Due Diligence Will Reduce Mistakes For Real Estate Investors
Any time of day you turn on your television you can find several infomercials or shows which depict investing in real estate as an easy path to riches and wealth. Every day you get in front of your computer screen you will run across ads and coy and clever marketing programs which also suggest that you should quit your job and begin a high-powered career in real estate investing. The truth is that real estate investing, like every business requires significant education, due diligence, and perseverance. Importantly, most new real estate investors make many mistakes along the way which are sometimes avoidable, but do help with the education process and learning curve. Here are some very important topics which you need to become familiar with before you begin your journey down the path to real estate investing.
1) “Cash flow, cash flow, oh no, where did my cash go?” It is estimated that 8 out of 10 real estate investors use estimated numbers to calculate cash flow when purchasing real estate. Positive cash flow for the current owner, now seller, is going to be dramatically different for the new purchaser. The new buyer will have a substantially different cost basis than the seller and will most likely have debt. This will result in a different cap-rate than the seller currently has. A cap-rate, or capitalization rate is the gross rate of return on investment as a percentage of the value of the asset.
For example, if an investor paid $1,000,000 for an investment property and it produces $150,000 in positive net operating income (which is the dollars remaining after fixed and variable costs are subtracted from gross rental income) during a 12 month period – in this case $150,000/$1,000,000 = 0.15 the investor has a 15% cap rate. If the owner/seller has a cap rate of 15% then the buyer will most certainly have a lower cap rate because of increased costs due to debt service. Cap rates can also be used to determine how quickly an asset can pay for itself. A 10% cap rate will pay off an asset in 10 years.
This is a simplistic way to look at asset investments and there are many details not discussed here, but it is a general broad brush approach to understanding cap rates. The bottom line is that a new real estate investors needs to know precisely the costs involved in the purchase of the asset, the rents the tenants are paying, the potential for increased costs, the potential for tenants leaving, etc. Without these details it is impossible to know what an investment is worth, what you should pay for it, and what it can become. Take the time to do the due diligence and research the facts surrounding the investment before closing escrow.
2) Don’t underestimate the real numbers. Those investors who undertake the process of due diligence, research, and investigation still have a tendency to understate the true costs. They also have a propensity to be optimistic about future rental increases and vacancy rates, and overlook the potential maintenance required. For example, for a single-family home the homeowner’s insurance costs more than an owner-occupied home. In commercial buildings the vacancy rates can be higher than the assumptions the investor used when calculating the original cash flow projections. Be conservative with your estimates and always provide an extra buffer for contingencies.
3) Investment properties are like kids that require constant attention, require constant care, and consume resources. Even if you hire a professional property manager you still must be analyze the monthly statements and stay on top of the issues, the rents, the expenses, and any future events which might change the income and expenses. Stay in constant contact with the property manager and keep apprised of any upcoming tenant issues like lease extensions, etc. If you are planning on any improvements or remodeling make sure you add a 20% contingency on each item so that there are no surprises.
4) The location of the investment property is also critical to success. A seasoned real estate professional who knows the market and location of where you are looking for properties is tantamount to your long-term success. Make sure the real estate professional knows more about what you are looking for than you do. The last thing you want to do is hire someone who knows less than you about your investment. Due diligence on and about the location of your investment property will pay dividends in the long-term and you will not second guess yourself when you go to sell and exchange the property into a bigger building.
At the end of the process before you close escrow you should know everything there is to know about the building or asset you are about to purchase. You should spend every waking moment analyzing and investigating the asset so that you are an expert by the time comes to make an offer. Without this attention to detail you will end up making some mistakes and wishing you hadn’t purchased the building or worse having an asset that actually loses money. Don’t make mistakes that others have already made, or at minimum make less mistakes.