Real estate comes with incredible benefits for investors.
As a source of passive income, it never dries up or matures, but instead provides ongoing income with no loss of assets. In fact, the underlying asset appreciates over time, even as you pay down the mortgage against it. That makes real estate investment an excellent source of retirement income. It diversifies your asset allocation and protects against sequence of returns risk because you don’t need to sell any assets to produce the income.
Then, there are the tax benefits. Investors can deduct for every conceivable expense, from mortgage interest to maintenance costs to property management fees. They can even deduct some paper expenses that they never actually incurred, such as depreciation.
But for all those advantages, it also comes with its share of downsides and risks. Each property requires a high cash investment in the form of a down payment and closing costs. Real estate is notoriously illiquid, making it expensive and slow to sell. It also requires both skill and work to invest in, unlike stocks, which you can buy instantly through an index fund with no specialized knowledge.
Still, the knowledge and skill that you need to buy your first property isn’t rocket science. Anyone can learn how to invest in real estate. Here are seven tips to follow when buying your first investment property to avoid pitfalls and earn a strong profit from the outset.
1. Get the Numbers Right
The most common mistake I see new real estate investors make is miscalculating costs, values, and rents.
If you take nothing else from this article, take this lesson to heart: Learn how to accurately calculate cash flow and house flipping profits because it’s not intuitive. It’s how investors lose money.
Repairs & Carrying Costs
When you flip houses or buy rental properties to renovate, you need to know exactly how much repairs will cost. It sounds easy on the surface; after all, contractors give you a written price quote, right?
The problem is that contractors are notoriously difficult to work with, and renovations rarely go as smoothly as planned. Often, contractors over-promise and under-deliver, in terms of both costs and timeline.
For your first investment property, stick with relatively minor cosmetic repairs. Then, budget an enormous cost overrun reserve to handle the inevitable hiccups. Just don’t tell the contractor about it, or they’ll find an excuse to spend it.
Get at least three quotes from licensed contractors, and be extremely clear about the repairs you want. When you leave room for interpretation, you leave room for contractors to charge you extra later.
And don’t forget that renovation costs themselves are only the beginning. It also costs money to own the property while it sits vacant undergoing repairs. These carrying costs, or “soft costs,” include the mortgage, utilities, taxes, insurance, and permits.
For your first deal, budget 50% extra as a reserve for renovation costs, plus a 50% cushion for your estimated carrying costs. By managing your contractors attentively, you can avoid spending any of it, but as a new investor, you should budget for mistakes when working with contractors.
Pro Tip: Before you start the process of finding a contractor, check out HomeAdvisor. They’ve run background checks and found the best contractors in your area for you to choose from. Pick a few from their list and have each give you a quote for the work to be done.
After-Repair Value (ARV)
Just as new investors usually underestimate costs, they also often overestimate the after-repair value (ARV) of their property.
Do your own research on Trulia or Zillow to get a sense of comparable renovated property values. Then, visit a few comparable homes that are currently for sale. Walk through them and get a gut-level sense of how completed properties are priced in the neighborhood.
As a novice investor, your opinion alone won’t cut it, so also get three expert opinions on the ARV range for a given property before buying it. First, ask your real estate agent’s opinion, and ask that they be conservative in their value range. Then, find an experienced investor operating in your market and ask their opinion. Finally, review the lender’s appraiser for their opinion.
When you have those three ARV range opinions, take the low end of the range as your working ARV. This is not the time or place for optimism; you need to know your minimum profit from flipping the property and make sure it isn’t negative.
If you’re keeping the property as a rental, you need an accurate estimate of the after-repair rent. Go through the same process as estimating the ARV, but this time for rent.
If you’re local, don’t skip walking through neighborhood properties currently listed for rent. There’s no substitute for seeing how local comps look with your own eyes. You want to develop a sense for the local rental market, as well as what level of finish and amenities renters expect.
Ongoing Rental Expenses
Repeat after me: Your cash flow is not the rent minus the mortgage.
