There’s been a lot of conversation recently about the looming debt crisis in Washington. Terms like fiscal cliff are bantered around by every talking head on TV, radio and the internet. All this crazy conversation reminds me of Real Estate investing debt crisis I often come across.
While the national economy certainly has an effect on our lives, economics is like Real Estate – it’s local, baby. And there is not much that’s more local than personal investments.
Over the past several years I have seen an increasing number of over leveraged investors. Their plight, though not uncommon, tells the story of how not to invest in Real Estate.
Many of these individuals purchased properties either before the bubble burst, or as the air rushed out of the market. They now have portfolios with little, or even negative, equity. Few had any idea of the mistakes they were making. Nearly all now face financial ruin.
You make money in Real Estate when you buy, not when you sell.
Nearly the entire group of over leveraged investors I know bought their properties at a discount. Unfortunately, few bought actual deals.
Real Estate as an investment is a business of numbers. The important numbers are going to differ depending on your exit strategy. There is a different calculation for the purchase price of a fix and flip investment than for a long term rental investment. This fact was missed by nearly all of my over leveraged acquaintances.
Just because something is available at a discount, does not mean it’s a good investment.
Real Estate can be an unpredictable investment. Toilets leak. Tenants don’t pay. Heaters go on the fritz. Go into an investment with your eyes wide open.
Whenever I purchase a rental property, I anticipate problems. My job from day 1 is to minimize surprises so that I can maximize my returns. So when I evaluate a potential investment property, I budget for replacement of all major systems that may go bad over the next ten years.
If a heater or roof is more than 5 years old, I budget to replace it. If the windows have not been replaced in the last 10 years, I budget to replace them. If the kitchen is outdated, the bathroom is beat up, or the hot water heater shows wear, I budget to replace them.
Spending the money up front to proactively prevent complications saves time and headaches. It also saves money.
When I budget replacement of big ticket items in my offer calculation, I can spread payment for those expenses over the life of my financing. This keeps my cash flow consistent. But if I have to replace a heater unexpectedly, that can eat up months of my rental income.
Another tool I use to offset the cost of complications is to set up a reserve for repairs. I put aside 10% of each rental payment for maintenance, eviction costs and other surprise expenses every month. Once the reserve reaches one year of rental income, I stop adding to the pot. When I do get maintenance calls, I’m not wondering how I will pay for the repairs.
Stay for the Long Term
During the boom times, it was not uncommon for a buyer to finance more than the purchase price and closing costs in a transaction. At the closing, they’d walk out with a check and a house. This strategy seemed great until the check was gone. Ultimately those large one-time gains were short sighted and destructive.
Long term investments are the best way to build real wealth and financial independence. The wealth comes as a result of the growing equity built in a property over time. The financial independence comes from the passive monthly cash flow that results from rent payments.
Taking short term lump sums strips the equity and compromises the cash flow.
Real Estate investing is great for your personal economy. Over the next few weeks we’ll all see what Washington does to avoid the fiscal cliff. In the mean time, take the right steps to avoid your own debt crisis.