Real estate has always been one of the great equalizers in wealth creation in the U.S. As a tangible asset with generally low barriers to entry, people from all walks of life and income levels have succeeded in building real estate empires.
The numerous success stories coupled with the potential for lofty returns make the asset class tantalizing, but taking the plunge into real estate investing is not something to be taken lightly. Investors breaking into real estate should conduct a substantial amount of research and diligence before getting started to help safeguard against rookie mistakes.
In the modern age of information, access to a variety of resources is plentiful. The old adage that “failure is the key to success” may be avoided on a personal level by learning from the experiences of other investors to make smarter decisions going forward.
While there’s no denying that experience is a great way to learn, you can leverage a number of resources to avoid common mistakes. Here are five of the most common mistakes made by new investors and how to avoid them in your next deal.
Limiting yourself to a specific market. When it comes time to choose where to invest, your home market may feel like the safest place to start because it’s familiar, but that doesn’t necessarily mean it is the best option. Opportunity doesn’t have borders, and that should always be a consideration as you look for your next investment.
For example: It’s tough for someone living in an expensive metro area like New York or Los Angeles to find long-term rentals in their immediate area that generate strong yields, let alone get over the high barrier to entry from a price perspective. There are dozens of other markets across the country that are displaying economic stability, strong housing demand and high returns, so why eliminate those markets from contention?
Advances in technology, data and services have been a critical development in allowing investors to research and enter markets across the nation as they search for better investment opportunities.
Thanks to the institutional investors that have entered the single-family residential sector, there are now a growing number of national and regional service providers that provide resources to small investors in a way that historically didn’t exist.
Accessing these service providers across the country offers investors transparency and clarity into opportunities outside of their home markets, empowering them to transact in top-performing investment markets and feel secure in their team and decisions.
Over- or under-renovating. Understanding the level of renovations a rental property needs is key to a successful deal. Real estate investors should aim to renovate to the level of local market condition and realize that renovations can vary from neighborhood to neighborhood, even in the same city.
Regardless of the condition of the property, understanding the scope of the renovation is a bespoke analysis that requires focus. Investors may find themselves in a difficult situation when they renovate beyond what the market dictates. If all the homes in an area have tile countertops, adding granite countertops probably wouldn’t be a worthy investment as it wouldn’t cater to the typical renter or owner in that neighborhood. This could limit the return on investment by only having a marginal impact on the rental rate or sale price.
You may avoid over- or under-renovating by simply talking to your team of local professionals, including a real estate agent, property manager, contractor, etc. They are market experts and should be able to help you decide on worthy improvements.
You can also tour other houses in the area when possible or use online resources to see photos and scope out the local competition. Doing your diligence before initiating any renovation projects may boost your returns and protect you against wasting time and money on the wrong renovations.
Not understanding how debt works. Real estate investors typically use debt for two reasons:
- To expand their buying power. Rather than spending $100,000 of equity on a single property, financing can allow that same $100,000 to go further by spreading it out among several properties with a smaller down payment on each property.
- To improve returns. If an investor is able to obtain debt at a lower interest rate than the net yield of investment, the levered return of the investment is higher than if it was paid for with cash.
Both functions of leverage may be very attractive, but obtaining debt does not come without its risks, which is what novice investors should be wary of.
Less experienced investors may take on expensive debt that charges a higher interest rate than the investment yields. In that situation, you will experience negative cash flow, as the net income of the real estate investment is less than the monthly debt service. Now you’re forced to take money out of pocket to make up for this shortfall in order to keep the loan current and avoid defaulting.
The best way to avoid this scenario is to crunch the numbers of a deal and confidently know that the property will generate enough revenue to cover the loan amount. It’s also important to have a deep understanding of the costs and expenses that will be included in the operation and maintenance of the property.
Doing everything yourself. Most investors take on their first few deals as a part-time opportunity in addition to their primary profession and try to tackle the investment without any outside help. Given the lack of time available coupled with general inexperience investing, it’s not surprising how often people fail when employing this strategy.
It can be a challenge to stay on top of all the moving pieces involved in a real estate investment when it is your full-time profession, so what chance do you have if you’re only dedicating a few hours per week to a property?
Starting a real estate investment without focus or the right resources can put even the best deal in a bad position. Instead, before getting started make sure to have a clear scope of work, a strong understanding of what a property requires and someone assigned to complete each task.
Managing the project proactively rather than reactively can be a saving grace in real estate investments. It allows for you to assemble the right team who will be able to help keep your investment goals on track. Again, don’t reinvent the wheel. Leverage the experts you have at your disposal who can provide you with support.
Not saving for repairs and maintenance: The final common mistake that investors make is not having realistic expectations as far as maintenance costs and capital expenditures. Most sophisticated investors will set aside at least 2 percent of the value of the property into a reserve account on an annual basis for these potential costs.
Novices tend to set nothing aside and are in a tough situation when a major repair is needed or when replacing a critical component, as they don’t have the capital necessary to complete the work. Remember, everything in your investment has a lifespan and will need to be replaced eventually.
The best place to start when taking on any type of new project is with preparation. By knowing the most common pitfalls and having a plan in place to avoid them, new investors can find success in real estate investing.
Whether flipping houses or purchasing long-term buy-and-hold rental properties, investors who do their diligence are much more likely to find repeat success. While no deal is perfect and everyone is bound to make a mistake or two, those who learn from them and set up processes to avoid making them again in the future put themselves in a position to succeed going forward.