Common Pitfalls to Avoid
The world of real estate investing is a vast world full of complexities and intricacies. While your first real estate investment deal does not and should not have to be too complicated, it remains perhaps somewhat difficult and risky. Inherently, you can be prone to making mistakes simply because you are new to the subject and just starting out.
For that reason, it is imperative that you learn from other people’s mistakes. Doing your homework and paying close attention to details will help diminish the chance of failing in your first real estate deal.
“Learn from the mistakes of others. You can never live long enough to make them all yourself.” ― Groucho Marx
Analysis paralysis
Analyzing and planning are very critical and necessary. But, overanalyzing excessively could prevent you from taking any action at all.
Analysis paralysis does not, in it of itself, lead you to making mistakes in real estate investing. Technically speaking, you cannot make a mistake if you don’t even do anything. But think about it on the long run. Tomorrow, or 20 years down the road, will you look back and regret not investing in real estate? If the answer is yes, then analysis paralysis is your enemy today. Beat it! Take action.
Cynicism
Cynicism is a school of thought of ancient Greek philosophy. Cynics believe that the purpose of life is to live in virtue and in agreement with nature.
On the surface, cynicism is not necessarily bad. By the 19th century, emphasis on the negative aspects of cynicism led to the modern understanding of cynicism which means a disposition of disbelief and skepticism in the sincerity of human motives and actions.
Cynics are skeptics. Excessive cynics take an overly defensive posture to protect themselves. This is particularly true with some of us who have been ripped off by someone in the past or stabbed in the back by a friend. Such experiences can make us even more cynical.
While being cynical can help us avoid getting manipulated by some, it can become toxic if we live our lives at all times by observing everything through the negative lens of skepticism. A healthy dose of cynicism is not bad. But always seeing the glass half empty can be detrimental to progress and change. Avoiding cynicism does not mean ignoring important facts.
When it comes to real estate investing, being an ultra cynic will lead you to inaction. You will spend your whole time focused on excuses for not investing in real estate. You will amplify negative thoughts and diminish anything positive you come across. You will think that the real estate agent is out there to get you. You will think that the banks are out there to rip you off. You will think that the property manager is hiding something. In a hot market, you will assume that it is completely impossible to find deals. In a down market, you will assume that the economy is ruined and investing in anything would be insane. In other words, a cynic is very much focused on identifying reasons for inaction.
Reject cynicism! Don’t surround yourself with cynics who bring you down and draw you into their world of inaction.
Overconfidence
On the other hand, another pitfall to avoid is the overconfidence effect.
You meet a friend or two who tell you about their real estate experiences. You watch a tv show where so-called experts discuss their forecasts for the market. You read a book or two. Then, you jump into action and buy a real estate rental property that then sits vacant for months on end. This is the very definition of reckless confidence.
There is no exact science to balancing cynicism with confidence except common sense. Never assume that you know everything.
Learning is not a project that has an end date. It is a process that never ends, especially when it comes to complex economic and financial subjects like real estate investing.
Do your homework, get educated on the important basics of getting started in real estate investing, but proceed very cautiously.
Bad location
Who hasn’t heard the mantra “location, location, location”? The word location is repeated three times for emphasis. Could this possibly be because location is so important important important?
Real estate properties, with the exception of mobile homes, cannot be moved. They are generally constructed with the idea of them remaining stationary in the same location. While this is excessively obvious, it is often underestimated.
Owners change, mortgages get refinanced, tenants come and go but the property remains in place in the same exact location. Selecting the right location to buy your first real estate investment property in is of paramount importance.
Defining what good or bad mean varies based on your tolerance for risk. But generally, it is very much recommended to limit your search to very good locations especially if you are new to real estate investing. Although there is money to be made in every market including undesired locations, your chance of failure increases exponentially.
