You may have heard that your first real estate investment is the most difficult one. It’s true. Your first deal is difficult because you don’t know enough. How could you? Yet you still need to move forward and get started. If you wait until you’re 100 percent ready, you’ll never make progress. But even though your first deal won’t be perfect, you still don’t want it to be so bad that it will knock you out of the game.
So, this article will help you avoid the 10 most lethal mistakes on your first real estate investment. Use this like a checklist to ensure that you avoid the worst case scenarios. When you prevent the worst from happening, you will gain confidence so that you can buy your first deal, move forward, and begin your real world education.
Mistake #1: Bad Financing
Bad financing can be one of the most lethal mistakes possible. I have personally seen more real estate investors lose money or go out of business from bad financing than from any other mistake.
What is bad financing? For me, it includes a combination of the following:
1. High interest rate
2. Adjustable interest rate
3. High monthly payment
4. Balloon payment
5. Personal recourse
Most residential bank mortgages at least save you from the first four mistakes because the interest rates are low, fixed for 30 years, with amortizing payments, and there are no balloons. But they almost always require personal recourse, meaning you personally guarantee the loan with your other assets and future earnings. This is probably a reasonable trade-off. Many commercial, portfolio, hard money, and private lenders, however, do not meet any of these criteria. And that could be a problem, especially on your first deal. If you borrow at 12 percent interest with a large monthly payment, a balloon due in one to three years, and full personal recourse for the loan, you are likely taking too much risk.
Why? Because the property will likely have negative cash flow with the high interest rate. A balloon note means you will have to refinance or sell in a very short period of time. Trying to refinance when credit dries up is very difficult even with perfect credit and good income. And personal recourse means that if anything goes bad and your lender loses money, they could chase you around and take your other assets in order to collect.
Mistake #2: Bad Location
Real estate value always begins with location. The people and businesses who will rent or buy from you begin with location, and then they evaluate other criteria like the lot and the house. Because it’s so important, you should study the best and the worst locations in your area before buying. There are investors who make money in bad locations, but it’s a challenging game that beginners should probably avoid. I bought a lower-priced single family house once at a below market price with excellent seller financing terms. But the location was awful. I could not consistently attract good tenants because the neighbors were not pleasant (or safe) to live around.
On the other hand, I have bought properties in good locations that I made mistakes on, like paying a little too high of a price. The good location helped to bail me out of some of those mistakes.
Mistake #3: Misjudging Resale or Rent Value
I would argue that our number one job as investors is to understand how our end customers renters and buyers) make buying decisions and then to translate that to a value. If we can’t determine the full value potential, we will have a hard time making a confident purchase offer that earns us a profit. This job is important. But it’s not easy. It’s a skill that you must commit to learn and then continue to refine every day for the rest of your investment career.
On your first deal, it’s likely you are not yet an expert on value, so there are a few things you can do to help yourself:
§ Reduce your target market to a relatively small, manageable area.
§ Study all of the transactions in your market daily using tools like the MLS, Zillow, or your local tax assessor. For me, this is like the daily weight training of real estate that keeps me fit and competitive.
§ Hire professionals for assistance. For resale value find a very competent real estate agent and/or appraiser. For rental values find property managers with multiple units in your area.
§ Take courses on valuation at your local Associate of Realtors or other continuing education school.
Mistake #4: Underestimating Repair Costs
It is inevitable that you will underestimate repair costs at some point. But you want to avoid enormous cost overruns that could cause you to run out of cash or face other problems. To avoid large mistakes, learn a good repair estimating system. Also be sure to get help from other more knowledgeable investors or contractors. Don’t be afraid to pay these people for their time and knowledge.
You can meet these people by:
§ Attending local meetup
§ Attending local real estate club meetings
§ Driving neighborhoods looking for remodel projects
Mistake #5: Running Out of Cash
Your investment properties are like your race car. Cash is like your car’s fuel. When out of fuel, even the most powerful race car in the world sits still. If you run out of cash, even the best investment property will hurt your wealth building. So you want to avoid running low or running out of cash.
This usually happens for a couple of reasons:
1. Underestimating repair costs (see mistake #3 above)
2. Underestimating future capital expenses on a rental property
Capital expenses are big ticket items like a roof or a heating-air system replacement. If these costs hit you unexpectedly, it can become a big problem.
Mistake #6: Letting Emotions Drive Your Decisions
This is a huge mistake for newbies. And it’s understandable. I mean it IS an exciting chase to look for your first deal. But you have to balance your enthusiasm with cold, hard, and objective analysis. I love enthusiasm. It’s critical as an entrepreneur because it helps you push ahead through the many obstacles you will face. But I have also learned to never make big financial decisions with emotion alone. I use a process of analysis that filters each of my deals. I also run every deal by someone else, which typically means my business partner but sometimes includes other mentors and advisers. My process begins with basic criteria, including general locations, neighborhoods, housing types, construction quality, etc. This helps me to filter down the enormous number of properties out there.
I also like to calculate key metrics like the cap rate (or return on asset), the cash on cash return, the discount from full value, and the internal rate of return.
Mistake #7: Choosing the Wrong Real Estate Strategy
Real estate investing has many strategies. It’s easy to get overwhelmed or waste time chasing the wrong strategy.
Here’s a tip: You won’t find a perfect strategy. But you can find one that pretty well suits your unique strengths, your short-term needs, and your long-term goals. So, instead of borrowing the perfect strategy for someone else, think hard about what you really want and which real estate strategy will get you there.
Mistake #8: Choosing Bad Contractors
Finding contractors, who will do good work, finish up on time, clean-up after themselves, and charge reasonable prices is harder than finding buried treasure on a beach. Yet the people who do work on your fix-flip or rental deal will make or break its success.
Mistake #9: Not Using Your Due Diligence Period
Some experienced investors make offers with fast closings, in as-is condition, and with no due diligence period. This may help them get a lower price, but for your first deal this is probably not the best route to go. Instead, include a short but reasonable due diligence period that allows you to get out of the purchase contract if you find a problem.
Here are a few of the important things I usually do during due diligence:
§ Obtain a very good professional third party property inspection
§ Repair estimates (see mistake #3 above)
§ Evaluate zoning and local ordinances (for example, the college town where I invest has a law that you can’t rent to more than two students in a residential zoning district)
§ Get a professional third party opinion of value and rental value
Basically, you want to double check all of the key assumptions you used to make your offer. If you find that you made a bad assumption, you may need to renegotiate or walk out from the deal.
Some of your best deals may be the ones you don’t do.
Mistake #10: Not Learning From Your Mistakes
You have just read 9 mistakes to avoid, and I could probably tell you another 20. But no matter what you learn, you will still make mistakes. I guarantee it. This is called “The School of Hard Knocks. But the biggest mistake you can make is not learning from this School of Hard Knocks. Go ahead and decide to create your own personal School of Hard Knocks. It’s an invaluable education.
Real estate is an entrepreneurial venture. We entrepreneurs shoot for the stars, but we also take risks that could turn out badly. This can be a difficult pill to swallow on your first deal. But risk doesn’t have to be a bad word. I see it as a barrier to entry. It means that the less committed, pretender-investors don’t bother. They drop out when it gets too tough.The successful real estate entrepreneurs aren’t perfect. They have scars to prove all of their past mistakes. But they learn to avoid the fatal mistakes that would knock them out of the game. And they learn to always keep moving forward. Forward movement…That’s what entrepreneurship is all about.