5 Cautionary Lessons Learned About Real Estate Investing
I talk a lot about the benefits to be had from property investing, but recently noticed that I likely don’t shed enough light on the less flattering aspects that need to be taken into consideration before going this route. The benefits of real estate investing are real and can be a powerful financial weapon for boosting your net worth, but these benefits do not come without their fair share of work, hassle, education and risk.
That being said, here are some of the more cautionary but real lessons I’ve learned during my time as a real estate investor.
RENTAL INCOME IS NOT COMPLETELY PASSIVE
This is one I didn’t want to admit even when I began to realize it was true. Where was this completely passive income that I had been promised?!
Well, it turns out the concept that rental income is 100% passive is just not true. At least, it hasn’t been for me to this point in time. Indeed, my properties have provided income that is much easier to come by than earned income; however, there has been work to be had to both 1) initially obtain, and 2) keep maintaining.
Whether you are saving up money for a down payment or are out raising money for an acquisition, the fundraising process requires work and dedication. It’s neither passive or easy. And doing the research into which property you might obtain also requires education and research. Again, not passive tasks. But I was well aware of all of this before heading into my first (and 2nd through 4th) purchase. What I wasn’t expecting was how much was to be involved in post-acquisition phase.
Once you actually own the property, there are plenty of ongoing tasks required to properly maintain a high-functioning investment. This can involve anything from bookkeeping to repairs/renovations to tenant management to refinancing to performance measurement to shopping insurance, and so on and so forth. Even if you have a property manager in place there are plenty of tasks that fall to a owner (as explained in another point below).
I estimate that I likely spend anywhere from 5-20 hours/month on management items involving my properties. Yes, this is still a very good trade-off compared to the benefit received. But I would not categorize it as a completely passive endeavor.
CASH RESERVES ARE MANDATORY
This likely comes across as a no-brainer, but let me tell you that it’s not always easy to leave money on the sidelines, especially if you happen to have another investment opportunity staring you in the face. However, it is absolutely mandatory to have liquid reserves on hand for when (not if, when) an issue does arise.
Roofs might last 20-30 years but eventually they have to be replaced, which can easily run an investor $10k. Rather routine items such as this (roof, HVAC, flooring, paint, etc.) can be strategically planned but the unexpected items cannot. And this is where cash reserves are fundamentally necessary.
For example, a while back it was discovered that a sewer line had been leaking in the crawl space under one of my properties for some time before it was noticed by the tenants. Needless to say, the ongoing accumulation of sewage caused quite a mess and was not an item that could wait to be handled. $7,500 was required pronto! Quick, easily accessible cash reserves were absolutely mandatory to alleviate this concern in an effort to keep the property in healthy, proper working order and the tenants in place.
General guidelines for how much cash to have on hand vary, but an investor is probably best served by making sure they are following the Fannie Mae underwriting guidelines for liquid financial reserves. This way a person is already in compliance if looking to get quality, lower-interest financing for the next 1-4 unit property. Generally, the guidelines state that an investor should have 2-6% of the total unpaid principal loan balances on hand in form of liquid reserves.
A PROPERTY MANAGER DOES NOT ALLEVIATE MANAGEMENT DUTIES
As mentioned above, there are a lot of management tasks involved with owning rental properties. You can either handle these entirely on your own or with the help of a property manager. I never had the intent of creating myself another full-time job, so having a property manager on hand to lighten the load has always been a part of the plan.
Something I’ve learned is that a property manager does not alleviate all duties. Instead, a property manager is simply a subcontractor who also requires managing, and this requires its own unique set of responsibilities to help encourage good behavior. For example, I’ve found that it is necessary to always double check monthly statements for accuracy and immediately follow up when discrepancies are found. It is also important to know when leases are due and reach out to the manager ahead of expiration to see what measures are being taken to either keep the tenant in place or prepare the unit for turnover. These are just two examples of necessary monitoring which are important, because when a property manager knows a homeowner is proactive they are much more likely to be diligent with your investment. Getting to this point requires work in the form of careful oversight.
The main takeaway is that an investor who hires a property manager should think of their role as a shift from landlord to asset manager. The primary duty of a successful asset manager is to ensure the underlying investments are performing at their best and highest level, which requires work in making sure the property manager is performing at their best and highest level.
THE GET RICH QUICK MESSAGE IS FALSE ADVERTISING
Real estate investing is appealing to most people because it can be lucrative. But anywhere treasure can be found, pirates are likely on the horizon. The world of real estate is not immune to this and just might have more bad players than any other area of investing, with thieves often presenting themselves in the form of get rich quick schemes. You’ve likely seen a few of them advertised on your social media feeds or late-night TV infomercials.
I bought into a program once and afterwards wished I hadn’t. It was a multi-family investing seminar. There were some educational takeaways, but it was clear to see how the pyramid scheme was forming before my eyes. My program was simply phase 1 of a multi-tiered approach to displace attendees from much more of our money. I left thankful for the personal learning experience but also sad for those that were going on to potentially spend tens of thousands (!!) for a dream of riches, but a more likely 0% return on the money.
That’s why it’s important to remind ourselves that if something sounds too good to be true, it very likely is. Most successful investment strategies involve careful planning and a longer-term time horizon. While the idea of becoming an overnight millionaire is appealing to all of us, it is also a very unlikely outcome for any of us.
An err to the side of caution now brings us to the last point.
REAL ESTATE INVESTING HAS PLENTY OF RISK
There are a number of risks that come along with owning real estate as an investment. Those that say otherwise are often times trying to sell something. Some of the potential risks should be fairly well known but others I have experienced more keenly through actual ownership of properties. As with any investment, one has to be aware of the risks of owning a holding just as much as the potential opportunities to be had. With that knowledge in hand, steps can then be taken to help mitigate the pitfalls.
Here is a rundown of some risks to keep in mind when owning real estate (listed alphabetically, not by ranking).
Changing Local Demographics / Market Conditions
Concentration of Money
Neglectful Property Managers
Weather / Natural Disasters
All of these risks can have an impact to the bottom line. A thorough screening of markets, tenants and property managers can go a long way to alleviate some risk, but others are simply inherent to real estate and tough to avoid. For example, real estate cannot be bought and sold like regular securities so should be approached as a longer-term, illiquid holding. Real estate is going to require a larger capital investment than most other securities which can reduce diversification. Also, there is a much larger risk of litigation when dealing with tenants which is something not experienced by many other forms of investing.
These risks have to be taken into consideration before taking the leap into real estate investing. Be honest with yourself. Are these risks something you are comfortable taking on and managing? If not, maybe this is not your path. And there is nothing wrong with that!
THE BOTTOM LINE:
The purpose of this article not to scare people out of getting involved in real estate, but rather to shed light on some of the cautionary truths behind it. With every investment strategy there is some risk and learning involved. Real estate is no different. Yes, with careful planning and education, property investing can be a tremendous wealth building tool. But it is certainly not going to be the preferred strategy for all investors.
If looking to have a real talk about real estate, feel free to book an intro call to see if dabbling in this arena might be right for you.