Another set of numbers that new investors get wrong is ongoing rental expenses. As a general rule of thumb, expect your non-mortgage expenses to average about 50% of the rent. For example, according to the 50% Rule, if the rent is $1,200, your ongoing non-mortgage expenses will average $600. If your mortgage is $500, that leaves you with an average monthly cash flow of $100 – a far cry from the $700 that many novice investors expect.
Non-mortgage expenses include:
- Property taxes
- Property insurance
- Vacancy rate
- Major repairs and capital expenditures (CapEx)
- Property management costs
- Accounting, bookkeeping, and legal costs
Don’t exclude property management costs because you plan to manage the property yourself. Not everyone has the time or temperament required to manage rentals well. Even if you have it today, that doesn’t mean you’ll have it next year. Besides, managing rentals is a labor expense, whether you’re doing the labor or someone else is. Be financially prepared to hire a property manager by including these costs in your cash flow calculations now.
Don’t rely exclusively on the 50% Rule for your actual calculation, however. It’s a broad rule of thumb, and you need to calculate each expense for any given property before buying.
2. Consider a Turnkey Property
Not everyone wants to mess around with contractors, permits, and refinancing for a long-term mortgage. There’s nothing wrong with that.
If the idea of overseeing a renovation fills you with stress, buy a turnkey property. You can buy properties that are already rented to stable, reliable tenants or buy properties in rent-ready condition.
In today’s increasingly connected world, you can even buy turnkey properties anywhere in the country using platforms such as Roofstock. Imagine a nationwide, public access version of the MLS just for turnkey rental properties, and you have a good sense of the power and convenience of this platform.
Roofstock also includes a wealth of data for each listed property, from local market data to historical and forecasted home value trends to details about the property’s condition. Best of all, they include two guarantees: one allowing you to “return” the property at no cost within 30 days, and another guaranteeing you’ll rent the property to a tenant within 45 days of buying. See our full Roofstock review for more details.
3. Stay Detached & Be Patient
As mentioned above, buying real estate takes work. That work multiplies tenfold if you want to find a good deal – which you better as an investor, or else what’s the point?
Many novice investors get emotionally attached to the first property that attracts their interest. They love the location and think, “I would love to retire here,” or they love the kitchen or the mosaic tile in the second upstairs bathroom.
Emotion has no place in investing of any kind. It leads to decisions made for the wrong reasons and “intuitive investing” such as trying to time the market.
Never, ever let yourself form an emotional attachment to a prospective investment property. In all likelihood, you’ll need to review dozens – perhaps hundreds – of properties before you find the right deal. If you make offers on 15 properties, there’s a good chance that five of the sellers will negotiate with you, and of them, three will come to an agreement with you. Of those three, two will fall through before settlement, leaving you with one closed deal for all your efforts.
Few people have the patience and ability to remain detached from each of those deals. Direct real estate investing is a numbers game in two senses: It’s all about the profit and expense numbers, and only a small percentage of your prospective deals actually close. Embrace those realities now before wasting vast amounts of time and money in a failed investment attempt.
4. Negotiate (and Don’t Be Afraid to Walk Away)
Sellers expect you to negotiate. If you don’t, they start second-guessing their pricing and wondering if they should have asked for more.
Negotiating real estate starts with seller research. Find out everything you can about the sellers, such as how urgently they want to sell, why they’re selling, and when they’re moving if the property is owner-occupied. If you’re using a real estate agent, have them feel out the listing agent. You’d be surprised how often listing agents get talkative.
Come in with the lowest offer you think the seller will take seriously enough to counter. The more urgently the seller wants to close, the lower that number can be.
To reduce your cash due at settlement, don’t hesitate to build a seller concession into the negotiation.
Most importantly, set a ceiling price before you even make your opening offer. Commit to it in writing, and tell someone what it is to lock it in place. If, after negotiating back and forth, the seller won’t accept a number under that ceiling, walk away. A surprising number of sellers call you back after a few days to say, “Well, maybe I can make those numbers work after all.” Sellers bluster and posture, but when you stay emotionally detached, you can walk away from not-so-stellar deals, which positions you to buy nothing but good deals.
Follow these negotiating tactics to keep a firm handle on negotiations, and always be prepared to walk.
