Investors are constantly flooded with advice about how to invest in real estate. The vast amount of that advice is about what you should be doing. Very little is about what not to do. A good businessperson understands both the good and the bad about their business. New investors need to understand both the upside and the potential downside of their real estate investing opportunities.
You don’t need to reinvent the wheel. Real estate investing is among the oldest professions. You can and should learn from those who came before you. You will make mistakes but make them your unique mistakes. That way there will be fewer mistakes to work through. Here is where you begin:
1. Not thinking outside your home market. It’s easy to become enamored with your hometown market because you are so familiar with it. It is critically important that you fully understand the market you are investing in. But it’s also important that you not be narrow-sighted. Research and explore other possible markets. That doesn’t mean jumping into the most promising market before you understand it. However, it does broaden your vision to identify possibly bigger gold nuggets that you can learn the details about.
2. Not having an exit strategy. A deal that appears to be a bargain at first glance isn’t worth a dime if you don’t know how you are going to make your profit. Remember that it’s a bargain for a reason. Investors are always looking for distressed properties but buying for dimes on the dollar will leave you with only dimes if you don’t have a solid plan to make the dollars.
3. Avoid too risky financing. There’s a lot of money out there to finance your investments. There are high-interest loans and low-interest loans. There are personal recourse loans and non-recourse loans. There are balloon payments and 30-year loans. Each comes with tradeoffs that lenders use to manage their risk. You need to carefully select your financing source to manage your own risk and match your investing objective.
4. Underestimating costs and overestimating profits. Beginning investors are typically overzealous about the profit potential. This can lead to underestimating costs and overestimating profits. A good rule of thumb is to diligently include every possible cost. Then increase your cost estimate by 15% to 20%. Do the opposite with the profit calculation. Determine what you realistically think you can make. Then decrease that by 15% to 20%. If you still see a profit, you have a relatively low-risk investment opportunity. This lowball strategy almost eliminates the chance you’ll lose money.
5. Not managing cash flow. This is part of both your financing and managing of the property after the investment. Some loans come with milestones. Partial funds are only released as defined goals are completed. You need a backup plan if one part of a project runs over budget. This is why some lenders require you to have reserve funds that are separate from the primary loan. Another potential problem is not reserving cash for maintenance and repairs. After renovating a property, you may not plan to invest any more money for three years or more. But you need to have a maintenance and repair fund just the same. Another potential pitfall is not having cash for holding costs if the ready-to-occupy property sits vacant for 90 or 120 days.
6. Not keeping an eye on the property. A fellow investor once found his rental house destroyed after the renter moved 2 of her friends and 7 kids into an 800-square-foot house. The rent check was coming in every month, and no one was complaining that repairs needed to be made. He thought everything was good and just sat back collecting the rent. Unfortunately, when she moved out two years later, he thought a bomb had gone off in the house.
You need to visit your tenants occasionally. Do it frequently when they first move in. Just knock on the front door and ask them how everything is going. If they complain about something being broken, you can go inside to see what the problem is. You will save yourself a lot of trouble just by checking up once in a while.
7. Manage your property. Many beginners treat investment properties as a hobby. This is not a hobby, it’s a business. Before you buy, you need to know the numbers. Know what your return on investment will be. Keep good accounting books so that you can write off expenses on your taxes. Keep good repair records. Over the years, you’ll buy new appliances and other features for the house. You’ll have a record of your actual costs. Someday you’ll want to sell the house and being able to show repairs, maintenance, and improvement records will bring you a higher selling price as well as being able to file accurate expenses as capital gain tax write-offs.
By no means is this a complete list of mistakes that beginning and even experienced investors need to anticipate. These are only some of the most common. What’s important is that in your enthusiasm, you fully understand both the opportunities and possible consequences before investing your time and money.
What potential mistakes do you think investors should be watching for? Please comment below.
Also, our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions, inquiries, or article ideas to [email protected].