Your first investment will be a learning process. While you’ll definitely make a couple mistakes along the way, there are a few common pitfalls that can be avoided if you educate yourself beforehand.
10 Lethal Mistakes to Avoid on Your First Real Estate Investment
From financing errors to underestimating repair costs, newbies are at risk to lose serious cash if they’re not careful. Still, a real world education is invaluable, and this guide will help steer you down the best path possible to your very first real estate investment.
You may have heard that your first real estate investment is the most difficult one. It’s true.
Your first deal is difficult because you don’t know enough. How could you?
Yet you still need to move forward and get started. If you wait until you’re 100 percent ready, you’ll never make progress.
But even though your first deal won’t be perfect, you still don’t want it to be so bad that it will knock you out of the game.
So, this article will help you avoid the 10 most lethal mistakes on your first real estate investment. Use this like a checklist to ensure that you avoid the worst case scenarios.
When you prevent the worst from happening, you will gain confidence so that you can buy your first deal, move forward, and begin your real world education.
Here are 10 lethal mistakes to avoid.
Mistake #1: Bad Financing
Bad financing can be one of the most lethal mistakes possible. I have personally seen more real estate investors lose money or go out of business from bad financing than from any other mistake.
What is bad financing? For me, it includes a combination of the following:
- High interest rate
- Adjustable interest rate
- High monthly payment
- Balloon payment
- Personal recourse
Most residential bank mortgages at least save you from the first four mistakes because the interest rates are low, fixed for 30 years, with amortizing payments, and there are no balloons.
But they almost always require personal recourse, meaning you personally guarantee the loan with your other assets and future earnings. This is probably a reasonable trade-off.
Many commercial, portfolio, hard money, and private lenders, however, do not meet any of these criteria. And that could be a problem, especially on your first deal.
If you borrow at 12 percent interest with a large monthly payment, a balloon due in one to three years, and full personal recourse for the loan, you are likely taking too much risk.
Why? Because the property will probably have negative cash flow with the high interest rate. A balloon note means you will have to refinance or sell in a very short period of time. As many learned in the 2008 credit crisis, trying to refinance when credit dries up is very difficult—even with perfect credit and good income.
And personal recourse means that if anything goes bad and your lender loses money, they could chase you around and take your other assets in order to collect.
I have always used a lot of private and seller financing for my real estate deals, and I keep this list of financing mistakes in mind. For example, I might trade off a little higher interest rate and a larger down payment in exchange for a longer loan term and no personal recourse.
The beauty of private financing is that everything is negotiable. But no matter what type of financing you use, be sure to negotiate hard and avoid the worst mistakes.
Mistake #2: Bad Location
Real estate value always begins with location. The people and businesses who will rent or buy from you begin with location, and then they evaluate other criteria like the lot and the house.
Because it’s so important, you should study the best and the worst locations in your area before buying. There are investors who make money in bad locations, but it’s a challenging game that beginners should probably avoid.
I bought a lower-priced single family house once at a below market price with excellent seller financing terms. But the location was awful. I could not consistently attract good tenants because the neighbors were not pleasant (or safe) to live around.
On the other hand, I have bought properties in good locations that I made mistakes on, like paying a little too high of a price. The good location helped to bail me out of some of those mistakes.
Mistake #3: Misjudging Resale or Rent Value
I would argue that our number one job as investors is to understand how our end customers (renters and buyers) make buying decisions and then to translate that to a value. If we can’t determine the full value potential, we will have a hard time making a confident purchase offer that earns us a profit.
This job is important. But it’s not easy. It’s a skill that you must commit to learn and then continue to refine every day for the rest of your investment career.
On your first deal, it’s likely you are not yet an expert on value, so there are a few things you can do to help yourself:
- Reduce your target market to a relatively small, manageable area.
- Study all of the transactions in your market daily using tools like the MLS, Zillow, or your local tax assessor. For me, this is like the daily weight training of real estate that keeps me fit and competitive.
- Hire professionals for assistance. For resale value, find a very competent real estate agent and/or appraiser. For rental values, find property managers with multiple units in your area.
- Take courses on valuation at your local Associate of Realtors or other continuing education school.
Mistake #4: Underestimating Repair Costs
It is inevitable that you will underestimate repair costs at some point. But you want to avoid enormous cost overruns that could cause you to run out of cash or face other problems.
To avoid large mistakes, learn a good repair estimating system.
Also be sure to get help from other more knowledgeable investors or contractors. Don’t be afraid to pay these people for their time and knowledge.
