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What’s the big advantage of real estate over equities and other investments?
You can predict the returns!
Having said that, your ROI forecasts are only as good as the numbers you start with.
Here are the seven of the most common mistakes real estate investors make when running their numbers — and how to avoid them for a perfect win record in your investing.
We’ll start with numbers that affect all real estate investors, then narrow our focus to rental investors and cash-flow forecasting.
1. Not Budgeting for Unexpected Repairs
Years ago, I bought a property to renovate and flip. I was awfully proud of myself: I bought it for $20,000, was planning on putting $40,000 into it, and then sell it for $105,000.
Two days into the renovation, I got a call from the general contractor. Sure enough, he found more work that needed to be done. A lot more work, in fact: The framing was rotted through and needed to be replaced … throughout the whole house.
That story actually just gets sadder from there, as the loan market for lower-end properties in Baltimore completely collapsed (this was 2008). Suddenly, there were no homebuyers in this type of neighborhood who could be approved for a loan. I ended up having to keep it as a rental, and (shocker!) it didn’t cash-flow well (or even positively; more on cash flow later).
This brings me to my ultra-important point: Always budget extra for unexpected repairs.
Sometimes, you’ll get lucky and won’t need to tap this overflow budget. More often than not, though, the contractor will call you with a perfectly reasonable explanation of why you need to pay them more money.
The same goes for carrying costs, too. Expect your renovation projects to take at least one month longer than projected — possibly two or three months longer (construction schedules rarely ever finish on time, as you may already know).
The other moral of this story? Spring for a home inspection, and use the best, most detail-oriented, anal-retentive inspector you can find.
2. Ignoring Your Exit Costs
I hear property owners brag all the time about how much equity they have in their property:
“My property is worth $250,000, but I only owe $200,000! I have $50,000 in equity!”
That $50,000 exists only on paper. Actually, it’s less real than that; it’s an illusion.
Sure, you have an asset worth $250,000 … but it will cost you $25,000 to actually cash out and liquidate it. Between Realtor fees and other seller closing costs, budget conservatively and set aside a full 10% for exit costs if you sell the property traditionally.
And that says nothing of your carrying costs, while you’re marketing the property. If you’re selling for top dollar (which is what those braggarts are assuming, right?), how likely is it that you’ll have renters living there right up until the closing date?
The same logic even applies to homeowners: Are you truly going to live in your home until the closing date on the 31st of the month, close on the same day for your new home, and be all moved in the next day?
Subtracting your mortgage debt from your property’s market value looks nice on paper. You get to pat yourself on the back about high your net worth is growing. Nice, but not accurate.
Unless you have an atypical exit strategy (e.g. a lease option), drop 10% from your property’s value when calculating your equity. What’s left is what you could realistically expect to walk away with, and even that is only after several months of marketing.
3. Being Over-Optimistic on Vacancy Rate
Far too many rental investors assume minimal numbers for their vacancy rate.
“Vacancies shmacancies. I’ll be able to rent this bad boy in no time!”
Then their tenant slips out of town in the middle of the night, leaving the property trashed. Two months later, the landlord is still showing the property and cursing under her breath.
Unless your property is in a very hot rental market, budget at least 8% of the rent as a vacancy rate. That’s one month a year.
And hey, if your expense-reserve fund for your rentals gets too high, you can always siphon some off and invest it elsewhere. But it’s far better to budget too much for vacancy rates than too little.
4. Not Budgeting for Property Management
Our course students get sick of hearing me make this case. But it’s an important one.
Over and over, I hear new real estate investors say:
“Oh, I don’t need to worry about property management costs. I’m managing the property myself!”
Good for you. Until you get sick of 3 AM phone calls from tenants. Or move out of state. Or pop out three squawking infants and the last thing you want to hear is a tenant whining about a burnt-out light bulb.
And even that argument isn’t the crux of the matter. The truth is it doesn’t matter who’s doing the labor, property management is a labor cost. If you’re doing all the work, you need to account for that work in your budget.
Otherwise, how can you possibly compare your returns on your rental to those of a truly passive mutual fund?
Budget a bare minimum of 10% of the rent for property management. In reality, it will likely be closer to 12-15%, because most property managers charge new tenant placement fees.
5. Underestimating Repairs & CapEx
Capital expenditures happen.
Let’s beat up on newbie landlords a little more, shall we?
“Well, sure, my returns this year got thrown off by that big furnace repair. But I’ll make it up next year!”
I used to say that to myself all the time. Then guess what happened next year? The roof sprouted a leak. Then it was updating the outdated kitchen. Then replacing the rear fence. (And so on, and so on.)
I like to budget around 8% for major repairs and CapEx — and much more for older homes.
When those big bills come, you’ll be disappointed, but not destitute.
6. Underestimating Regular Maintenance
What’s the difference between repairs and maintenance, you ask? Why exactly are they separate expenses?
Repairs and CapEx are significant upgrades or replacements to the property, based on age. Every single component in a property has a limited lifespan and will need to be replaced or upgraded on somewhat predictable intervals.
Maintenance has more to do with your tenants’ use (or abuse) of the property and hit you hardest during turnovers.
The classic maintenance expenses are repainting and recarpeting (or refinishing, or reflooring, or whatever needs to be done for your property’s floors). The good news is you generally only have to do this maintenance during turnovers.
The bad news? It is quite expensive and means your turnover rate has an enormous impact on your returns.
I generally budget around 5% for maintenance. The better you are at retaining your tenants, the less you’ll need to spend on maintenance.
7. Failing to Budget for Administrative & Miscellaneous Costs
Landlords run into a slew of other small expenses, each of which seems trivial. But combined, they add up to significant costs.
For example, many active real estate investors spend a lot of time in the car:
- Scoping out new markets
- Touring properties for sale
- Going to auctions
- Visiting their own properties
That mileage adds up, both in fuel and in wear and tear on your car.
How about bookkeeping? Do you do it yourself? Hire it out? Once again, it’s a labor expense either way.
Do you own your properties under legal entities? Those cost money, both to file and to maintain.
Your tax return is also more complicated and time-consuming, with the wrinkles added by your real estate business. Expect to pay more for your accountant, or to spend more of your Saturdays behind your computer filling in form fields.
You’ll have home office expenses that you wouldn’t have otherwise.
Again, none of these by themselves is a budget-killer … but they add up, and more than most investors realize.
I recommend budgeting 2-4% for your miscellaneous and administrative costs, as a landlord.
Accurate ROI Forecasts Mean Never Buying Another Bad Investment
I love equities — don’t get me wrong. I diversify across a range of industries, micro-cap to large-cap, U.S. and international, in my mutual funds and ETFs.
And then I cross my fingers and hope they deliver good returns for me.
My rental investments, though, are another story entirely. I know what my long-term return on investment will be, for each property I buy.
It gets even better. With my mutual funds and ETFs, I have zero control over my returns. All I can do, once I’ve bought shares, is hold them or sell them.
But my real estate investments? I’m in the driver’s seat. I can sign long-term leases and incentivize my renters to stay for the long haul, minimizing my turnovers and maintenance costs.
If I want higher rents, I can find ways of improving my properties to appeal to higher-paying renters.
If I’m strapped for cash, I can often postpone repairs for a few months or even years.
It all starts with your numbers though. Using accurate numbers when you buy real estate will prevent you from ever buying another bad investment.
Talk about an unfair advantage – how many of your friends can say that about their stock picks?