Over the course of the 20+ years Marc Bautis has been in the financial services industry, he’s seen and helped many people purchase real estate investment properties. Some of these investments have been prosperous, while others have led to financial disaster. In this episode of The Agent of Wealth Podcast, Marc Bautis shares the five biggest mistakes investors make when buying rental properties, and how to avoid them.
In this episode, Marc will detail the following:
- Mistake 1: Believing that rental properties are a passive investment.
- Mistake 2: Improper financial analysis before purchase.
- Mistake 3: Incorrectly estimating expenses.
- Mistake 4: Looking for the highest yielding property.
- Mistake 5: Overextending yourself.
- And more!
What Every Real Estate Investor needs to know about Cash Flow…And 36 Other Key Financial Measures | Biggerpockets.com | Bautis Financial: 7 N Mountain Ave Montclair, New Jersey 07042 (862) 205-5000
4 Major Benefits of Owning Rental Properties
Rental properties can be a great addition to your portfolio. They are one of the few investments that can make you money in multiple ways:
- Cash Flow: When your tenants pay your rent and the net income is positive after covering all of the expenses associated with the property.
- Appreciation: A real estate property is a hard asset that usually appreciates over time. Like every asset it sometimes can be volatile, but even in today’s inflationary and rising interest rate environment, it has been holding up well… so far. This also includes forced appreciation where you can rehab or renovate a property to increase its value.
- Amortization: One thing that can supercharge (or crumble) your investment is the fact that most people are buying real estate using leverage. While you are paying back that loan part of your repayment goes to pay the interest and part pays back the principal. So the loan repayment acts as a forced savings.
- Depreciation: Even though your property may generate positive cash each month and each year on paper, it may be showing a loss.
For the many benefits that real estate investing can bring, it can also run the spectrum on the negative side. It can cause everything from a headache to a downright financial disaster.
I’ve seen and helped many people purchase real estate properties. Most of them have worked out, partly because the last 10 years have been very kind to real estate investing. I’ve also seen investors make some major mistakes… On today’s podcast we are going to talk about five of the biggest mistakes I’ve seen investors make when purchasing real estate investment properties, and how to avoid them.
5 Mistakes Rental Property Owners Make
Mistake 1: Thinking rental real estate is a passive investment – that you can just sit back and collect cash without having to put any time and work in.
Rental properties can be great wealth builder, but it will very rarely be truly passive. When talking about passive income, think of your assets generating income for you without any active management or work.
When you start building a real estate investment portfolio, you’re essentially starting a business. While some people may hire a property manager to deal with leaks at 3AM, the property owner will still have to get involved in various aspects of the business, even with a great property manager. After all, no one will care about the property more than the property owner.
If you truly want to invest in real estate passively, there are other ways you can do it, such as through REITS (Real Estate Investment Trust) and some crowdfunding websites. Both of these strategies work by investing money either into a single project or portfolio of projects. But, you usually don’t have any input into how the properties are managed… although some people may like that.
The issue of passive vs active management also goes for purchasing a property with the intention of fixing it up. Many people underestimate the amount of work it will take to be successful. That’s not to say it can’t be done, but you have to make sure you have the time available to do it.
Mistake 2: Improper financial analysis before purchase.
I see a lot of people wing it when purchasing a property, refusing to do any analysis on the numbers.
One of my favorite books on real estate investing is What Every Real Estate Investor needs to know about Cash Flow…And 36 Other Key Financial Measures by Frank Gallinelli. You don’t have to run 30+ calculations to determine if a real estate property is a good investment – like the title suggests – but I recommend doing some kind of due diligence prior to purchase.
My two favorite ratios are:
- Capitalization Rate: Also called Cap Rate, this is a real estate valuation measure used to compare different real estate investments. It’s calculated as the ratio between the annual rental income produced by a real estate asset to its current market value.
For example, if a buyer is looking at an apartment building that has 10 units, each earning $2,000 a month in rent; this means the property is grossing $20,000 a month or $240,000 a year. The buyer then subtracts the property’s expenses, which are $96,000, and the result is a net operating income (NOI) of $144,000. If the buyer knows the market is a “7 cap market” (i.e., a 7% capitalization rate), the buyer can divide the $144,000 by 7% and determine that a reasonable purchase price to offer the seller is $2,057,143.
You can use the Cap Rate the reverse way, too. If the seller is marketing the property at $2,060,000, and the buyer requests and receives a 12-month trailing profit and loss statement that shows $144,000 in net operating income, the buyer can determine that the asset is being sold at a 7 cap rate ($144,000 / $2,060,000) and compare it to other similar properties to determine if the sale price is reasonable.
