Some Lesser-Known Mistakes With Real Estate Investing

Most of us involved in real estate investing know there are common mistakes most beginners make. For instance, many don’t allow themselves a large enough contingency reserve. Here is a list of mistakes that are not as widely recognized but still critically important:

NOT ACCOUNTING FOR THE RISK-FREE RATE OF RETURN

This is more applicable to the Buy and Hold investor then it is the Flipper. What many of these landlords fail to account for in their capitalization rate calculations is opportunity cost vis-à-vis the risk-free rate of return. Given the risk-free rate of return is about 1%, taking a huge amount of risk to get 3% or 4% might not be the smart move. Instead, consider the calculation very often used in the stock trading world, expected return: if the chance of getting 1% is 100% then your expected return is 100%, if the chance of getting 5% is 75% then your expected return is 3.75%. As you can see, simply take the rate of return and multiply by the probability. While the rate of return is easily calculated, the probability isn’t, especially when dealing with rental properties thanks to the vast number of variables. Vacancy rate, actual rent, deferred maintenance etc. are all values that can be estimated but are not guaranteed. Therefore, although he property has been providing a specific gross rent, that is no guarantee that it will continue. In short, when buying a property for the long-term, ask yourself if you would be better off just putting it into some kind of certificate of deposit, or perhaps buying a dividend paying mutual fund. Sure, there is market risk associated with the latter, there is also considerable risk associated with renters.

WHEN BUYING A MULTIFAMILY, NOT ACCOUNTING FOR ALL ACTUAL EXPENSES, PARTICULARLY WHEN BUYING FROM A SELF-MANAGED OWNER.

Whenever I look at multifamily properties for any of my buyers, I tend to be especially skeptical of the numbers produced by an owner who is also the bookkeeper. The vast majority of the time a number that the seller/bookkeeper gives me is going to be off, usually by a considerable margin. Seller/bookkeeper’s also have a habit of “forgetting” certain expenses, especially major repairs. In one instance, I was looking at purchasing a nine unit for a buyer and upon my analysis of the gross rental income realized that there was about $15,000 of gross income that was missing from the bottom line. As it turns out the owner/bookkeeper was giving free rent to one of the tenants in exchange for lawn/ground maintenance and handyman services. $15,000 a year to mow the lawn and unplug a toilet was a little high in my opinion. Needless to say, this was not the first bit of information that the owner/bookkeeper forgot to mention or miscalculated, and we did not make close on the property. Interestingly, this property was listed with an experienced and highly respected real estate broker in the area whose memory and mathematical ability was on par with the owner’s.

NOT ACCOUNTING FOR ALL CLOSING AND HOLDING COSTS

If you’ve ever watched any of the home flipping shows on HDTV, such as Flip or Flop, you’ll notice that the numbers they outline are not very detailed. For instance, I saw one episode in which they bought a property for $300,000, put $50,000 into it and sold for $450,000. Their profit came out to $75,000 or so “after closing costs.” In this instance, they have a mere $25,000 in closing costs. This isn’t typical, especially if there are holding or financing costs. Trust me, these extra, ancillary costs can add up very quickly and most people don’t account for them when making a purchase.

PAYING TOO MUCH

When it comes to flipping properties, you make most of your money when you buy. Since we are in the strongest seller’s market, perhaps in all of history (at least in the Northwest) there is little doubt that your remodeled property won’t sell. Therefore, you’ll see the future fruits of your labor when you first make the purchase. And consider this, the fastest and easiest way to eat into future profits is to overpay.

NOT PROVIDING ENOUGH BUFFER IN THE TIME-FRAME

Most remodelers and real estate flippers will tell you that whatever their estimation of the time-frame for completion of the project, it’s best to add a 30% - 50% buffer to that number. Unfortunately, not only do most new investors fail to do this, but also experienced investors fail to realize that the uncertainty of the time-frame increases exponentially with the complexity of the project. As a very simple example, if all you had to do was paint the interior of the house, there is little doubt that your painters would find something structurally unsound with the property and put a halt to the job. Therefore, the chance of completing this job within a day or two is pretty close to 100%. On the other hand, if you are making an addition which requires a permit, rarely can you say with any degree of confidence under what time-frame you will receive a permit. And of course, whenever work is being done to an electrical, plumbing, heating system, etc., the chances of discovering a latent defect is considerable. Whether you have experienced this first hand or seen it HGTV, I am sure you’ll agree that when structurally-based repairs are done they usually lead to the discovery of other, more serious and costly problems.

In conclusion, while nothing can be prevented all the time, it never hurts to be prepared for the worst. A good real estate investor says “no” much more than “yes.” And, since there will be surprises, would you rather have a good one or a bad one? Believe me, it’s a very nice feeling to make more money than you expected.