Investing in real estate may seem like a simple proposition. You find a property, buy it, make improvements and then lease or sell it for a profit.
But going about it the wrong way greatly increases your chances of owning a property that costs you far more time and money than you planned on, says Joseph V. Barna, SIOR, principal, CRESCO Real Estate.
“The key is to start with a good investment model and an understanding of what you can do, what you can afford, what is realistic and what you’re capable of accomplishing,” says Barna. “Then you find something that fits. Once you think you have it, go back and make sure your research is correct as it relates to the specific investment. What do you think you can rent it for? What do you think the property can sell for? What are the trends and needs in that particular market? You have to anticipate the worst and plan for it, and if your numbers still come out, you’re probably going to be OK.”
Smart Business spoke with Barna about how to avoid rookie mistakes when investing in real estate.
Where do you begin when looking to invest in real estate?
First, you need to have a well-thought-out plan. In most cases, a poor plan, or lack of a plan, is the biggest mistake first-time investors make. The key is to choose an investment model that works for your financial position and comfort level, then identify a property that is well aligned with your model.
Most people do the opposite. Rookie investors will find what they think is a good deal and then try to develop an investment plan to make that work. But that’s where the trouble starts. You need to put together a business plan and then find something that suits that plan, not just stumble into what you think is a good deal and then grab at straws to put it together.
What are some mistakes first-time investors make?
A common mistake is failing to have an exit strategy, which is just as important as having a plan when you go into an investment. Rookie investors will have one investment strategy, perhaps even a pro forma, then assume that investment is going to perform as it’s laid out based on what they think is going to happen.
An experienced investor, however, will have an investment pro forma and run the worst-case scenario and look at the downside, then run the best-case scenario and look at the upside. You have to plan an exit strategy for multiple situations or you can get burned.
How important is doing research on a potential real estate purchase?
It is extremely important. Real estate is local and each submarket within a specific market is different. It’s crucial to understand local market conditions, the specific submarkets within a market as well as the cycles and trends within those sub-markets, because what was a hot area two years ago could be cooling off today.
What role does due diligence play in determining whether to make an investment?
When people think of due diligence, they commonly focus on the physical structure, the condition of the roof, the mechanical systems and the environment condition of the property, but it goes far beyond that.
For example, if you buy a multi-tenant building in a healthy market in which the rents are at the extreme high end, you’ll get a great return, so you may think that’s well and good. But that property may have a tax abatement in place that will end in three years, and when it does, increased property taxes are going to kick in. That can add considerably to your operating expenses. All of a sudden what you thought was a good return isn’t, and because tenants don’t want to pay an above-market rate, you start losing them when you attempt to pass through the increase.
Zoning is another consideration. Meet with the city before the purchase, because your intended use may not be quite in line with the zoning requirements. If you don’t, you’re going to spend extra time and money trying to get variances, and the cost of that may offset the logic of buying that property.
How can bad math cause problems?
Inexperienced buyers may think it’s easy to buy a property, improve it and either lease or sell it. But they often underestimate the time and money it takes to improve the property as well as the time it takes to find a buyer or tenant. If you think you’ll have to hold it for six months and it’s actually 12, then you’re paying a mortgage with no cash flow coming in.
If you think you are going to buy a building, then flip it for a profit or lease it, double the amount you think it’s going to take to improve it, double the carrying costs as well as the time you think it’s going to take to sell or lease, and if the numbers still make sense, you might have a good deal.
Another mistake regarding money is overleveraging a property and failing to leave enough room to carry the property. If you can’t lease it or sell it, you still have to pay the mortgage, insure it, pay property taxes, heat the property and market it. All of a sudden, that great deal is not so great because you didn’t compensate for the downside.
How important is having advisers?
You need to surround yourself with trusted advisers, including a real estate broker, banker, real estate attorney, accountant, contractor and perhaps a mentor. If you do that and do your homework, you’re much better off than going in with your eyes shut and you increase your chances of success.
Joseph V. Barna, SIOR, is a principal at CRESCO Real Estate. Reach him at (216) 525-1464 or [email protected]