You can meet these people by:
- Attending local real estate club meetings
- Driving neighborhoods looking for remodel projects
- Asking on the Divito Real Estate Blog
Mistake #5: Running Out of Cash
Your investment properties are like your race car. Cash is like your car’s fuel. When out of fuel, even the most powerful race car in the world sits still. If you run out of cash, even the best investment property will hurt your wealth building.
So, you want to avoid running low or running out of cash.
This usually happens for a couple of reasons:
- Underestimating repair costs (see mistake #3 above)
- Underestimating future capital expenses on a rental property
Capital expenses are big ticket items like a roof or a heating-air system replacement. If these costs hit you unexpectedly, it can become a big problem.
Mistake #6: Letting Emotions Drive Your Decisions
This is a huge mistake for newbies. And it’s understandable. I mean it IS an exciting chase to look for your first deal.
But you have to balance your enthusiasm with cold, hard, and objective analysis.
I love enthusiasm. It’s critical as an entrepreneur, because it helps you push ahead through the many obstacles you will face.
But I have also learned to never make big financial decisions with emotion alone. I use a process of analysis that filters each of my deals. I also run every deal by someone else, which typically means my business partner but sometimes includes other mentors and advisers.
My process begins with basic criteria, including general locations, neighborhoods, housing types, construction quality, etc. This helps me to filter down the enormous number of properties out there.
Then, I use a deal analysis process to analyze the numbers. Here is my basic go or no-go system for a deal.
I also like to calculate key metrics like the cap rate (or return on asset), the cash-on-cash return, the discount from full value, and the internal rate of return.
Mistake #7: Choosing the Wrong Real Estate Strategy
Here’s a tip: You won’t find a perfect strategy. But you can find one that pretty well suits your unique strengths, your short-term needs, and your long-term goals.
So, instead of borrowing the perfect strategy from someone else, think hard about what you really want and which real estate strategy will get you there.
To get started in this process, contact Divito Real Estate Group
Mistake #8: Choosing Bad Contractors
I bought our very first fix-flip deal in December of 2010. I proceeded to go through three different painters, two different heating and air companies, and two different carpet installers before we got the house looking decent.
These were expensive mistakes. I was lucky to even make a small profit on that first deal!
Finding contractors who will do good work, finish up on time, clean up after themselves, and charge reasonable prices is harder than finding buried treasure on a beach. Yet the people who do work on your fix-flip or rental deal will make or break its success.
Mistake #9: Not Using Your Due Diligence Period
Some experienced investors make offers with fast closings, in as-is condition, and with no due diligence period. This may help them get a lower price, but for your first deal this is probably not the best route to go.
Instead, include a short but reasonable due diligence period that allows you to get out of the purchase contract if you find a problem.
Here are a few of the important things I usually do during due diligence:
- Obtain a very good professional third party property inspection
- Repair estimates (see mistake #3 above)
- Evaluate zoning and local ordinances (for example, the college town where I invest has a law that you can’t rent to more than two students in a residential zoning district)
- Get a professional third party opinion of value and rental comps
Basically, you want to double check all of the key assumptions you used to make your offer. If you find that you made a bad assumption, you may need to renegotiate or walk from the deal.
Some of your best deals may be the ones you don’t do.
Mistake #10: Not Learning From Your Mistakes
You have just read nine mistakes to avoid, and I could probably tell you another 20. But no matter what you learn, you will still make mistakes. I guarantee it.
This is called “The School of Hard Knocks.” Go ahead and listen to Annie sing “It’s a Hard Knock Life” and join the club.
But the biggest mistake you can make is not learning from this School of Hard Knocks.
In our first year of business, my partner and I agreed that we didn’t know everything. We knew we would screw up many times. But we decided to call each mistake a seminar, and then write down the lesson.
We have attended thousands of these real world seminars since then, and our education continues today.
Go ahead and decide to create your own personal School of Hard Knocks. It’s an invaluable education.
Real estate is an entrepreneurial venture. We entrepreneurs shoot for the stars, but we also take risks that could turn out badly.
This can be a difficult pill to swallow on your first deal.
But risk doesn’t have to be a bad word. I see it as a barrier to entry. It means that the less committed, pretender-investors don’t bother. They drop out when it gets too tough.
The successful real estate entrepreneurs aren’t perfect. They have scars to prove all of their past mistakes. But they learn to avoid the fatal mistakes that would knock them out of the game. And they learn to always keep moving forward.
Forward movement. That’s what entrepreneurship is all about.
I hope the lessons of these 10 fatal mistakes help you to continue moving forward at whatever step of the entrepreneurial journey you find yourself.