Oh, how Instagram makes it look so easy. Investment properties! Passive income! Simply collect your rent and live fabulously on the beach forever!
Boom: Real Estate Mogul (sweet tan and margarita included.)
Might you have a glass of water nearby? Please throw it in your own face. Then listen. Buying an investment property could be the worst thing that ever happened to you. It can also be the best thing, if you do it right.
What Investment Property Shoppers Get Wrong
It breaks my heart to get these calls. A defeated voice asking what’s the soonest they can unload a property.
This dream they had hoped would bring them prosperity has only cost them in time, money, and worry. Then, because they usually just want to get rid of this financially suffocating asset-turned-liability, they have to sell at a loss. They become the “motivated buyer” that creates a great deal. For someone else.
When I look at what they got themselves into, I know I would have never advised a client to let it happen.
Top Reasons People Regret Buying a Rental Property:
1. Underestimating the cost
The way to do it wrong, wrong, wrong is to think it’s easy money, or almost no money at all beyond the mortgage. But you have taxes that you pay on the property. You have maintenance expenses. If something’s broken, you have to repair it. Every time you turn over a tenant, you have to paint. All those things that you never really thought of add up. In order to own the property and run the property, you have to incur a ton of expenses. As a landlord, you need liquid capital to hold up your end of the agreement. If you don’t, you’re in trouble.
2. Underestimating the time and energy
The other thing is that because you’re a landlord, unless you hire someone to manage the property, you’re managing the property. It’s a lot of dealing with the day-to-day needs of your tenants.
One apartment could take you an hour a week, but if you buy something with 10 apartments, it could cost you 20 hours a week. At some point it’s better to find someone to effectively manage it. But then, of course, a property manager will take between 5 to 10% of what you take in in rent.
There’s a cost to this gig, and it’s either going to be time or money. There’s no getting around that.
People think you can leverage a ton and still have cash flow. But if you have a mortgage, you have to pay the monthly cost of borrowing money. If the market changes and rents go down, the rent could stop covering all of the expenses including the financing. People often make this move before they can really afford to make a move, and it can make for a money-pit.
4. Planning too short-term
The number one rule in buying an investment property is that you buy it well so that you (hopefully) never have to sell it. True investment properties should never be something you want to flip.
The rental market is just too volatile. If you buy a property and you think your return will just be mediocre, it could easily swing down to a level where you’re putting expenses into the property just to stay above water. Then you become the person wondering how fast you can sell.
The right time frame? At least 10 years. I don’t think 5 years is long enough. Unless you’re in the business of property flipping. That only works in a market that’s going up and you plan on making big improvements. If you’re buying a property in a depressed market, it’s going to have to take some time for the market to rise so you can make it out whole (let alone make a profit). Then, you have transaction costs when you sell. You can expect 8 to 10% of the property.
How to Get An Investment Property Right
The only way to do it right is that you have to buy it well. I will say it again: the buy is the most important part of a good investment.
You know that you bought well when you (or your trusted advisor) looked at the comparable properties in the marketplace to determine that your asset is A grade, was obtained for a fair price, and provides a yield that is AT or above the market norm. If the yield is a bit below the norm, there could still be a deal if there is a potential for upside.
Upside is something that will happen to the property over time that will make it worth more in the future than just normal appreciation and inflation. Rent-stabilized tenants leave. Or the building next door is being renovated and half of yours is covered in scaffolding now, but when it comes down, you’ll get more rent for the wonderful view—and the new curb appeal of your beautiful neighbor’s home. It could be improvements to the neighborhood, public transportation, some other public work project that has been planned and will be finished someday, like a park.
The upside isn’t always calculable. There is an intangible factor to quality real estate. Every good investment most likely has some 1% aspect of specialness, something that made it stand out. It could just be the story behind it.
The idea is you either want to buy something extremely well or something decent with upside. But never calculate with the upside. That’s like exercising and then eating a bunch of calories. Ideally, you’re supposed to buy well and then the upside will take it to another level beyond the possible swings in the market.
How to Know Whether You’re Ready to Buy an Investment Property:
You’re ready when you are willing to get your hands dirty or able to give up a lot of money so someone gets their hands dirty for you. Unless you’re buying a full-on multimillion dollar investment portfolio, you are most likely going to have to handle some of it yourself.
You should be prepared to have to cover no less than 6 months of the entire rent in liquidity. If you need to rely on your liquidity, you should not rely on real estate.
If you need to, just start smaller. Look for a less posh neighborhood or farther out from the city center.
What Price Point to Hit
The returns are always going to be lower on something that is inherently an expensive property, highly desirable to an end user. For example, if you have a beautiful two-bedroom apartment in a top building worth $3M, and you have a similar size in not as nice a building that’s $1.5M, it’s not like they’re worth that much more or less in rent. That two bedroom you could rent for $7,000 in the fancy building or $5,000 in the not-as-fancy building. However, it’s 100% more expensive to buy it.
The thing with the rental properties is that tenants are not renting it because the bones of the building are fabulous. They want to get the best apartment they can rent for the least amount possible. It’s not like, “Let’s max out the budget!” It’s more like, “Let’s live below our means so we can save money to buy something.”
What Renters Rent
Tenants seem like they are all looking for something different, but the majority are looking for clean finishes that feel like end-user quality, but they do not need to be. And a bit of character goes a long way. They just want enough so that they feel like they’re living in an environment they can live with.
Every person is hoping to get something that makes them feel like they’re not renting. But it doesn’t need to be the top of the line. You just need it to look and feel nice. You don’t want things to be falling apart.
If you can add in a doorman, all the better.
What to Focus on
What you should focus on are the bones of the property, the location, real actual rent roll, and the potential for upside and the numbers.
During quarantine, you might want to go for buildings with lower monthlies as well. The buildings that have more services do have a good chance of having higher monthlies, but in a moment like this, people don’t care as much. People can’t use the amenities and many don’t want to.
What you should try to look beyond are the style of the finishes orand the specific aesthetic. You’re going to paint it all Benjamin Moore decorator’s white anyway.
When to buy
In theory, the best season to buy is between mid-November and March, and because everything looks terrible, you’re able to buy against less competition because it is the bleakest time of the year. No one wants to be traipsing around in January looking at properties.
But promise me this: no matter how much you love something, if the numbers don’t make sense, wait for the next one. Overpaying for a real estate investment is going to give you a big burden and you are going to be calling a broker to bail you out before you know it!