The Five Biggest Mistakes Income-Property Investors Make and How to Avoid Them
Investing in real estate seems so easy. It has low barriers of entry, there is plenty of supply and there always seems to be demand for it. Who couldn’t make money as a landlord?
Well, as it turns out, many people purchase real estate with the goal of renting it for supplemental income or as a retirement nest egg only to find that making a profit can be very difficult. But done correctly, income-property investing is the best vehicle to wealth creation.
Every investment is different but there are certain characteristics they all have in common. These commonalities provide for best practices when purchasing, managing and then selling income properties. It also creates opportunities for common mistakes. There is no substitute for experience but there is no need to reinvent the wheel.
Knowing what the five biggest mistakes income-property investors make and learning how to avoid them will greatly increase the likelihood of your investment not going off track.
Limiting Yourself to a Specific Market
Where you purchase property will be a huge factor in the success of your investment. There are great advantages to investing in your own neighborhood (e.g. easily self-manage, market familiarity, easy access) but the investment environment may not be great.
For example, there is a high barrier of entry from a pricing perspective in many areas of Los Angeles, limiting the opportunity to find properties with strong yields. More cash will also be needed to get started in these markets. On the other hand, long distance management is a huge risk when it comes to investment properties.
Since the Great Recession the income-property market has undergone substantial change. There are now many more institutional investors in the market. And with them, a growing number of regional and national service providers, who can also provide services to small investors.
Advances in technology and data availability, combined with these service providers, allows the small investor to enter markets not geographically close to where they live. Leveraging these resources will allow you to get into markets you never thought would be available.
Improperly Renovating Your Vacancies
Knowing what tenants expect or want is key when determining the extent of renovations to your vacancies. What they want will vary significantly depending on the location and class of the property.
If you over-improve a vacancy, you will find yourself in the position of trying to rent it at an above-market rent in order to justify the capital investment. For instance, installing granite countertops in a market that only expects formica wouldn’t be a good investment because the typical tenant in the area is expecting formica countertops and won’t pay the higher rent for granite. This would limit the return on investment by only marginally impacting the rental rate or sale price.
Technology can really help you avoid over or under improving your property. Simply access one of the many online rental services to see what similar rentals in the area are offering and for what price. You can also check with local professionals such as real estate agents, property managers or contractors. Finally, check out your competition. Visit open houses in the area of your vacancies to see what you are up against.
Not Knowing How to Use Debt
Using debt to leverage into a property will help you in two ways. It will increase your buying power and security by spreading your investment over several properties. For instance, rather than investing $500,000 in one property and taking a smaller loan, you can spread that capital over several properties, each with a larger loan.
Second, if you are able to obtain debt at a relatively low interest rate—and less than the net yield of your investment—you can increase your return on investment to more than if you had paid all cash.
But financing the purchase of income-property comes with substantial risks. Less experienced investors may take on debt with an adjustable rate that could very easily increase to higher than what the investment yields. This puts them in the untenable situation of negative cash flow. The property is not generating enough income to service the debt. In this case, the investor would have to take money out of their pocket each month to make the mortgage payment.
The best way to avoid this is to crunch the numbers before you buy the property. Be confident that the rental income is what it seems and that its future growth is reasonable, that the expenses won’t be higher than anticipated and that there aren’t any needed capital improvements. Having a deep understanding of what these are and what they should be is key. If you don’t have this knowledge, consider hiring a professional manager or just pass on the properties you don’t fully understand.
Doing Everything Yourself
Most new investors try to do everything themselves. They believe they can manage the investment while keeping their regular job or continuing to enjoy their retirement. Even experienced investors who self-manage have to make a substantial time commitment to a new investment. The lack of experience and knowledge of a new investor will only increase the time commitment and frustration level.
It is a challenge even for seasoned investors or their property manager to stay on top of all the moving parts of a income-property investment. Starting an investment without focus or the right resources is a recipe for disaster.
The successful investor surrounds himself with experienced professionals. Managing a property proactively will make the investment significantly more profitable. Before purchasing your investment, have a clear scope of what is involved, a strong understanding of the property’s requirements and a team to assist you with each task. Again, don’t reinvent the wheel.
If you don’t know how to do something, hire someone who does. This would include a real estate agent who has experience with investment property, a property manager familiar with the type of property you are considering and one who has a good knowledge of the market in which you are purchasing, and an attorney and tax advisor familiar with income-property investing. Leverage their experience to maximize your investment.
Not Saving for Repairs and Maintenance
The final common mistake that income-property investors make is not having realistic expectations as far as maintenance costs and capital expenditures. Experienced investors will put money into savings each year, perhaps with monthly contributions. A general rule of thumb is at least 2% of the value of the property, depending on its age and condition. Again experience is important in knowing how much is appropriate.
Novice investors tend to set nothing aside thinking that cash flow will cover all expenses. With this line of thinking, they often find themselves in a bind when a major repair is needed and they don’t have the capital necessary to complete the work. This is one of the biggest reasons new investors lose their property.
Every part of your property has a useful lifespan and will need to be replaced eventually. The best time to assess the remaining useful life is when you are conducting your due diligence before purchasing a property. Knowing the condition of all of its components and how much longer they will last is key to planning for their replacement, either with an adjustment in the purchase price or with enough cash reserves.
Whether flipping houses or purchasing long-term buy-and-hold rental properties, investors who conduct proper due diligence are more likely to be successful. While no deal is perfect and everyone is bound to make mistakes, those who learn from them or set up processes to avoid making them in the first place put themselves in a better position to succeed.