Investing in real estate can be an outstanding way to increase your wealth. In fact, Entrepreneur.com calls it “your smartest investment.”
However, investing in real estate does come with pitfalls. Make sure you set yourself up for success by avoiding these costly mistakes.
Pitfall #1: Speculative Buying
You may have heard a lot of stories about “flippers” making big bucks. The idea sounds simple enough. Buy some ugly fixer-upper for a low, low price. Get all the work done. Sell it for a higher price.
But don’t get blinded by the dollar signs in your eyes. Speculative real estate purchases are a terrible place to start. They’re extremely risky. First, you risk that the repairs will take far more money and time than you hope they will. Second, you’re risking a lot on the idea that the home will sell quickly. If it doesn’t, you’ll still have to pay taxes, upkeep, and insurance on the house while you’re waiting for it to move.
By the time you’re done meeting these two expenses the benefits of buying and re-selling the home may evaporate. Some newbie investors have been lucky to break even. Others end up losing money…lots of money…while trying to play this game.
Pitfall #2: Failing to Calculate Your Return Properly
Let’s assume you’ve overcome the first pitfall and are not attempting to “flip” the home. That means you’re going to become a landlord and rent the property out to someone else.
But don’t assume the amount your tenant pays in annual rent is actually going to go into your pocket.
Instead, your return will be the Total Annual Rental Income minus condo fees and taxes, divided by the price of the property.
Let’s say you pay $250,000 on a condo you plan to rent out for $1000 a month. Most newbie investors say, “Great, so that property will pay me $12,000 a year. Score!”
But let’s follow the formula. Their condo fees are $250 a month, which means they’re losing $3000 on an annual basis. Property taxes can easily eat up another $6000 a year.
Remember, you won’t get the benefit of the residential exemption.
That $12000 has already shrunk to $3000. The annual return is just $0.01. You’ll need to raise the rent or you’ll need to find another property at a lower price. And if rental properties in that neighborhood are going for less than what you plan to charge you may want to move on to a different property before making a purchase.
You can use this calculation to make an apples-to-apples comparison and learn the value of the property you plan to purchase. Note that your mortgage should be covered by the income or you’ll be out of pocket. However, you don’t use mortgages in return calculations.
Pitfall #3: Failing to Account for the Change of Vacancy
Rental properties don’t have tenants 100% of the time. You must account for turnover. When people move out it can take several months to find someone else to move back in. You’re going to have to budget for the months when you’ll be covering your mortgage instead of your tenants.
Keep in mind that market conditions fluctuate. Sometimes, people will snap up condo rentals so fast it will make your head spin, simply because there won’t be much rental inventory available anywhere in town. At other times, the condo can sit for half a year or more.
Ask your real estate agent to talk frankly with you about the typical state of the market so you’ll know how much to set aside. You shouldn’t be paranoid about vacancy…but you should be realistic.
Pitfall #4: Purchasing Investment Property Without a Qualified Buyer’s Agent
It’s never a good idea to buy any kind of property without the help of a qualified buyer’s agent. However, this is especially true when you are trying to invest. As noted above, the buyer’s agent can give insight into market conditions that might be very difficult to research on your own. Once you tell your agent that you are hoping to purchase an investment property he or she can steer you towards desirable neighborhoods and properties that will provide a decent return.
I help people invest in real estate in Boston every single day. If you’ve got questions, feel free to contact me so you don’t make any major mistakes as you start working to build your financial future.