August 9, 2019
This article originally appeared on The Smart Investor, an online academy helping people invest smarter and make better financial decisions.
Last Updated: August 6, 2019
As a real estate investor, the experience is going to be necessary to get far, but the more you know before you start, the better off you’ll be. Here are the 7 most common mistakes that first time real estate investors make – and how to avoid them.
If you’ve heard about real estate investing you may be interested in trying it out for yourself, but it’s not always easy. Some people are able to get into the market and get results quickly. Others … tend to have a harder time with it. The great news is there’s something you can do about improving your chances. You just need to know what these important mistakes are, so you can avoid them for yourself.
“Real estate investing has created more millionaires than any other asset class. But it also can be fraught with peril for the uninformed investor” says Alan Lewis, DiversyFund’s Co-Founder & Chief Investment Officer.
“These same inexperienced investors tend to underestimate or entirely miss some of the costs involved with real estate investing and are overly optimistic on their numbers. I’ve seen first-time investors run the numbers on a new deal and miss critical costs like debt service or property taxes on their spreadsheets”.
When you’re in real estate investing, numbers are your best friend. You have to know how you’re going to make money on the project, after all. The important thing is to do a simple cash flow calculation that shows you the income you’ll get from any kind of rental especially, but also properties you’re going to flip.
You’re not going to get a great investment out of everything you try. In fact, you might find that some properties won’t be worthwhile even if you make a whole lot off of them. That’s why it’s crucial to run the numbers on everything before you make a bid.
According to Lewis, investors should make sure they adjust their assumptions. “We see some sponsors that are very aggressive in their pro forma assumptions like exit cap rates, year over year rent growth and operating costs for multifamily deals. Many of these key assumptions are based on local market comparables”.
At the very least you’re going to need to know the mortgage payments, insurance, repair costs, ongoing maintenance costs, taxes and anything else that you can tell the place needs immediately. Then, look at how much the place will be worth after you’re done and how much properties are selling or renting for in the area. If you’re not going to make some money, then it’s definitely not the kind of deal you want to go for.
“Another mistake that first time investors make is not questioning the comparables to make sure that they are apples to apples with the proposed deal. I’ve seen sponsors use a Class A multifamily comparable sale cap rate for their Class C value add deal. That’s just not a true comparable at all”, says Lewis.
The numbers are going to let you know what to do. You also need to play around with the numbers to find out where your best possible outcome is, where the breakeven is and where you’re not going to make money. That way you know what you can afford to do and still make this a profitable deal. You also want to think about how much it’s going to cost for repairs. Don’t estimate too low, as most new investors tend to do.
Generally, first-time investors go at real estate investing as a part-time gig, while they’re still working a regular job. Then, they try to do it all on their own. The problem is, you don’t really know what you’re doing, and you don’t have a whole lot of time to devote to the project. That means, most people fail the first time around.
“The biggest mistake we see with first-time investors is when they try to do deals themselves and woefully underestimate the amount of effort that goes into successfully sourcing and managing any real estate deal”, says Lewis.
It takes a lot of time, effort and hard work to keep track of everything that goes into managing your investment. If you don’t have a full-time period to work on it, you’re going to struggle. Spending just a few hours a week is going to cause you a whole lot of problems in the long run.
So, if you’re starting without having a dedicated plan in place you might be off track before you even get moving. That’s why it’s important to know exactly what you’re going to do, what’s going to be required for the specific project and who is going to take care of it.
Make sure you’re being proactive about everything that you do in your real estate investments. That way you’re going to have a great team that can keep you on track and makes sure that you’re meeting your goals. It takes a skilled and knowledgeable team to get you moving in the right direction.
If you want to be successful in anything you need to have goals. Whether they’re long term or short term, you need to know where you’re going.
When you’re brand new, it gets to be quite exciting. You always want to be going after the next deal and the next. And you might find yourself going for deals that don’t fit your comfort zone or have a high-risk level. The important thing is to have a goal that makes sure each project you undertake fits the plan. Not only that but your goals serve as a type of motivation for when things start to get hard. They give you something to keep pushing forward on. Not to mention, they keep you right on course.
When you’re looking to make your mark in real estate investing, step one is going to be setting goals and then learning how you’re going to get there.
Think about it in terms of what you want in the short term and the long term and then figure out how you can create a strategy that fits.
Have you ever thought about how much it’s going to cost to maintain a piece of property? Any property you buy, even if it seems like it’s in immaculate condition, is going to need some form of maintenance. An experienced investor will know to put aside at least 2% of the value of the property every year to account for any of these potential costs.
According to Lewis, such surprises are inevitable. “Every real estate deal, be it commercial or residential, will always have a few surprises. First-time investors often fail to bake in a contingency expense for these unanticipated costs that can quickly kill a deal’s profitability. I’ve seen sponsored deals where the reserve line item for Capex is way too low for the asset’s age and that mistake will always bite you in the end”, says Lewis.
Those who are new, however, tend to ignore the idea of repairs or maintenance and then they end up surprised when something is needed. You may find yourself without the much-needed funds. If you’re looking for an investment property you need to think about the fact that this is a permanent investment for you and there’s always going to be something that needs to be done. At some point in the lifespan of the property it will need repairs, right? Pay attention to what could happen so you’re prepared whenever it does.
If you’re looking to flip a house or you’re looking to rent it out for a long time you need to do your due diligence.
You need to look at everything that could happen and you need to learn from your mistakes whenever you do make them. That puts you be in the right position when you’re moving forward.
Do not let your heart rule on any of the decisions when it comes to buying or selling a property.
If you let your emotions get involved too much you could end up making the wrong choices and you may end up spending more than you actually need to as well.
Some people tend to just fall in love with different properties. They feel like everything is going great and they’re doing great on the property and cash flow. They may also feel like they have an amazing group of tenants as well. But the important thing is that you need to be more objective. Always know that you should be aware of the situation and don’t let your emotions rule on any of it. Buy based on the numbers.
When you’re looking to finance a property that you’re going to use for investment purposes it’s crucial that you get the right type of advice. Far too many people think that it’s most important to get a cheaper mortgage and may spend hours researching ways to cut a few bucks here and there. On the other hand, it’s important to look at the real estate market conditions instead. The key is to spend your time where it counts. Don’t haggle so much on the mortgage when you could be more constructive at auction.
“Most first time investors are better suited investing with an experienced real estate sponsor that takes care of all the work involved. Even then, first-time investors should be wary of the mistakes made in looking at a sponsor’s deal”, Lewis Says.
Keep in mind that your interest is usually going to be tax deductible, but that doesn’t mean that everything about your purchase will be. Some of the costs to borrow are not actually deductible. That means you want to know how to structure the loan and how to make sure that you have the right features built into it. A financial advisor can help you with this process. Make sure you keep your investment property loans and your personal home loans separate as well. You want to get the most tax benefits you can, after all.
Now, when it comes to a fixed or variable rate loan you get to make the decision on what works best for you, but be careful. Variable rates are generally going to be the less expensive option over time, but if you can get in while the rates are low you’re going to do great with a fixed rate. Keep in mind, however, that when interest rates rise it usually means property prices rise too, which means that you’re going to have a great time for selling a property.
If at all possible, you want to opt for an interest-only loan because it’s going to give you better tax breaks. This is especially important if you already own your own property that you use personally. Still, look at things like flexibility and how you’re going to make the payments. With these types of properties, you’ll be able to get even better balance when it comes to paying off the mortgage along the way.