[TRANSCRIPT SUMMARY] In this video, I will discuss the common mistakes that new investors often make. Over the years, we have personally made numerous mistakes and have witnessed others make the same ones. Our aim here is to shed light on these mistakes and guide real estate investors like you in avoiding them.
Welcome back to Money Mondays, where we release a new video every Monday. These videos are based on our experiences and are designed to help you grow your real estate portfolio. We have successfully invested over $700 million in real estate and have worked with thousands of investors. Our goal is to continue expanding our investor network while providing valuable insights.
Unexpected Expenses in Real Estate Investing
Let’s start by addressing the first mistake: unexpected expenses. When purchasing real estate, it is crucial to factor in replacement reserves. These reserves serve as funds to address deterioration over time, such as replacing an air conditioning unit. Additionally, having additional reserves set aside for unforeseen circumstances is essential. For instance, insurance costs can unexpectedly rise, causing financial strain. Another common mistake is underestimating the complexity of a deal. While a transaction may seem straightforward on paper, the reality is often more intricate. To mitigate risks, it is vital to prepare for unexpected expenses and plan accordingly. Over the years, we have learned from our mistakes and increased our reserve amounts. Today, we allocate approximately 3 times more reserves compared to our previous investments. Consequently, when purchasing a $15 million deal, we may set aside $2 million in reserves in an interest-bearing account as a safety net.
The next mistake to address is vacancies. In the real estate market, vacancies are inevitable as rental trends fluctuate. It is crucial to account for potential vacancies and develop strategies to manage them effectively. For example, in our value-add approach, we upgrade unit interiors whenever they become available. However, this process can take 30 to 45 days, resulting in extended offline periods for those units. Additionally, ongoing construction projects around the property may deter potential tenants. Therefore, when creating your business plan, it is prudent to project lower than expected occupancy, particularly in the initial years. Furthermore, it is crucial to have a realistic understanding of market vacancy rates, as maintaining 96% occupancy consistently is challenging. As the number of available units decreases, the turnaround time for getting new leases becomes longer. Hence, it is important to consider both economic occupancy (based on leased units) and physical occupancy (actual tenants in units).
One aspect often overlooked is the provision of unit and model unit – something provided at no cost to employees or for security purposes. Additionally, bad debt, vacancies, and evictions play a significant role. It’s important to write them off when necessary. Occupancy is not just about having someone in the unit, it’s about them paying rent.
Real Estate Investing and Financing
Next, let’s talk about financing. Some assume they can always secure 80% leverage with a 5-year interest-only period. However, this may not be accurate, especially for your first deal. Financing can be more challenging, and you need to have a plan for such scenarios. Real estate is cyclical, and the market changes. Even for us, having done 20 to 30 deals, it becomes harder to secure financing depending on where we are in the cycle. As evidence, our current development project is struggling to secure new construction financing, forcing us to reassess and plan differently. Remember, as an investor, financing can impact your deal even after it’s under contract. Ensure you have multiple ways to finance and structure the deal to protect yourself in case one option falls through.
Now, let’s discuss property management. This is where the real work lies. Many believe they can buy a property and hand it over to property management, thinking it’s that simple. But in today’s economic environment, operating deals is challenging. It’s the toughest part of the business, and yet, many tend to focus solely on the acquisition phase. But your deal’s success hinges on effective management. We learned this the hard way and ultimately started our own management company. Relying on third-party management can be hit or miss. While there are good options out there, there are also subpar ones that can lead to years of fixing and unwinding a deal. Stay on top of what happens after you acquire the deal. Be prepared to actively manage the asset, ask tough questions, and track progress diligently.
Most importantly, find a property management company you truly trust and feel comfortable with, or consider starting your own. However, keep in mind that starting your management company is a challenging task. There are many intricacies involved, and I don’t recommend it lightly. When selecting a property management company, prioritize honesty. Some management companies overpromise and underdeliver simply to secure the business. You want a company that will be upfront with you. For example, if the market indicates $1100 rent, but they say they’ll aim for $1300, they should be accountable for the lower figure. Examine their portfolio and verify their ability to handle the deal at hand. Are they actively involved in the market, or are they solely relying on chance? Remember, the property management company is your partner in this venture. Choose one that is forthcoming and sets realistic expectations.
It’s crucial not to seek property management companies that make empty promises, as our experience has shown that market fluctuations can quickly overturn outstanding rent growth. For instance, we recently witnessed a remarkable 30% rent growth in Austin, only for the market to shift abruptly, resulting in stagnation. Real estate operates cyclically and can rise and fall in waves, so it is vital to plan for such changes, have reserves, and adapt to evolving circumstances. Remember, what works today may not work tomorrow. By staying informed, understanding your market, and anticipating seasonality, you can ride the highs and mitigate the lows. Summertime, in particular, marks the peak leasing season, making it crucial to approach it with open eyes and prepared units. Capital expenditures that take units offline during this period may face challenges in leasing.
Finally, legal issues are an inevitable part of being in the business long-term. It is essential to have the right insurance and legal support to navigate such matters. Slip and fall incidents and other situations may arise, but with the proper structure and professional guidance, these challenges can be managed. While the situations can be stressful and disheartening, it’s important to recognize them as part of the business journey and not let them deter you.
Your attorney, a valuable member of your team, can assist in navigating challenges and leveraging their experience to guide you. Be cautious of overestimating returns, as it is easy to get carried away with a deal and overlook potential obstacles. Stepping back and realistically assessing the likelihood of achieving ambitious goals is essential. Many investors fall into the trap of overestimating returns in the initial years, causing disappointment among stakeholders. Therefore, it is vital to set realistic expectations and gradually exceed them to build trust and confidence. Remember, it takes time, typically around 14 to 15 months, to fully comprehend and optimize a deal, including its strengths and weaknesses. Flexibility is crucial, as the original business plan often undergoes refinements based on acquired data and learnings. By tempering expectations and delivering on promises, investors will continue to support your endeavors. While real estate is a numbers-driven business, you don’t need advanced mathematical skills to succeed. However, a solid understanding of key financial metrics is paramount. Consider utilizing existing models or building your own to better appreciate how different factors interact and impact your investment. By delving deeper into the numbers, you can make informed decisions and evaluate the potential profitability of your endeavors.
Reserves and Liquidity
Additionally, having ample reserves and liquidity is essential for handling unexpected challenges that may arise. Adequate financing is a protective shield, preventing potential setbacks that could result in losing the deal. Real estate investments can indeed generate substantial wealth, but caution must be exercised to avoid detrimental mistakes. By learning from our own experiences and understanding the pitfalls outlined in this video, you can steer clear of common errors that plague many new investors. If you are feeling overwhelmed by these concepts, consider partnering with an experienced operator who can navigate these complexities on your behalf. Feel free to leave any questions in the comments, and don’t hesitate to share this video with others who may benefit from it. Let’s learn and grow together.