Characteristics of good locations:
- Low crime rate
- High-rated schools
- Near amenities
- Near public transportation
- Near major employers
Characteristics of bad locations:
- Shady areas where crime is rampant
- Close to hazardous sites like landfills or toxic waste dumps
- Excessive noise from trains and flights
- Ghost towns with no jobs
There is no exact science to perfecting the location selection. This is especially true in evolving markets that may look undesirable today but are slowly but surely getting facelifted and resurrected again. Think Detroit! It was a ghost town and many parts of it still are. But it is slowly changing with major employers moving in. There is no telling if the trend will continue. But this example goes to show that it is important, as always, to do your homework.
You can’t possibly know everything. But you should know enough to avoid bad locations.
Emotions
Don’t let emotions get involved in your decision making. Analysing the property based solely on cold facts is sufficient. Feeling excited and enthusiastic about investing in your first property is great but you should never allow your emotions to undermine the objective approach of adequate property analysis.
By allowing emotions to get in the way, we tend to be overly optimistic about the outcome. We tend to miscalculate the potential rental income by having high hopes of renting the property for more than the market value. If you love the property, you might make yourself believe that a tenant will see eye-to-eye with you and be willing to pay top dollars to rent it. This can be a fatal mistake that turns a good idea into a negative cash flow deal that you will regret.
Getting emotional about a property will lessen your ability to assess repair costs accurately. You tend to underestimate the level of effort involved in rehabbing the property.
Commingling funds
Simply put, it is best to maintain your business finances separately from your personal ones. If you have checking and savings bank accounts, don’t deposit the rental income in them. Don’t cut checks to contractors from them.
Instead, it is best to set up separate bank accounts for your real estate business needs. Whether you do this under the name of an LLC or not is unrelated. The fact remains that it is significantly easier and clearer to maintain all real estate related transactions in separate bank accounts.
For example, if you are driving to a new location to scope out the area and see several properties that you might invest in, you can use the debit card or credit card of your business for expenses incurred during the trip such as filling up gas or paying for parking at the location.
1031 Exchange
In a nutshell, a 1031 Exchange is a swap of one asset for another. Most swaps of assets are taxable but a 1031 Exchange can be tax free.
Generally speaking, when you sell an asset, you have to pay taxes on the gains. If you sell an investment property, pocket the profit and dump it in your savings account, you will have to pay taxes on any gains. This is obviously a mistake if you intend on buying another property shortly thereafter.
In a 1031 Exchange, you can avoid paying taxes on the gains if you swap the real estate property you just sold for another like-kind one within the designated timeframe specified by the IRS as long as you never have direct access to the cash gained from the sale. The IRS specifies that you must designate a replacement property within 45 days and close within 6 months. You should not receive any cash at all, otherwise, it is taxed.
To perform a 1031 Exchange properly, you need to insert a special clause in the purchase and sale agreement specifying that you are relinquishing the property and will be exchanging it for another one. The funds received from the sale of the property should not go to you but rather to a qualified intermediary of your choosing such as a bank or law firm. The intermediary will handle the funds throughout the 1031 Exchange transaction. You should never have direct control over the funds. You should identify one or several replacement properties and communicate that in writing to the intermediary within 45 days and then close on the property within 6 months of the sale of the relinquished property or the due date of that year’s income-tax return, whichever comes first. Finally, you need to file IRS form 8824 with the IRS to effectively defer the taxes.
There is no limit to the number of times you can do a 1031 Exchange. You can keep repeating the process as long as you want from one property to another while avoiding paying capital gains.
As always, it is highly recommended to seek professional help from an attorney, tax specialist or accountant since 1031 Exchanges can be very tricky given the strict IRS requirements at a federal level and potential additional state level requirements.
Insurance protection
Lack of adequate insurance protection can be a common pitfall in the world of real estate investing. As with everything, this also varies based on your tolerance for risk.
In addition to general property insurance and liability insurance on the rental property, it is a good idea to also have a personal umbrella insurance policy.
A Personal Catastrophe Liability (PLC) coverage (personal umbrella insurance), can give you an extra layer of protection. For a nominal fee usually around $200 a year, you can get $1 million in additional coverage for covered claims brought against you or your family for things like bodily injury and accidental damage to another person’s property. A PCL policy typically kicks in when other insurance coverage is exhausted.
Check out the The Ultimate Beginner’s Guide to Buying Real Estate Rental Properties.