Real estate has probably been the best vehicle for building wealth since, well, forever – and income-producing real estate (aka rental property) may be the type of real estate that offers the greatest opportunities to small and mid-size investors.
But nothing worthwhile comes without a few potential pitfalls. You can and certainly should prosper as an investor, but to do so means being mindful of some mistakes that could derail your success. Let’s consider a few of the most important:
Mistake #1: Lack of Due Diligence
Pardon my Latin, but due diligence is the sine qua non of real estate investing. As I have written in many places before, two types of research are essential to investing successfully in real estate.
One is to vet the property itself. That means a physical inspection with an eye out for any underlying issues such as deferred maintenance and possible code violations. If you don’t feel at home around power tools and electric panels, hire a professional inspection firm. They should provide you with a comprehensive report and perhaps save you from costly surprises.
The second part of your due diligence concerns the market. No property lives in a vacuum, and you need to understand the local market dynamics before you jump in. How strong is the demand for rental properties in this location; how much inventory is there for units like the ones in this property; what are the prevailing rental rates; what is the business and employment climate, and are the any changes on the horizon? Ready to add artificial intelligence to your toolbox? A source of multifamily market data that I encountered recently is HelloData.ai, which claims to have real-time data on over 25 million units nationwide. Use every means at your disposal to understand the market that you’re about to become a part of.
(Please note that the HelloData link is an affiliate link, which means that we may earn a commission at no cost to you. I only add links that I believe will add value for my readers. For a 10% discount at HelloData.ai, use this link or enter this promo code: realdata10)
Mistake #2: Misjudging Financial Info
A very common mistake that investors, especially beginners, make is overestimating the potential rental revenue and underestimating the operating expenses. The seller or the seller’s broker will probably give you some revenue and expense data for a property they want to sell, but be cautious about taking all or even some of this data at face value. Get copies of the current leases, and, if possible, inspect accounting reports that show actual revenue collected and expenses paid. Gaps in the revenue stream can be a tip-off to chronic vacancy.
Don’t simply look to see if the amount of any expense item seems suspicious. Look also to see what might be missing from the data handed to you. The most common expense I see omitted in seller presentations is property management. Even if you think the current owner – or you as the new owner – are treating ownership as a DIY project, the bank appraiser won’t agree. Time is money and any time you spend on management is a cost.
Are you going to have professional fees for lease and tax preparation? Do you need someone to shovel snow, or cut grass? Put yourself in the shoes of the owner before you buy, and project your cash flow realistically.
Mistake #3: Inadequate Financial Planning
Related to the previous caveat is the lack of financial planning. Are you budgeting realistic amounts for repairs and maintenance? Do you put money aside in a reserve fund so you won’t be blind-sided the day the heating system gives out, or the roof needs replacement, or some other unforeseen expense occurs? Are you accounting for revenue that might be lost in future years due to turnover, vacancy, or leasing commissions? Keep in mind that your property taxes, insurance, and mortgage payments are going to come due, and you can’t play kick-the-can with these. You need to forecast future cash flows realistically.
Mistake #4: Not Buying at the Right Price
Speaking of forecasting future cash flows (shameless self-promotion here): that’s what our Real Estate Investment Analysis software has helped investors do for more than 40 years.
What a seller is asking for a property should not be the driving factor in what you decide you’re willing to pay for it. Keep in mind that buying a rental property is akin to taking on a business. It’s not like putting money in a bank account and collecting a nominal return, but involves both a degree of risk and a measure of personal effort. You need to make a multi-year forecast of the likely revenue, vacancy, expenses, and debt service, as well as an estimate of funds to earmark for reserves, needed improvements, and replacements (like that heating system I mentioned). In that way, you can forecast your future cash flows and make a data-driven decision about the price at which this property will give you an acceptable return on your capital invested.
Mistake #5: Poor Tenant Screening
You probably wouldn’t buy something on Amazon without first checking some of the reviews. As a landlord, it’s even more important to be proactive and maintain a thorough screening process for potential tenants. But also keep in mind that there are some legal and ethical Dos and Don’ts you should observe, as described in this National Association of Realtors® article. Perhaps your best move is to use a professional service. Investopedia has reviewed what it feels are the 7 best for 2024, including First Advantage and RentPrep.
Mistake #6: Not Having a Professionally Drafted Lease Agreement
A comprehensive and well-written lease agreement serves to protect both landlord and tenant. It specifies key provisions like rent payment terms, security deposits, termination date, and renewal options. But it can also provide clarity for both parties about tenant and landlord obligations, maintenance responsibilities, trash removal, recycling policies, quiet hours, pet restrictions, and other practical day-to-day concerns. Keep in mind that there may be state or local laws that govern the content of leases, particularly for residential property. A well-written lease is a good way to avoid misunderstandings that can escalate into legal disputes or financial losses.
Mistake #7: Ignoring Legal and Regulatory Requirements
Being in business of any kind – and investing is a business – seems to grow more complicated and more regulated every day. If you’re into residential, be sure you’re up on fair housing laws and landlord-tenant ordinances. Be aware of all disclosures and forms you could be required to give to new tenants and any rental licenses you may need to secure. With all types of real estate, be aware of local zoning and building codes and make it your business to be compliant. Ignorance of codes or regulations, or trying to cut corners, is not likely to end well.
A Final Word
Income-producing real estate can be your vehicle for generating passive income and building long-term wealth, as it has for many others, so long as you commit yourself to careful due diligence, thorough financial analysis and planning, and effective management. Invest wisely. By avoiding the mistakes I’ve discussed here you should be able to optimize the success of your rental property investments.
Image: nattanan23 at pixabay https://pixabay.com/users/nattanan23-6312362/ Copyright 2024, Frank Gallinelli and RealData® Inc. All Rights Reserved