By Shane Cummings, CFP®, AIF®, Wealth Advisor & Director of Technology/Cybersecurity
Understanding Common Pitfalls in Real Estate Investing
Did you know that while 90% of millionaires credit real estate for their wealth, countless others have faced significant setbacks due to avoidable mistakes? If you’re looking to diversify your portfolio, real estate may potentially be a helpful wealth-building tool – if you’re willing to invest the time and effort.
Starting your journey in real estate investing can be both exciting and challenging. By being aware of common mistakes and educating yourself about ways to avoid them, you may significantly increase your chances of success. Real estate investing is a long-term commitment that requires patience, diligence, and ongoing education.
In this article, we’ll walk you through ten do’s and don’ts of real estate investing that often trip up investors who lack experience in this asset class.
1. Don’t Rely Solely on Appreciation
Many novice investors tend to focus exclusively on potential property value increases, neglecting cash flow. Successful real estate investors generally place a strong focus on the cash flow a property can produce. As opposed to assets invested in the financial markets, one of the biggest long-term benefits of rental real estate is its potential to provide ongoing cash flow to the owner. Shrewd investors also have an eye on vacancy rates – any months when the property is not rented equate to lower potential cash flow.
2. Avoid Overleveraging in Order to Weather Market Downturns
Taking on too much debt can leave you vulnerable to market downturns. Be sure to maintain a healthy debt-to-equity ratio. If you’re considering using leverage strategically, keep it conservative, and keep cash reserves for unexpected expenses or vacancies.
As a case in point, when the pandemic hit and short-term rentals shut down and other rental vacancies ticked up, real estate investors who were overleveraged ran into serious problems keeping above water. Leverage can be beneficial when the market is booming and rentals are in demand. But when times are lean, too much leverage reduces the leeway you have to reduce rents when local markets are under pressure.
3. Do Your Due Diligence
Before making a commitment, scrutinize all the variables. You should conduct comprehensive market research, perform detailed property inspections, and analyze potential cash flow, expenses, and ROI. Never rush into a purchase without thorough research and analysis. There are online tools available that look at many quantitative factors in a given market – such as average rents, property taxes, expected maintenance costs – the list goes on. These factors are critical in determining whether a given property has the potential to produce positive cash flow or just break even.
Many real estate professionals rely on professional property inspectors to uncover potential issues before they make the leap; you should consider making use of this kind of expertise as well. Successful property owners treat real estate as a business, not a side gig.
4. Don’t Underestimate Property Expenses
Failing to account for all costs associated with property ownership can potentially erode profits. Calculate all potential expenses, including taxes, insurance, maintenance, and property management. Budget for capital expenditures like roof replacements and HVAC upgrades. Use conservative estimates in your financial projections to avoid surprises.
5. Avoid DIY Property Management—Unless You’re Prepared
Underestimating the time and skill required for effective property management is a common mistake for unseasoned investors. You should consider professional property management services, especially if you’re new to real estate investing. If you plan to self-manage, educate yourself on landlord-tenant laws and implement systems for tenant screening, rent collection, and maintenance.
6. Know the Tax Implications of Your Property Inside and Out
Failing to understand and plan for the tax consequences of real estate investing can potentially impact your returns. You can meet this challenge by working with a tax professional familiar with real estate investments. A financial advisor can play an important role here as well.
It’s important to educate yourself about potential deductions, depreciation benefits, and other tax-related strategies. For example, you should know about 1031 exchanges for tax-deferred growth – like-kind property swap strategies that experienced real estate investors take advantage of in an effort to defer capital gains. And many investors fail to plan for future depreciation-related tax surprises.
7. Make Sure You Secure Adequate Insurance Coverage
Underinsuring your properties can potentially leave you exposed to risk. Be sure to research and secure comprehensive property insurance. Consider additional coverage like flood or earthquake insurance, if applicable. Umbrella policies can be good for added liability protection; these policies typically are an inexpensive way to get extra protection. All it can take is a small accident at the property to impact your investment – and potentially your other assets – at risk if you are un- or under-insured as a landlord.
8. Diversify Your Real Estate Holdings
Diversification can be a huge challenge for investors in real estate. Over-concentrating your portfolio in a single property type or location increases risk. If you’re serious about focusing on this asset class as a major part of your portfolio, diversification is critical.
For successful investors, it can be a temptation to take a successful formula and repeat it. With real estate investing, one way to diversify is to purchase properties in different geographical areas. If that’s impractical across state lines, you might consider if it’s possible to invest in properties in different cities or counties.
Another potential option is investing in REITs (real estate investment trusts), which are securities offerings that invest in real properties and /or mortgages associated with real properties. In this way, your assets are less concentrated – while also having the advantage of these instruments’ liquidity.
9. How to Calculate ROI for Rental Properties
Mastering the art of accurately calculating and understanding the return on investment for rental properties will help you make informed investment decisions.
For cash purchases, use the formula:
ROI = (Annual Rental Income – Annual Operating Expenses) / Property Purchase Price
For financed properties, calculate the cash-on-cash return:
ROI = (Annual Cash Flow / Total Cash Invested) x 100%
Remember to factor in vacancy rates, maintenance costs, property management fees, taxes, and insurance when calculating ROI.
10. Involve Your Financial Advisor in the Conversation
Typically, our clients utilize real estate investing as just one part of a unified financial strategy. We can work with you to help evaluate the role of real estate investments in the context of your entire portfolio, making sure they align with your overall financial and life goals. Your advisory team can help you stay educated on law or tax changes that may impact your real estate investments.
If you’re interested in getting started in real estate investing, we can help provide some guidance on navigating the complexities of this asset class – and help you understand how costly mistakes may derail your wealth-building efforts. As always, we’re here to advise you on financial matters. Talk to your advisory team members if you’d like to learn more.
Disclosure:
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser located in Long Beach, California. Registration does not imply a certain level of skill or training. Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com. This blog is provided for informational purposes only and should not be construed as personalized investment advice. It should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. The information provided does not constitute any legal, tax or accounting advice. We recommend that you seek the advice of a qualified attorney and accountant.
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