8 Mistakes To Avoid With Your First Real Estate Investment
You’ve decided to make the jump into real estate investing. A wise choice but not easy. Here are some key mistakes to avoid.
1: Bad Financing
More real estate investors lose money or go out of business from bad financing than from any other mistake.
- High interest rate
- Adjustable interest rate
- High monthly payment
- Balloon payment
- Personal recourse
Most residential bank mortgages at least save you from the first four mistakes because the interest rates are low, fixed for 30 years, with amortizing payments, and there are no balloons. But they almost always require personal recourse, meaning you personally guarantee the loan with your other assets and future earnings. This is probably a reasonable trade-off.
Many commercial, portfolio, hard money, and private lenders, however, do not meet any of these criteria. And that could be a problem, especially on your first deal.
If you borrow at 12 percent interest with a large monthly payment, a balloon due in one to three years, and full personal recourse for the loan, you are likely taking too much risk.
Why? Because the property will likely have negative cash flow with the high interest rate. A balloon note means you will have to refinance or sell in a very short period of time. As many learned in the 2008 credit crisis, trying to refinance when credit dries up is very difficult even with perfect credit and good income. And personal recourse means that if anything goes bad and your lender loses money, they could chase you around and take your other assets in order to collect.
You might think about trading off a higher interest rate and a larger down payment in exchange for a longer loan term and no personal recourse.
The beauty of private financing is that everything is negotiable. But no matter what type of financing you use, be sure to negotiate hard.
2: Bad Location
Real estate value always begins with location. The people and businesses who will rent or buy from you begin with location, and then they evaluate other criteria like the lot and the house.
Because it’s so important, you should study the best and the worst locations in your area before buying. There are investors who make money in bad locations, but it’s a challenging game that beginners should probably avoid.
3: Misjudging Resale or Rent Value
Arguably, your number one job as an investor is to understand how your renters and buyers make buying decisions and then translate that to a value. If you can’t determine the full value potential, you’ll have a tough time making a confident purchase offer that earns a profit.
This is a skill that you must commit to learn and then continue to refine every day for the rest of your investment career.
On your first deal, it’s likely you are not yet an expert on value, so there are a few things you can do to help yourself:
Reduce your target market to a relatively small, manageable area.
Study all of the transactions in your market daily using tools like the MLS, Zillow, or your local tax assessor.
And hire professionals for assistance with determining accurate value.
4: Underestimating Repair Costs
It is inevitable that you will underestimate repair costs at some point. But you want to avoid gross cost overruns that could cause you to run out of cash or face other problems.
To avoid large mistakes, learn a good repair estimating system, and be sure to get help from other more knowledgeable investors or contractors. Don’t be afraid to pay these people for their time and knowledge.
5: Running Out of Cash
Your investment properties are like your race car. Cash is like your car’s fuel. When out of fuel, even the most powerful race car in the world sits still. If you run out of cash, even the best investment property will hurt your wealth building.
So you want to avoid running low or running out of cash.
This usually happens for a couple of reasons:
Underestimating repair costs
Underestimating future capital expenses on a rental property
Capital expenses are big ticket items like a roof or a heating-air system replacement. If these costs hit you unexpectedly, it can become a big problem.
6: Letting Emotions Drive Your Decisions
This is a huge mistake for first time property investors. An abundance of enthusiasm is a good thing because it helps you push ahead through the many obstacles you will face. The key is balancing your enthusiasm with cold, hard, and objective analysis.
Start with with basic criteria, including general locations, neighborhoods, housing types, construction quality, etc, to help narrow down the amount of potential properties.
Then calculate key metrics like the cap rate (or return on asset), the cash on cash return, the discount from full value, and the internal rate of return. Check out What Every Real Estate Investor Needs to Know About Cash Flow by Frank Gallinelli.
Running every deal by someone else like a mentor or advisor is a good idea too.
7: Choosing Bad Contractors
This can be a very costly mistake. Finding contractors who will do good work, finish up on time, clean-up after themselves, and charge reasonable prices is harder than finding buried treasure on a beach. Yet the people who do work on your fix-flip or rental deal will make or break its success.
Experience, referrals, and more referrals will help you find the right contractor. Use the internet and ask friends and family members. Friends who are contractors may not be the best decision.
8: Not Using Your Due Diligence Period
Some experienced investors make offers with fast closings, in as-is condition, and with no due diligence period. This may help them get a lower price, but for your first deal this is probably not the best route to go.
Instead, include a short but reasonable due diligence period that allows you to get out of the purchase contract if you find a problem.
Here are a few of the important things to do during due diligence:
Obtain a very good professional third party property inspection
Get multiple repair estimates
Evaluate zoning and local ordinances
Get a professional third party opinion of value and rental comps
Basically, you want to double check all of the key assumptions you used to make your offer. If you find that you made a bad assumption, you may need to renegotiate or walk from the deal.
Most importantly, if you make these mistakes, learn from them, move on and apply the knowledge to your next deal.