3 rules for new investors to know when buying real estate
RULE #2 You make money when you buy
There is a fallacy in thinking when people assume they can buy a good asset and then over time they will make money guaranteed. The problem is when people value the long term gains in larger consequence than the purchase price. Meaning, they value the future potential of an asset rather than buying at a discount NOW. This isn’t to say the future value doesn’t won’t produce a good annuity, but paying retail is generally an indicator of this particularly noticeable symptom that new investors are especially guilty of: people want to buy any deal to get started, more than they want to buy a great deal.
This is a bad habit to get into because retail homes when purchased at retail market prices don’t allow much wiggle room for variance or error, which you will experience during ownership. Combine this with real estates unavoidably high transactional costs it can really hamper profitability and the ability to sell in a pinch. It also makes lending harder when you have a low equity position in an asset It leaves you no outs. George W Bush’s made this error with the Iraq war, always have an exit strategy. Equity is the door to all the exit strategies.
For this reason, I’ve written and spoken adamantly against veterans designing strategies around using the VA loan program. The VA program allows investors to buy a property with 0% down, which sounds good but it’s such a trap. VA home loans require inspections to ensure the house is in move-in ready condition, essentially a retail home. This is because the VA loan is for owner-occupied properties and no one wants veterans moving into a ratty house with no equity. None of this is to say the VA loan program is bad or can’t be used to buy investment properties (though it is harder), but if you want to buy profitable properties you must buy at a discount. Paying retail is a mistake, and that mistake is made at the purchase.
If you noticed this is listed as rule #2 but I put it out of order for a reason. Pretty sneaky I know.
It seems everyone interested in real estate is spending their time looking for great deals, talking about great deals, and analyzing deals. This is obviously good because as this rule states: You make money when you buy, but it also has to go along with the #1 real estate rule, the one everyone knows but seems to have forgotten.
RULE #1 Location, Location, Location
In a world of massive amounts of data at our fingertips, it’s become extremely easy to “analyze” deals in a blink. Spreadsheets, online deal calculators, and Zillow allow us for more information metrics we can possibly know how to use effectively, but more information is good, right? Maybe. Sometimes it can be a distraction from all the data that isn’t available.
On a local scale, the old advice was “buy the lousiest house in the nicest neighborhood”. Not a universal rule by any means, but we can use it to extrapolate on its strengths. While people are busy analyzing the numbers for their deal endlessly, do they really know the neighborhood that the unit is in? Are there bars on the windows? Are the numbers from a pro-forma or are the actual historics? Are the rent numbers from Zillow or Rentomoter or from a well vetted and established property manager who knows the area intimately? I can find deals all day with fantastic numbers, and a large portion will be in neighborhoods I would be too scared to drive through. For this exact same reason, really nice neighborhood houses have worse numbers, Why? Because risk is built into the profitability of an asset. In a commercial building we do this in the capitalization rate, but on single family there is no corresponding metric, thought the mechanic for building in risk is the same. Knowing the neighborhood and what risks to expect in that area are not to be underestimated.
It’s important to consider location on a large scale as well. What town/city are you buying in and are you accounting for future growth? So many deal calculators allow you to add in future appreciation and rent growths, but does that metric have any real world correspondence to the city in which you’re buying? For instance, I buy in a small North Carolina town with little to no growth and there is no appreciation to speak of. If you buy retail in this town the odds are quite likely that your house will depreciate over time rather than appreciate, is this factored into your calculation? If you buy new construction in a small town and pay retail with little down payment there is a chance you can have negative equity in your property.
Job growth is the biggest factor in rental purchasing, so does the town you’re buying in have good job diversity and future growth? Even single industry towns cause massive volatility when they experience industry downturns. This isn’t to say small towns can’t be profitable, but it should highlight that there are metrics that need to be considered but won’t go into common profit analysis.
Who is going to manage the property? I find this question to be grossly overlooked when investors are doing analysis on paper and not thoroughly considering the area. Your property manager is not a tireless robot, this person is a human being with lots of other responsibilities, preferences, and flaws. What I mean to say is, if you buy a house in a scary area you may find the property manager doesn’t like going there. More realistically, if you buy a place that looks great on paper, it usually means the risk is higher (that’s how market capitalism works: you get paid more to take more risk). So when deciding to buy that $20,000 property which rents for $600 a month (which looks great on paper). Consider what kind of tenant you will attract for that income. In some areas it’s a lot, in some areas it’s nothing. It’s easy to say the numbers look good, and it’s easy to say “I’ll get a property manager to run the asset”, but in real life, it might not work out so easily. The great managers are going to try and contract the easiest properties (although this is rent-seeking behavior, it is most efficient and therefore should be expected). Your property manager might get sick of dealing with hard-to-deal-with tenants and poor neighborhoods. Don’t assume because it works so well on paper, that the systems you build around that purchase are stable, the micro and macro market matters, what also matters are the factors that can’t be seen on paper. Which brings us to rule #3.
#3 You can’t calculate stress on paper
Your expense ratios will not flow out as evenly on paper as they do in real life. For example, you may account for 8% vacancy but that’s a lifelong average when in reality you may experience 3 months of vacancy all at the start. This doesn’t change profitability, but it is much different to mentally accept the possibility of 3 months of vacancy and quite another to go 3 months with no income on a rental property.
Every day you think about this, you’ll dwell on it, stress over it.
It’s not just vacancy either: What if your house doesn’t appraise for what it should? what if you find recently after purchase that the city wants to add a connection to the sewer company to the property for $5,000? (this has happened to me!)
Real estate is so easy on paper, and I LOVE to run around telling people how easy it is, but it does come with stress. Debt, responsibility, and complex deals will add up the burden. Sure the internet makes it seems like real estate can turn anyone into a millionaire in a quick hurry with little to no risk, but the internet said the same thing about real estate 2008. This isn’t even to say that people are under calculating the risk, but lots of people are certainly underestimating the weight it puts on your shoulders.
Houses are illiquid, rentals make money slowly, and most mortgages you sign will be for 30 years; rental real estate is a super long play. It’s quite easy to oblige yourself to debt all in year 1 though. Unfortunately, though you’re going to feel stress acutely when a unit floods, a hurricane knocks a tree over onto a roof, or when half your units go vacant at the same time. Even if you have plenty of reserves, you’re going to feel the pain of writing those checks, and those terrible phones calls.
None of this is to act as a deterrent, but over the last few years getting better at real estate I’ve found that people love to shout out their strategies, which many times work on paper, but they don’t accurately calculate the responsibility they are signing up for. This forgotten rule is just something I wanted to mention to those who read my site.
I still love real estate
I’m in no way trying to be negative about building wealth through real estate, I just wanted to share some thoughts had based on what I see new investors doing. Real estate is in super vogue again, and people are buying silly. I don’t want to shade on anyone’s ambitions, but it’s important to remember for many people it’s a long play. Don’t be in such a race that you forget these 3 rules. Buy good deals, know the area, and don’t underestimate how much this business will infuriate you.