What Are Some Common Mistakes To Avoid As A New Real Estate Investor?
Steve Nabity
September 02, 2024
Introduction
Why did the real estate investor get locked out of his own property? Probably because he made so many mistakes that he couldn’t find the right “key” to success. Maybe that wasn’t a good joke, but the message is important. You wouldn’t want to be the real estate investor that makes common mistakes. Such mistakes can be easily identified and avoided.
So, in order to help new investors save a lot of stress and money, we have decided to write about some common real estate investment mistakes that new investors can avoid. We hope that real estate investments can be more about stable returns and long-term growth rather than painful experiences of getting caught on the wrong end.
Lack of Research and Due Diligence
One of the classic mistakes in any investing, not just real estate investing, is the lack of research and thorough due diligence. Real estate market research is more than just a macroeconomic study. It involves understanding the trends and conditions of the local submarket where a prospective property is located.
At Skyline Point Capital, we closely analyze not just the population and employment trends, but also competitor properties, micromarket dynamics, local laws and tenant regulations, and the overall market cycle before going forward on any deal. There is significant due diligence even after a property goes under contract.
The goal of in-depth research and due diligence is to avoid nasty surprises in the future, minimize risks, and make informed decisions.
Underestimating Costs
Sometimes, to make a deal work or due to a lack of experience, investors may underestimate the cost needed to run and maintain a property. This is a classic mistake that can hit hard a few months down the line. Underestimating costs isn’t just about underplaying the known operational expenses. A problem can also arise when there is a need for unexpected capital expenditure like fixing the roof or carrying out structural repairs. Inaccurate budgeting and financial planning are the culprits if no provisions for such unforeseen events are made.
Vacancy is also like an invisible expense. It results in the loss of income. Plus, when a tenant moves out, there are certain turnover expenses that a property owner has to incur. This could involve cleaning and minor repair work on the unit that has been vacated. One has to have a nuanced understanding of costs and their impact on cash flow before investing in a property.
Over-Leveraging
Another common investing mistake, not just limited to real estate, is over-leveraging. It means taking on too much debt. It results in interest payments being too high to be covered by cash flows generated by the property. Plus, think about all the known and unknown maintenance and capex that you need to take care of while making those mortgage payments every month. Another potential headache can be a hike in interest rates and floating rate loans. A thin debt service coverage ratio can lead to a difficult situation if the Fed suddenly decides to hike rates.
Positive leverage can enhance returns, and there may be a temptation to borrow more. However, seasoned investors tend to finance their deals conservatively. There is a fine balance between boosting returns through leverage and over-leveraging. Another strategy is to build an interest reserve or an emergency fund reserve that can bail you out in difficult moments.
Neglecting Property Management
We often come across properties that are earning incomes far below their potential. They have high vacancies, substantial bad debt, significant deferred capex items, and people don’t get excited about living there. These properties are under-managed. It results in unhappy tenants and a disgruntled property owner who has to foot the bill for serious repair work.
Sometimes, owners believe that they can self-manage a property. This works if the owner has the skills and expertise to professionally manage the property. More importantly, the owner should have the time to manage as property management can be a full-time job for many. The other option is to hire a professional service to get the job done. Sure, it may cost more than self-managing. But, the benefits derived from happy tenants and an efficient operation can certainly cover the cost of a property management service.
Ignoring Market Cycles
Real estate, like many other asset classes, is cyclical. It operates in a discernable cycle – expansion, peak, contraction, and recovery. The trick is to have the insight and expertise to discern to become a successful real estate investor. New investors can sometimes overpay for a property at the peak of the cycle and experience negative equity when values collapse.
Let’s consider a case study. If an investor bought a property in 2007 during the peak cycle, he probably over-leveraged and paid a massive price. When 2008 happened, there was serious pain. But, if the situation is flipped, and if the investor purchases the property in late 2008 or early 2009 at an attractive price, he would be sitting on a decent profit a few years later. It is all about aligning your investment decisions with the market cycles. That is one way returns can be maximized.
