The following is a guest post by FMF reader Apex. He has been investing in rental real estate for more than four years and is authoring a Real Estate 101 series, posting every Friday, based on his experiences. The series is designed to give prospective investors the basic tools they need to succeed.
This might seem like a strange place to start and perhaps a disappointment to some who want to be cheered and encouraged into the wonderful benefits of real estate investing. After all, usually one leaves it to their detractors to make the opposition’s case. But the point is not to turn everyone into a real estate investor. That is a job best left to the late night infomercials. The point is to help people succeed at investing in real estate. To do that two things are important. First is setting proper expectations, and second is targeting the message to those who are up to the task.
And it is a task. Real estate investing is a bit of a misnomer. It’s not like stock investing, or buying a CD, or investing as a silent partner in your brother-in-law’s bakery. Real estate investing is really running a business. Investing is a part of it, but it shares every aspect of what people more traditionally think of as a business.
Even business owners often take on their ventures with unrealistic expectations. My wife is a former corporate trainer for an international food company. She saw many people come through her classes who had recently purchased a franchise as part of an early retirement plan. They had fanciful notions about managing this business as a part time semi-passive activity in retirement and living the dream of their golden years off the bountiful returns they would reap. Why did they have such lofty expectations? Because no one told them differently. Running a fast food restaurant is a lot of work. It’s not part time, and you will not be reaping bountiful returns with just a single franchise. After they had been through my wife’s class they would learn that their notions might have been a bit naive. But alas, they had already purchased the franchise. What they really needed was to know why not to purchase a franchise before they decided if they should purchase one.
Before you can be confident that you should invest in real estate, you have to know the reasons why you shouldn’t. Some people invest in real estate with high hopes only to sell out later with a bitter taste in their mouth. These people tell a terrifying tale. They describe what a horrible experience it was, how they lost money doing it, and how they had nothing but one problem tenant after another. Anyone listening to their experience would reach the conclusion that only a fool would invest in real estate. But their story is tainted by a mismatch between their expectations and reality. Often these people have entered real estate investing with the same type of misconceptions as the nostalgic new franchise owners. Misconceptions that reality quickly disabuses them of once they begin actually running their business.
The truth is that some people are not cut out for investing in real estate just as some people are not cut out for running a franchise. The best time to find that out is before you start. Consider the following reasons why you may not want to invest in real estate.
1. It takes work.
The IRS defines income derived from rental property as passive income. However, this is merely an IRS classification for tax purposes. There is nothing passive about investing in real estate. The following is a short list of some of the important tasks you need to be able to do:
(1) Find and determine the right kind of properties to purchase;
(2) Properly prepare your properties to attract the best tenants;
(3) Be able to properly screen candidates to find the best tenants;
(4) Take calls at many different hours and either personally address the issues or coordinate with professionals to fix the problems;
(5) Collect rent and chase late rent;
(6) Evict tenants not paying rent or violating the lease;
(7) Pick-up, clean-up, and fix-up properties when tenants move out.
(8) Identify and perform routine maintenance to retain the value and quality of your properties.
2. It consumes time.
It's one thing to realize you have to do work, but you have to have time for it too. Many of the tasks that need to be done cannot be simply deferred until your schedule is more accommodating. When the toilet is not working it needs to be fixed now. When 3 units have tenants move out at the same time and the units need a fair amount of work to get them ready for a new tenant you either have to work many long nights and weekends immediately after move out or forgo 1 or more months of rent on multiple properties. Your family time may suffer. You may find yourself trying to juggle your day job responsibilities with the demands of your rental business because too many things are happening at the same time. Rental property demands tend to come in bunches. You can have months with nearly no effort required at all followed by a month of solid work. You need to think about how this will fit into your life and your schedule.
3. It requires management.
It's not enough to just spend time and do work. This requires some basic management skills as well. You need to be able to find a host of reliable professionals and contractors to perform tasks that you are not able to do. You need to be able to coordinate activities between contractors and tenants often times when you are not going to be there. If you get that wrong, it will not go well with either the contractor or the tenant. You need to manage finances and leases and navigate local laws regarding tenant rights.
The work, time, and management responsibilities can all be mitigated by hiring a professional property management company, but that has some of its own problems. First it's generally somewhat expensive. More importantly however, a management company will not be as concerned about your property as you are. They may not get the type of tenants you want or keep the property in the shape you would. If they don't you will pay extra for maintenance, repair, and turnover, and you will pay them to manage their mismanagement. There are plenty of horror stories about management companies just as there are about tenants. Hiring a management company will not make all of your problems go away. You still need to manage the management company. That’s a smaller job than managing tenants but it is complicated by the fact that the management company is running the operations while you generally have little to no interaction with the tenants. That makes it difficult to know what is actually happening with your business until after it has happened.
4. It demands capital.
There is really no way to get started in real estate with a small buy in like $2,000. You will need to have enough for a down payment on a property and that down payment is typically 20% at a minimum. In addition to the down payment you will need cash reserves saved up to deal with the potential of repairs that may require several thousand dollars. Some large items can cost even more. If you don't have cash to pay for things that come up your tenants will likely stop paying you rent or perhaps even allow issues to cause excessive damage to your property. This can spiral from bad to worse. If you intend to continue investing in real estate you will find yourself trying to scrape up every spare dollar you can find. New cars and other toys are a detriment to your real estate business. If you want to grow your business you will need to keep your personal expenses as low as possible for a considerable time while you continue to accumulate property. Unless you are already cash rich, expect to feel somewhat poorer for a while.
5. It needs debt.
Unless you are sitting on a high 6 figure or low 7 figure pile of cash, you simply can't take this beyond a hobby stage without debt. If you want to grow it you will need considerable debt. You will need to spend time exploring multiple financing options. You will need good credit, and the more debt you take on the more important your financial standing will be. You will need to be comfortable carrying considerable debt for an extended period of time.
6. It grows slowly.
While the returns on real estate can be good they are not going to be so excessive as to have you swimming in cash. Furthermore, as already mentioned, any cash your real estate generates needs to be carefully conserved and used to purchase your next property. The business constantly demands most of the money it generates to feed itself. Some people find this demoralizing because it seems like you are not getting anywhere. You are building assets that have value and that can generate considerable cash, but it may take a decade or more to get your business to where you want it. Any money you extract from it will only delay how long it takes to reach your goal because real estate is a capital constrained business. It cannot grow any faster than the capital available to grow it. You cannot merely produce more widgets or hire more sales people. The only path to growth is increased capital investment which means you cannot afford to enjoy the fruits of your labor if you want the business to continue to grow.
These issues are not insurmountable and are not excuses for not investing in real estate. However, if you are not aware of them or have assumptions to the contrary they will quickly overwhelm you and likely lead to the demise of your real estate venture. If this list is overwhelming to you, you are probably not ready to enter the world of real estate investing. But if you go in with your eyes open, prepared to face the challenges that lie ahead, you will have laid a solid foundation for success.
Click here to read the next post in this series: The Benefits of Investing in Real Estate