Ten Things to Know About Real Estate Investing
Every real estate investor makes mistakes, It is a part of the process. Below are ten lessons to help newer investors avoid some common mistakes. For more strategies on real estate investing and creating financial freedom see the Become Loaded for Life! books.
1. $2,000 Per Property in Reserves: Real estate investors should save 5% of annual rents for repairs, 5% of rents for capital expenses and 5% of rents for vacancies. Setting aside these reserves prevents unexpected expenses in the future and accounts for the real costs of owning rental properties. I also encourage investors to also set aside $2,000 at the time of purchase for each property as an additional reserve. This $2,000 provides a cash cushion if a major repair occurs immediately after purchase.
2. Watch Rent to Purchase Ratios: We were fortunate to anticipate a real estate crash prior to the global financial crisis by tracking rent ratios. Prior to the crash a property that cost $1,000 per month to buy (mortgage payment, taxes, insurance) would rent for $1,000. As the real estate bubble inflated, the cost of this property rose to $2,000 per month to buy, but the rent only increased to $1,100. The process continued and a few years later the cost of owning a property was $3,000 per month due to rising prices and increasing property taxes, yet rents only increased to $1,200. It does not make financial sense to pay $3,000 to own something that you could rent for $1,200. Rents might increase over time, but this ratio did not make sense and real estate prices soon came tumbling down.
3. Get Adequate Insurance: Investors should add an umbrella insurance policy once they own a few properties to provide additional insurance coverage. Also, investors should be reluctant to file insurance claims for damages they can afford to absorb. Insurance companies often raise their rates on all your policies to recoup the expense of these payouts. Investors end up paying out more in higher premiums than they received from the payout.
4. Five Properties = Financial Freedom: The book Become Loaded for Life explains how to create a Basic Living Expenses Budget and a Lifestyle Expenses Budget as two key steps to financial freedom. Building a portfolio of five single-family properties is likely to cover this Basic Living Expenses Budget. As the rental properties are paid off, the rental income will likely cover the Lifestyle Expenses Budget.
Some people prefer to refinance every property to keep the leverage ratio high and redeploy these funds to other investments. That strategy can be an effective way to create wealth, but only if it does not take on too much risk. Keeping five properties debt free secures your financial freedom. This conservative strategy reminds me of the quote by Warren Buffet, “rational people do not risk what they have and need for what they don’t have and don’t need.”
5. Multifamily Properties Creates Wealth Faster: Multifamily properties with more than four units tend to generate higher monthly cash flow, as vacancies and expenses are spread among many units. Making the switch from single family properties to multi-family properties can help grow wealth more quickly. But, it requires the necessary due diligence to make sure this transition is successful. It may help to bring in a seasoned partner for the first deal or two.
6. Create Value: Renovations and improvements are an excellent way to create value in properties. Buying newly renovated properties makes managing the properties easier, but someone else made the money from creating this value. In addition, properties that need updating or renovations often sell at a discount because there are fewer buyers interested in them. Most people are looking for a home to live in, not a messy renovation project. Looking for properties that need work or that can be converted from one unit to two units can rapidly increase the value of properties.
7. Verify Every Tenant: Difficult tenants equate to difficult house problems. And remember that unqualified tenants will go through great lengths to appear qualified. We once had an applicant with a great job and a graduate degree from a good university who looked like an ideal tenant. The applicant was in a hurry to move in, claiming their current lease was expiring. A tenant who says they need to move quickly is often a red flag. They are trying to rush your due diligence process so they can get into the property. They will sometimes offer to pay higher rent or sign a longer lease, in an effort to get you to drop your guard.
We soon discovered this person had horrible credit and had defaulted on almost every debt they had. Letting this person move in would have devastated our finances at the time. The way to protect yourself is to never bend your rules and follow every step in your tenant screening process. Never, under any circumstances, let a tenant move in, or move their property in, until they clear the necessary vetting and make the required payments.
8. Know the Landlord/Tenant Laws: Similar to the last point, be careful buying rental properties in states or countries with laws biased against property owners. If a tenant is violating the lease, unreasonable landlord/tenant laws will only make it harder to evict. Investigate these laws before buying property and talk with a qualified real estate attorney. If a tenant is violating the lease, follow all the rules regarding evictions. Don't do something foolish like turn off the power or change the locks while they remain in the property. It takes time to get a tenant out and it must be done legally.
9. Creative Financing: There are many ways to finance a property. These include conventional financing from a bank or credit union but fixed rate mortgages are preferable to variable rates. Otherwise, rates can rise, turning a profitable property into a loss. Owners of a primary residence can use a home equity line of credit (HELOC) to secure the down payment for a rental property. Or as mentioned above, refinancing an existing property to cash out some of the equity can also be used to buy the next property. As long as the payments after refinancing are manageable and do not put the real estate portfolio at undue risk.
Seller financing is an option if the current owner is willing, or private money if the deal is profitable with this short-term higher interest rate. These types of financing can be replaced with a traditional loan with lower interest rates once the property is seasoned. Newer investors will also want to consider working with a partner to split the deal. It is better to have 50% of a property than 100% of nothing. Investors with a good real estate deal rarely have trouble finding a way to finance it. But if an investor cannot secure financing then maybe the deal is not as good as they think.
10. Get Everything in Writing: The baseline for every investor should be there are no oral contracts in real estate. Everything is in writing and signed by the necessary parties. Whether it is buying, selling, repairs, terms, conditions, waivers, estimates or leases, get everything in writing. I have heard people say that they do not need the deal to be in writing because the deal is with a friend or a family member. This is how you create conflict and stress in life. Putting the agreement in writing prevents future misunderstandings by ensuring each party has the same expectations. Your real estate investing needs to run like a proper business from the very first day and businesses get agreements in writing.