Here’s how to avoid the costly errors that turn your once-promising investment into a losing proposition.
Investing in real estate can be incredibly lucrative, but it can also be a lot harder than it looks. Although the past few years of skyrocketing home values have given a lot of novice investors the idea that buying property is a “can’t-miss” investment, the reality isn’t quite so simple.
There are endless variables that can eat into your profit margins—everything from capital gains taxes to unexpectedly high carrying costs to spiking property taxes. These can slowly turn what you thought was a prime investment into a losing proposition.
Let’s look at some of the most common mistakes that can kill potential real estate deals—and touch on how you can avoid them.
1. Buying High
One of the cardinal rules of real estate investing is to “buy low, sell high.” On some level, investing really is that simple. If you sell for more than you paid, you’ve made a profit. If you don’t, you’ve lost money.
Everything starts with your purchase price. If you’re a house flipper, the gap between the purchase price and the future sale price determines your renovation budget, your list price, how much you can afford in carrying costs, and your timeline. If you’re going to rent the place out, your monthly mortgage price is going to be a big factor in how much rent you will need to charge. If it’s too high for the market, you’re stuck with a money pit.
Overpaying on the front end has killed countless real estate deals, so make sure you crunch the numbers carefully.
2. Using Bad Comps
One of the most common mistakes that cause investors to overpay for properties is to use the wrong comps.
Estimating property value is an art, not a science. The market sets the price, so it makes sense to turn to the market to figure out what you should pay. The best way to do that is to find and study comps (i.e., comparable properties that have recently sold). You average the sale prices of those comps, make a few adjustments, and you have your purchase price, or at least a usable estimate.
But you have to get the comps right. Many investors are too loose with their comp standards. They look at homes across town that are in a better neighborhood, or they include homes with the same number of bedrooms but more bathrooms or homes that are the same size but on a bigger lot.
If you get your comps wrong, you’ll get your property value wrong—and that’s how you end up overpaying.
3. Underestimating Repair Costs
This is another pitfall, especially among many novice house flippers. Because it will persuade sellers and lenders, an accurate repair estimate will not only make a purchase easier, but also provide an investor with a roadmap to profit.
If your repairs cost more than you bargained for, your whole deal could be in jeopardy. For example, if you buy a property for $150,000, plan to do $50,000 in repairs, and eventually intend to list it for $250,000, that’s a decent profit. But let’s say that once the work is finished, you end up paying $70,000 for repairs—an overage that’s not unheard of. That $50,000 in projected profit is now reduced to $30,000. And if your sale takes longer than you planned for, suddenly your carrying costs are eating into that $30,000. Before you know it, your margins are razor thin.
A good general rule is to come up with an estimate for your renovations—and then add 20%. A lot of this is going to depend on your contractor. You want to work with someone you trust, who won’t overrun their estimates too much, who won’t disappear for days or weeks on end, and who won’t gouge you on material markups. It might take a while to find a dependable, trustworthy contractor, but the search is worth it. A good contractor is an investor’s best friend.
4. Your Timeline Is Too Optimistic
Despite recent economic turmoil, we’re still in a pretty strong seller’s market, especially when it comes to urban areas. That means most properties will sell quickly, many of them for above the asking price. But there are always exceptions. If your house flip languishes on the market for too long, your deal could go from a net gain to a net loss in a matter of weeks.
Many novice investors fail to realize that just owning a property costs you money. These expenses are called “carrying costs,” and they include everything from property taxes to insurance premiums to utilities to HOA fees.
These are costs that come out of the owner’s pocket every day they own the property—and they can add up fast. If your property doesn’t resell quickly because you unknowingly priced it too high, didn’t do appropriate renovations for the market, or an inflated purchase price forced you to set the sale price sky high, those carrying costs can quickly eat up all your profits. In real estate investment, time is money!
5. Your Renovations Aren’t Appropriate for the Market
Another mistake many investors who are just starting out tend to make is to over-renovate their new property.
It’s exciting to buy and rehab a home, but don’t go overboard. If you pour a lot of money into the property putting in premium features like marble countertops, custom closets, high-end stainless-steel appliances, or exotic hardwood floors, you’re going to have to recover those costs when you sell or rent. But if the market won’t bear those costs, you’ll have to take a loss.
Remember, when you renovate, it’s rarely a good idea to make the home as nice as you possibly can. Good enough is almost always better than great.
6. Not Keeping Enough Cash on Hand
If you’re going to be a landlord long term, make sure you’re putting a good percentage of your rents away to use for maintenance and repairs. Experts estimate that a property will require about 1% of its value in maintenance each year. So, if your property is worth $200,000, you should plan on spending at least $2,000 a year on maintenance.
This could very well increase steeply, depending on who you’re renting to. Some tenants can be hard on a property, which will translate to more repairs—2%, 3%, or even 5% a year. Putting cash reserves away for maintenance means you won’t have to put a new water heater or an exterminator bill on your credit card.
Luke Babich is the co-founder of Clever Real Estate, a real estate education platform committed to helping home buyers, sellers, and investors make smarter financial decisions. A licensed real estate agent in Missouri, his research and insights have been featured on BiggerPockets, Inman, the LA Times, and other media outlets.
Babich has a bachelor’s degree with honors in political science from Stanford University.