What is the risk of rent income?
Real estate investment is often very large compared to stock investment. If you succeed, you will get a stable profit, but if you fail, you will regularly lose. Therefore, if you do not fully understand the characteristics and risks of real estate, you cannot make a successful investment. So what are the specific risks involved in real estate investment? This time we will discuss the risks associated with income from real estate.
Vacancy risk (vacancy is negative, not zero income)
The main source of income from real estate investment is the monthly rent income earned by lessee (residents, tenants) by renting real estate. Therefore, if lessee moves out for some reason, owner will not be able to earn rent income until owner finds a new lessee. Moreover, as a property of real estate, management costs, property taxes, city planning taxes, and other expenses are incurred regardless of whether there is a lessee or not. Therefore, if rent income does not come in due to vacancy, the balance will be not zero, but negative. For example, if six months of the year are vacant and you cannot get rent, the rent income will of course be halved, but expenses will be incurred throughout the year, so the actual income and yield will be less than half.
Early termination system advantageous to Lessee
When entering into a lease agreement between the lessor and the lessee, the contract period is usually set for 2 to 3 years. However, even during the term of the contract, it is possible to cancel the contract in advance, excluding special contract types, by prior notice from the lessee (6 months to 1 month). In other words, for the lessor, the contract period specified in the lease contract is only expected to earn rent income, and even during the contract period, there is always the risk of being canceled early (vacant).
When land prices, commodity prices, and rents were rising, it was called the “lender market” and it was relatively easy to secure a new tenants even when there were vacancies. Also, at that time, land prices and rents were on the rise, so in some cases owners were able to rent under conditions that were more favorable than previous rents. In addition, key money and other lump-sum payments can also be received, so the early cancellation by the lessee was not a major issue. However, with the increase in the supply of rental properties, the number of vacancies has increased, and the polarization of land prices and rents is now remarkable, and it is called the “borrower market”, it's becoming a serious problem for the lessor whether or not a new lessee can be secured promptly after the tenant moves out, and whether the lessee can pay at the previous rent level. In the current “borrower market”, stable income cannot be obtained unless the next step is taken promptly when it becomes clear that the lessee has terminated early or has terminated.
Risk associated with falling rent
If the rent obtained from the real estate to be invested is higher than the market price in the neighborhood, there is a high possibility that you will be forced to reduce the rent at the same level as the neighboring market at the time of contract renewal or when the lessee is replaced. Therefore, even if the yield at the time of purchasing a property is high, the rent may be reduced in the future due to the replacement of the lessee, negotiations for reducing the rent, etc., and as a result, the yield may decrease.
Risk of rent arrearage (rent arrearage are harder to handle than vacancies)
Even if the lessee has already been secured and there is no concern about vacancy for a while, but there is a risk of the rent will not be paid as planned due to the economical situation of the borrower and individual circumstances, etc. If the rent is overdue, a reminder to the lessee and a reminder to the guarantor will be required. In addition, if you request a real estate agent or lawyer to do business for moving out due to demand for rent, collection, or nonpayment of rent, there will be a charge. Thus, in addition to the effort and expense involved in paying rent in arrears, you may suffer even more damage than if the property were vacant, since you will not be able to secure a new tenant and generate income in the meantime. Even if the eviction is established, it is not known whether the rent for non-payment can be recovered or not.
Therefore, if you are investing in real estate, you will need to conduct a thorough investigation into the creditworthiness of guarantor as well as the creditworthiness of the lessee. It is desirable to investigate the lessee's past arrears history when buying the real estate that is already in lease.
Investing involves risk, and there is no investment product without risk. In real estate investment, a thorough understanding of the characteristics of these risks will determine the success or failure of your investment. In addition, the various risks associated with rental income discussed in this article can be mitigated to some extent through your own efforts, ingenuity and judgment. We will discuss ways to mitigate these risks in the next section.
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Arrows International Realty Corp.