5. Arrange Financing Before Making Offers
When you make an offer, sellers expect you to provide details about how you plan to actually pay for their property. Which means you need to line up financing before you start throwing around offers. Your options vary based on whether you’re looking for a short-term purchase-rehab loan or a long-term rental property mortgage.
For short-term purchase-rehab loans, go with a hard money lender. They’re fast and flexible, if expensive. Alternatively, you may find luck with a local community bank, but these operate individually, and each has a different lending policy.
For long-term rental mortgages, you can try conventional mortgage lenders when you first start investing. But banks and conforming lenders are not scalable beyond your first couple of properties as they place limits on how many mortgages you can have reporting on your credit.
Consider portfolio lenders as “next-level” financing. These lenders don’t sell your loan to a large, corporate lender, but rather keep it in-house. Local community banks sometimes offer these loans, as do some online lenders.
Eventually, once you’ve proven a track record of success, you can borrow money privately from friends and family to fund your deals. But that comes years after your first deal.
Pro Tip: When searching for a mortgage lender to finance your first property, start with Credible. Within minutes, you can have multiple loan quotes you can compare side by side.
6. Don’t Bank on Appreciation
Real estate does not always go up in value. Homes usually go up in value, but if you count on “usually,” then you’re speculating, not investing.
If you’re a flipper, flip based on today’s prices. If you’re a long-term rental investor, buy based on today’s cash flow. While home values can collapse, rents remain surprisingly resilient. Even in the Great Recession, when home values dropped by 27.42%, rents continued to rise, according to the U.S. Census Bureau.
That’s the beauty of rental investing. When you learn how to forecast cash flow, you can calculate the returns on any investment property accurately, and you can opt to invest only in high-yield properties. And when you invest in rental properties based on current cash flow, then any appreciation is gravy.
7. Be Prepared to Enforce & Evict
Just as not everyone has the temperament to be a real estate investor, the same goes for being an effective landlord. It requires attention to detail, self-discipline, and the willingness to enforce the rules of your rental agreement.
Human beings push against their boundaries. As a landlord, that means that some of your tenants will try to push your boundaries. It’s your job to defend those boundaries. Not everyone has the discipline to enforce the rules of their lease in the face of a sobbing tenant. But enforcing rules is one of the challenges of being a landlord that you must be comfortable with if you want to succeed.
Your mortgage lender won’t be swayed if you call them sobbing and ask them not to charge you a late fee or start the foreclosure process. If the rent isn’t in by the end of the grace period, serve an eviction warning notice, which gives the renter a second grace period before you file for eviction. If they don’t pay by the end of the second grace period, file with the local court. That will start another lengthy process with an eventual hearing and lockout date, all of which takes months.
Of course, it rarely comes to that. When you serve an eviction warning notice and file in court immediately, renters often start prioritizing their rent over their credit card bills, discretionary spending, and other expenses.
If you don’t like the sound of any of that, you’re not alone. But it means that you’re not temperamentally suited to landlording. You should either outsource it to a property manager or find other ways to invest in real estate.
Direct real estate investing is not a good fit for many, or even most, people. They just don’t have the patience and discipline.
Fortunately, you don’t have to invest directly to gain real estate exposure in your portfolio. Indirect ways to invest in real estate include REITs, which you can buy instantly through your brokerage account or IRA. You can also invest in real estate crowdfunding websites. While these once allowed only accredited investors to participate, a few, such as Fundrise, now allow anyone to invest.
If you do have the interest, patience, and temperament to invest directly in real estate, your discipline will be rewarded with predictable returns, strong tax benefits, and high-yield passive income. One easy way to buy your first investment property is to live in it by house hacking. Contrary to popular belief, you don’t have to buy a multifamily property to house hack. You can house hack with roommates, with an accessory dwelling unit, by renting out rooms on Airbnb, or even by bringing in a foreign exchange student.
You have plenty of options for real estate investing, whether you choose direct ownership or a more hands-off approach. Either way, make sure you do your homework and vet each investment carefully, paying particular attention to the numbers.
Are you considering buying an investment property? What’s your long-term plan?