Historically, investing in real estate has been one of the best ways to build long-term wealth. Many of the world’s richest people made their fortunes by investing in properties.
However, just as with any other type of investment, real estate investing is not without risk.
Here are a few pitfalls you should be aware of before becoming a real estate investor. We’ve divided them up into two installments.
Risk #1: Choosing the Wrong Location
When buying any type of investment property, location should always be your primary consideration. You can’t move the house to a more desirable location if the neighborhood deteriorates or a strip mall goes in a block away. For commercial properties, you don’t want to own the only occupied storefront or office on a vacant block.
Things to Research
You’ll want to research the market trends and zoning in the area you’re targeting. What has been the property appreciation rate over the past few years? What changes, if any, are being planned by the zoning board?
Additionally, you’ll want to study the neighborhood. Survey the shopping amenities. Drive around during rush hour to assess traffic congestion. Look into the crime rate trends and check out the ratings of the school system. All the things people want in their neighborhood. These factors matter to anyone who may want to rent or buy the property.
Why Location Matters
Location also determines supply and demand, which comes into play when you want to sell. You may be tempted to buy in a certain location where prices are lower. But this could be a terrible choice. If prices are low, there’s usually a reason.
The location may lack a growing population or a good job market. Or too many available investment properties may be bringing down rental income. Low demand will be reflected in a lower sales price and a higher number of days on the market. And these increase your holding costs.
Some areas will have a high tenant occupancy rate with few owner-occupants. Owners who live on site usually take better care of their property. They also monitor crime in the neighborhood. So, areas without owner-occupants often have a lower quality of tenant.
Thus, your initial cash outlay may be lower, but you may end up paying more in repair costs. And that does not help your bottom line. Also, you may face an increased risk of getting vandalized or robbed. No one wants that. It all can lead to unexpected expenses and high repair costs, in addition to legal matters.
Location is also the biggest determinant of property appreciation. Low appreciation can mean a negative return on investment when you decide to sell. No appreciation means you’ll likely lose money when you sell, after paying commissions and transaction fees. You may be tempted to purchase a cheap investment property, but in most cases, the risk is not worth it.
Risk #2: Paying Too Much (Or Not Getting What You Think You Paid For)
Buying the right property at the right price is arguably the most important part of succeeding as a real estate investor.
It’s paramount not to overspend on the purchase price or the renovation. In the purchase process, it’s far too easy to buy a property that’s more damaged than it looks. (You can’t see behind the walls or test all the systems during a walk-through.) You have to calculate costs with diligence and take some leaps of faith. That means there’s a risk that you are not getting what you think you’re paying for. This increases the chances of facing unexpected renovations, repairs and maintenance costs.
Always get an inspection even when you’re buying “as is.” That way you know what costs you will have once you become the owner. If you’re financing the purchase, your lender will do an appraisal, which will give you good insight as well. Property appraisers and inspectors are the buyer’s friend.
Once you purchase the property, resist the urge to over-improve it beyond what the local market expects. Most rental units don’t need granite countertops or top-of-the-line fixtures. Be sure to run — and rerun — your numbers to prevent overspending.
Risk #3: Bad Tenants
Finding quality tenants is paramount to your real estate investing success. It’s important to place tenants who pay the rent consistently, respect you and take care of your property. While that sounds simple enough, I’ve found that I need to weed through a lot of potential tenants to find these gems.
You want to avoid having bad tenants. So, you need to prequalify potential tenants. Go through a thorough tenant screening process. This includes verifying their employment, checking their credit score, checking their criminal background and court records, and contacting their previous landlords. Or use a tenant placement service, but make sure you do your due diligence on them as well.
Getting stuck with a bad tenant can be worse than having no tenant at all. Having your property empty means not collecting any rental income, but bad tenants can be worse. Some will constantly fall behind on paying the rent. This of course jeopardizes your cash flow. And you may be stuck dealing with the eviction process, which is time consuming, costly and just downright unpleasant.
In part 2, we’ll look at four more risks that you need to be aware of if you’re considering a real estate investment.