Three major financial mistakes, and how to avoid them

Don’t let these mistakes ruin your deal and kill your cash flow

What’s more important to you? Finding a good deal? Or avoiding a bad one?

One of the biggest challenges faced by real estate investors everywhere is finding the right properties to buy at the right price.

As a long-term buy and hold investor, I have the same challenge. In fact, when I started looking at investment properties, I made some financial mistakes due to lack of experience.

The upside is that I started investing – not just talking about it – and learned a tremendous amount in the process. Because of my mistakes, I better understood what to look for the next time and improved my approach.

Ultimately, some of the biggest mistakes an investor can make are financial. Poor choices not only cause you to lose money, time and effort, but a badly structured deal can quickly – or sometimes slowly – drain you of resources month after month.

While real estate investing carries risk, you can significantly improve your chances of buying right when you avoid these three major financial mistakes.

Mistake 1: Overpay

When you overpay to begin with, your upfront acquisition costs are higher. If you finance the property, your monthly mortgage payments will also be higher, impacting net cash flow. Positive net cash flow is critical, because it’s the lifeblood of a buy-and-hold investment strategy.

Positive cash flow, or money coming in, means the investment is making money. If your property depreciates in value, positive cash flow can keep you going and sustain the investment.

Negative cash flow, or money going out, means the investment is losing money. This isn’t a sustainable strategy, and as a result, investors have to subsidize the losses.

Avoid this mistake by:

• Carefully evaluating the whole deal, not just purchase price. Your goal is to generate positive net cash flow. That means income exceeds expenses, ideally by a generous amount.
• Understanding the property’s market value. Single family homes and properties with up to four units are valued based on comparable sales of similar homes. A knowledgeable real estate agent can provide you with a comparative market analysis. Or use sites such as Zillow or RedFin to look up prices for similar properties recently sold in the area.
• Looking for properties that are undervalued to begin with. Often, these homes are outdated, need repairs or have problems that make them less attractive to most home buyers. Just make sure the amount you pay for the property, combined with the amount to repair or improve it, still represents positive net cash flow and a reasonable return.
• Walking away from high priced deals. Overpriced properties, stubborn sellers, bidding wars and failed negotiations are part of the terrain. Other properties are out there, and sometimes it’s best to just walk away.

Mistake 2: Underestimate expenses

The place looked great – bright and open, fresh paint, new carpet and appliances. My first investment property was sparkling clean, newly updated and ready to rent. All I had to do was buy it, find a renter and celebrate my success.

Then reality set in. I hadn’t planned that it would sit empty for several months. Or that insurance costs would be so high. Or that a special assessment would kick in.

There’s a much greater chance that you’ll overlook expenses instead of income in your evaluation. Even small amounts add up quickly.

Avoid this mistake by:

• Verifying expenses. Call an insurance agent to get a reliable estimate. Check with the city or county on pending assessments. Call the homeowners association to see if improvements are planned. Check all sources, don’t take someone’s word for it.
• Looking beyond PITI. When you finance a property, it’s important to look beyond the cost of principle (P), interest (I), taxes (T) and insurance (I). These are important costs to consider, but there are many more.

Whether you pay cash or finance a property, other expenses can include: closing costs, property management fees, utilities, lawn care, snow removal, city license or inspection fees, homeowner association fees, repairs and routine maintenance.

Less common expenses include special assessments made by cities, counties or homeowner associations. You need to know about these ahead of time so you can include them in your evaluation.

• Planning for vacancies. Vacancy (when the property is empty) and credit loss (uncollected rent) cause lost income. Account for these in your cash flow analysis to ensure you can withstand the loss. I generally calculate 8-10% of income to account for potential loss, but it varies by property.
• Maintaining an emergency fund with cash reserves. If an unforeseen expense crops up, an emergency fund can be used to cover the cost and cushion the financial impact. It’s wise to start with a reserve fund with three to six months worth of mortgage and operating expenses.

Mistake 3: Bank on appreciation

Ten years ago, I counted on appreciation to improve my deal. Housing prices were rapidly increasing, and I choose a market that was especially hot.

Fast forward to 2014. The market value of my first investment property is steadily increasing after a big fall, but I’ll probably never recoup my investment. Appreciation didn’t happen. I also have a significant opportunity cost, because I invested in an asset that didn’t appreciate, instead of investing elsewhere.

Appreciation is a valuable thing, but it’s a paper gain until you sell the property or take money out via refinancing, home equity loan or line of credit.

Avoid this mistake by:

• Focusing on the numbers. Evaluate property cash flow on its own merits. Take a cautious approach and run the numbers as if the property won’t appreciate. Does it still cash flow? Appreciation is a bonus, not a guarantee.
• Double-checking cash flow. To repeat – you want positive net cash flow from the start. If your property depreciates in value, but has positive cash flow, this helps sustain the investment.
• Being realistic, not emotional. Don’t get carried away thinking about how much money you’ll make in the future. Buy a property that makes sense today and that you’re comfortable holding for the next ten or more years.

Bottom Line

Financial mistakes are painful. It’s no fun to lose money or watch the value of your investment property sink.

It’s even worse to compound the problem by losing money month after month, because the property doesn’t generate positive net cash flow. Unless you can subsidize the loss with other cash resources, this strategy isn’t sustainable. Just ask any real estate investor who counted on appreciation at the height of the real estate bubble.

Unfortunately, I made all three mistakes in my first deal. I bought a turn-key, expensive property in a hot market. It wasn’t a wise investment, but I learned dearly from the experience. I still own it, and the property value is rebounding, but I could have done so much better.

Avoid this route by not making these major financial mistakes: overpaying for your property, choosing investments without positive net cash flow, and counting on appreciation as the basis for your return.

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Three major financial mistakes, and how to avoid them was originally published by VelaView.