Failing to Diversify
This saying is very cliche. But, it still needs to be repeated, so here we go: Do not put all your eggs in one basket. Failing to diversify is a common investment mistake. Getting the asset allocation right makes a huge difference in the final returns delivered by a portfolio. You certainly don’t want to put most (or worse, all) of your money in one asset class. What if that asset class gets hit by some black swan event? You would ideally want to have investments in other low-correlation asset classes to balance out the volatility. Even within real estate, you don’t want to have all your investments in just multifamily, industrial, or commercial. Diversifying across asset classes and sub-segments within an asset class provides a better risk-adjusted return and can result in lower drawdowns.
An example of a well-diversified real estate portfolio could involve a few multifamily units in different geographies, some warehouses, and a few retail or commercial properties.
Emotional Decision Making
As investors, it is important to be objective and make decisions based on what the data suggests. Gut feeling is important as you cannot take emotions out of major decisions. But, emotions mustn’t take over completely and influence your judgment.
Sometimes, you may fall in love with the location of a property. But, the financial performance of the property and its underlying fundamentals may not be favorable. Your emotions may push you to invest in that property but the data indicates otherwise. Cash flow, margin of safety, and return on investment should be the priority. Don’t get us wrong, we are not saying that everyone should turn into robots. Emotions are good, but as Warren Buffet says, they are not good with your money.
One way to make rational decisions systematically is to have a strategy with well-defined rules/parameters. One should also rely on tools, analysis, and a data-driven approach to stay well-informed.
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Overlooking Legal and Regulatory Issues
Knowing the local zoning laws, regulations, and tenant laws is extremely critical before making any real estate investment. We wouldn’t want an investor to buy a property with a plan to repurpose it only to find out that zoning laws do not permit such use. Not knowing tenant laws can also be an issue as it can lead to disputes or penalties. Lease agreements, modifications made to a property, and other post-acquisition plans need to be in sync with the local laws.
As a real estate investor, it is always best to seek legal advice and stay on top of local regulations wherever you plan to invest. Not doing so can lead to nasty surprises later on which can potentially result in a permanent loss of capital.
Not Having an Exit Strategy
As the saying goes, begin with an end in mind. You can only get to your destination if you know where you plan to go. Having a defined exit strategy with some target return range in mind and a timeline for reaching that target are all essential elements of any investment strategy. It brings some structure to a strategy. Otherwise, a discretionary approach may bring in too much emotion and mess with your decision-making.
When you invest in a property to improve it, you need to know how long it will take to renovate, when you will lease out the upgraded units, and how long you will hold the property before putting it up for sale. You need to know how long your capital will remain locked and when you will be ready to pull out the capital for reinvestment.
If there is no exit strategy, and if the market conditions change suddenly, then it can lead to panic and wrong decision-making under pressure.
Getting Started with Smart Real Estate Investing
Any investment journey begins with self-reflection. Investors need to understand their risk appetite, goal for investing, how much capital they are willing to commit, and for how long. Once they have clarity on these things, you can start learning about the nuances of real estate investing.
At Skyline Point Capital, we regularly come out with content that educates real estate investors, entrepreneurs, and business owners who want to earn passive income and grow their capital by investing in real estate. You can check out all our resources here. They include ebooks, podcasts, blogs, and newsletters.
We also encourage you to call us and discuss your investment goals or any questions that you may have about real estate investing. There is no commitment to be made or any sales pitch to be heard. Simply network and learn something new. We learn new things talking to people even if all of them do not invest with us.
Conclusion
Now that you are aware of some common mistakes that real estate investors make, you hopefully won’t make them in the future. We covered the importance of doing thorough due diligence, not over-leveraging, keeping emotions in check, running the property professionally, being aware of market cycles, and knowing the local regulations before investing. We also touched upon portfolio allocation and diversification. Lastly, we discussed why you should have an exit strategy in place before you invest.
We highly encourage you to join The Founders Investors Club,. where we talk about live investment opportunities. We only share information on deals we are looking to invest in and have vetted thoroughly. We encourage you to check out our free resources to learn about real estate investing.
