The Number One Mistake that Would-be Real Estate Investors Make

I met with my friend’s wife this weekend to learn more about her thriving real estate business. She helped to confirm what I suspected to be the number one mistake that new investors make: they expect to make good returns by paying “retail” prices for real estate. By “retail” prices, I mean that they pay the same price for a property as someone would pay for their primary residence. It is very difficult (if not impossible) to make money in real estate by paying fair market value for investment properties, especially in today’s real estate market.

The real estate business is very much like any other in many ways. If you are buying and selling widgets on eBay and you buy your widgets for retail price at Wal-Mart, there is no way in hell you are going to make any money. You have to buy your widgets at a heavily discounted price in order to turn a profit. The same goes for real estate. If you are going to make money in real estate, you have to buy properties at a heavily discounted price.

Even if you use the cheapest kind of financing possible (i.e. an interest-only loan), it would still be difficult to make positive cash flow on a rental property. It would also be difficult to try to make upgrades to the property to sell it for a profit, if you paid fair market value for the property. The closing costs, holding costs, not to mention the cost of upgrades and repairs would erode your profit. Even if you paid cash for the property, it is may still be difficult to simply recover upgrade costs unless you made a major improvement such as adding a bedroom and/or bathroom.

The best way to mitigate risk when investing real estate is to make sure you pay as little as possible for investment properties. I’m talking about paying 65-70% on the dollar or less, not a discount of a mere 5-10% of fair market value. The less you pay, the more room for profit it will give you for recovering closing costs, holding costs, and the cost of repairing and upgrading the property. It also leaves room for positive cash flow if you plan on buying, holding, and renting (which is what my friend’s wife does). If you do ever decide to take the plunge and get into investing in real estate, be sure you are getting a steal on the properties you buy. Otherwise, you could very likely have a bad experience and will never invest in real estate ever again.

Of course, the big secret is how can you possibly manage to buy a home for 65% on the dollar. Perhaps that will be another article for another time, but there are many books and resources on the internet that will tell you how to do it. It is a matter of doing your research and acting on what you’ve learned. The biggest challenge (especially for an analytical person such as myself) is actually taking action after becoming educated with good information.

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    • Good post. I would add that the number two mistake is not understanding the numbers and the four ways you actually make money investing in real estate. Number 3 is not having a clear gameplan plan to either increase income or decrease expenses. I invest and write about commercial real estate investing where the NOI (Net Operating Income) driven by "Number 3" dictates the worth of a property.

    • Chrisfs

      It seems that at this point in time, it would be easier to find undervalued real estate than in the last few years. Real Estate, especially primary residences, are different from stocks because the sellers has a much greater emotional connection with his house than with his shares of Thornburg and selling stock doesn't require you to find another place to live,not are your stock losses as exposed to the whole world. Some buyers will take advantage of the sellers time limits and lack of experience in real estate (this may have been the seller's only experience in real estate ever).
      I believe it's tough to look people in the eye and buy something they don't want to but are forced to sell and give them a price that's lower than what they wanted.

      I recently read what was recommended as a classic book on the subject which despite it's name, "Make Big Money in Real Estate Foreclosures" by Ted Thomas, explains an ethical way of going about buying pre-foreclosure real estate.
      Chief among his policies is that at any point before the actual sale, he assures the seller that they can back out at any time, if they get a better deal or have a way to pay the back mortgage themselves.

    • Good advice. I agree that you need to "steal" a property for it to be worth while as an investment property that actually makes money. Although, paying cash doesn't hurt either. I know it sounds foreign for people to think about saving up enough money to pay cash for an investment property, but I think it can be done.

    • Anh F

      Jorge,
      I think you explained our meeting very well. Your writing is very clear and concise. Glad to help another one of my husband's friend and co-worker. By being analytical, you will not be too risky and that will keep you in the game.

      Good luck.
      Anh

    • Wealthboy,

      There is no question that, in real estate, you make money when you buy. Ultimately, I tend to shoot for around costs at 80% of below of improved value. My 80% figure would include rehab/improvement costs and transaction costs. Another related mistake is to consider cashflow as rents minus the mortgage payment. New investors seem to frequently forget taxes, insurance, and maintenance costs. Good article.

      In response to Ian's comment, I have heard this opinion often, but it seems to apply only to real estate and not other investments. I have never understood this. A stock market buyer who purchases in a down market and who resells at a profit is never deemed to be "taking advantage" of the seller. Even in the context of sales of goods, the analogy applies. To borrow from your article, WalMart has purchased at a price below what it sells those goods. WalMart is not "taking advantage of" its buyers by doing so.

      To the extent that any investor, real estate or otherwise, uses deceptive or unethical means in a transaction, it's wrong. To the extent they don't, it's what we call "the market."

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