Yet they're excluded by most insurance companies.

The reason for this is that insurance collect premiums from a large base of people, and use those premiums to pay out claims to people who experience accidents and other unexpected expenses. When most of the people paying premiums live in the same area, and are all affected by the same major disaster, what happens then? Well, the insurance company simply doesn't have the money to pay out those claims.

So the insurance companies stick to covering only the events that they can afford to pay out benefits for.

What troubles me most about this is that the risk of natural disasters seems to be increasing with time. As a kid growing up in Oregon, we almost never had wildfires. Now, we're affected by them almost every year. Even after a very wet and cloudy spring last year, we still had them!

Real estate comes with a number of other, invisible risks. Economic shifts can undermine the economy of an entire region. Consider what happened to Detroit and the other major manufacturing cities in the rust belt. These were once prosperous boom-towns. Sadly, that's no longer the case. Those jobs and factories are gone, along with real estate values.

Drought is another risk that can devastate entire regions. We NEED water, not only for personal living uses, but also for farming and industry. Manufacturing, for instance, requires tremendous amounts of water. What happens when a region dries up? What happens to those jobs? Those renters? Those property values?

And then you have interest rate risk. Look at what has happened to home sales this year as interest rates have risen. New buyers are almost nowhere to be found. Meanwhile, any plans you may have had to refinance and buy another property are unlikely to pencil out at these higher mortgage rates.

Recessions are also a tough environment for real estate investments. Even ignoring the decline in value of your property, what happens if your tenants lose their jobs? You'll still have the mortgage to pay, but that money will have to come from somewhere else if you can't find a paying tenant.

And on a personal note, what do you do in that scenario? Do you want to be the person to evict someone when they're on hard times?

Tenants come with other risks. What if they damage the property, or fail to report important maintenance needs? What if they have a party and one of their guests falls down the stairs and breaks their neck? As owner, you're usually liable.

At a minimum, events like these will hurt your investment returns. And that's if you're lucky. Any one of these things also carry the risk of destroying your financial freedom. I'm just not a fan of that.

"But I thought real estate was supposed to be safe!"

Ask someone who invested in Detroit back in its heyday. Ask someone whose tenants stripped the copper piping out of their walls. Ask someone who couldn't get tenants to pay during Covid. They'll all tell you the same thing, it's very possible to lose money in real estate.

But the thing about risk is that it either happens or it doesn't. Flip a coin. Sometimes it will come up heads several times in a row. In that moment, it will seem like the risk of getting tails is relatively low. But does that mean you should bet half your net worth that it will turn up heads again? Of course not. We all know that if you flip a coin 1000 times and you'll get something close to 500 heads and 500 tails. The same way we know that it might someday be our house that gets hit by an earthquake, or a once-in-a-century flood.

As more time passes, the more likely any given risk is to materialize. If something has a 5% chance of happening in any one year, it has a 64% chance of happening at some point in 20 years. Even a seemingly negligible 1% risk annually has an 18% chance of happening at some point over that same timeframe. If I'm betting a large portion of my net worth, I don't particularly like those odds.

So what's the best thing to do? Should you not buy a home? Should you hold all your assets in cash and gold coins? Let's return to what I said at the top of this article, "The best solution, in my mind, is to spread your wealth across a broad range of high quality investments, don't take too much risk, and avoid situations where a single bad event can ruin your financial future."

You need a positive return on your money just to keep up with inflation. Getting that requires at least some risk. Too, if you want to grow and replenish your assets throughout a 35 year retirement, you'll need a little extra growth beyond inflation. That too, requires accepting some risk. But you'll notice, inflation is its own risk. Outliving your money is a risk (in fact, it's the biggest risk for retirees). And doing nothing means letting those risks grow over time, both in likelihood of happening, and severity of impact when they do happen.

As a result of these long term risks, most people need to accept at least some amount of market risk so that their assets and income keep up with inflation and their future living expenses. But notice what risks they don't need to take: wildfires, earthquakes, bad tenants, unlucky tenants, unexpected property damage or personal liability. Retirees just don't need to take risks that contain an all or nothing outcome. Especially "all or nothing" outcomes that dictate a huge chunk of their net worth.

Life is full of risk. There's healthy risk that leads to good returns. And there's unhealthy risk that is both catastrophic in impact, and unnecessary in the first place. But sadly there's no option with zero risk. That's life.

All you get to do with that information is decide which risks are acceptable for your situation. This is a key part of what I help clients with as I create their personalized retirement plans. I help them avoid or mitigate those big, dramatic risks, as well as prepare for the invisible risks like inflation that sneak up on you over time. And I help them determine what amount of risk is necessary and acceptable when it comes to their investment portfolios.

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