- Cash-on-Cash Return: This is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage. This is especially valid if cash flow is important to you.
You can calculate your cash-on-cash return by taking the annual net income the property generates and divide it by the amount of cash that you need to purchase the property. Let’s say you take $100,000 and purchase a $400,000 property. If that property generates $10,000 of net income cash each year, your cash-on-cash return is $10,000/$100,000 = 10%
After you own your property for a while, you’ll want to change the calculation: instead of using the downpayment for the purchase, you’ll want to use how much equity you have in the property. Because of appreciation and amortization, this number should increase the longer you have the property.
It’s important to have an accurate account of how the equity is working for you in the property because there may be options to refinance and pull cash out of it, if that’s part of your strategy.
A common scenario I see is people move out of their condo and decide to keep it as an investment property. But remember, what made the condo a good place for you to live does not necessarily make it a good investment property, so you should do an analysis in these instances as well – sometimes it’s better to sell the condo and use the cash for a better investment property.
There are many tools out there that can help with running these calculations. One of my favorite websites to use is biggerpockets.com, which is a great resource for new investors.
Mistake 3: Incorrectly estimating expenses.
This is another mistake that’s related to improper analysis. I see many people who think this is a good way to determine if a property will be a good investment:
The mortgage is going to cost $2,500/month, and the rent will bring in $2,600/month. $2,500-2,600 = $100, which is positive, so it must be a good investment.
What they’re forgetting to do is calculate things like:
- Vacancy: Even with the greatest tenants, you will likely experience vacancy at some point. If one tenant moves out, it’s very unlikely that the unit will be ready for move-in the following day.
- Repairs & Maintenance: When a tenant does move out, it’s likely you’ll have to do things like paint, clean, replace flooring, etc.
- Capital Expenditures (capex): These are big repair items like a new roof, furnace, hot water heater, etc. While these expenditures don’t happen every year, they can take a big chunk out of your profits when they do.
One of the recommendations I make is to request a maintenance history log from the previous owner/property manager. If you can’t get one, you’ll want to factor in some work.
For a property in good condition, you should still factor in 5% vacancy, 5% repairs and maintenance and 5% cap ex.
Speaking of property management, even if you plan on managing the property yourself, factor in the cost of having a property manager to your analysis, which is usually 7-10% of the gross rent. You may get to a point in your real estate portfolio where it doesn’t scale with you managing all of your properties, so you need to hire a property manager.
Mistake 4: Looking for the highest yielding property.
Rental markets are highly localized, with a unique supply and demand for each ZIP code, borough and neighborhood. Tenant quality, the safety of the neighborhood, and the amount of demand for rental properties in that area will determine if the investment is profitable or a total nightmare.
Highly affluent areas with expensive real estate prices may check the boxes for safety but not demand or return. Low-income neighborhoods may produce tremendous cash flow but have higher rates of crime or higher tenant turnover rates. Finding the happy medium between affordability, safety and stable rental demand should be the ultimate goal for buying rental property in any market.
Many people just look at the highest cap rate and cash-on-cash return to decide where to invest. Although I stressed the importance of those numbers earlier, it’s important to take other things into consideration too.
While neighborhoods and the property’s price can have an impact, it’s also extremely important to understand how to vet and underwrite tenants. You should have a strict screening process in place that looks at the complete picture of the tenant, not just their credit score or income, and follows federal and local laws for screening tenants. Poor tenant underwriting can lead to a nightmare tenant, no matter where your property is located.
Mistake 5: Overextending yourself.
Being overextended on a rental property is not a good position to be in, no matter how lucrative the property could be down the road. It’s important to make sure you go into the investment with enough cash for the down payment, which will be around 20% or more, as well as several thousand dollars in savings to have as a safety net for unexpected repairs or expenses that could arise while you build up capital reserves from rent.
You should never buy a property without knowing you can maintain the debt obligations associated with it on your current income. Economic circumstances can change. Your income may fluctuate, and if the tenant isn’t paying or the property is vacant longer than expected, you are still responsible for it. If you aren’t yet there financially, wait until you have more savings, and don’t spread yourself thin. I’ve seen a lot of people get crushed in the 2008/2009 financial crisis and overextending themselves in investment properties was one of the main reasons.
Purchasing a real estate property can be a great way to set yourself on a path for financial freedom. It can also be a disaster. To summarize, you want to make sure you do your due diligence and put as much analysis into the property as possible. There’s always going to be risk when purchasing a property – sometimes taking the risk is necessary – but you want to be in as strong of a financial position as possible. Things will go wrong with the investment and you want to make sure you can weather the storm.
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