Switching Niches: Why Changing Investing Strategies Can Be Costly

Real estate has a great number of niches as many of the writers here on BiggerPockets have pointed out. Many have also pointed out how critical it is to focus on one or maybe two versus endlessly falling for the “shiny object syndrome.”

As I once noted,

“I’ve seen real estate investors move from one investment class to another to another without ever planting a firm foundation in one niche (you know, where the riches are). These investors always seem to be doing something interesting that makes for great conversation, but they also tend to do little more than tread water, financially speaking.

“All too often, those perceived opportunities are little more than distractions. Doing the same thing over and over again may sound boring, but it can sure be effective.”

Indeed, one of the first things I noticed after moving to Kansas City in 2011 were the various turnkey companies selling properties to Australians coming in from Sydney (and elsewhere). Not all of these companies were bad, but some were downright awful. They would buy terrible houses in the worst parts of town, slap lipstick on a pig, rent it out to someone who was unlikely to pay for more than a month or two, and then sell this “investment opportunity” to out-of-state—or usually, out-of-country—investors.

These investors from Australia were used to houses costing well over a million dollars. When they saw what appeared to be relatively decent houses for only $60,000 or $70,000, they immediately thought it was the deal of the century. I saw similar stories with investors from China, New York, Los Angeles, and elsewhere who made the same mistake.

Generally speaking, these properties could never bring in sufficient cash flow to keep them up (a common problem with cheap properties in bad areas) and quickly fell into disrepair. The out-of-country owners would inevitably lose a substantial amount of money hoping the property would eventually turn around only to inevitably sell it at a loss (and sometimes a huge loss).

Check Your Assumptions

Obviously there were some very questionable business practices going on here, but that doesn’t change the fact that many of these investors didn’t challenge their own assumptions going in. If someone were to switch from stock market investing to real estate investing, that person would immediately understand that what they know about stock market investing cannot be safely applied to real estate.

This obvious truth gets blurred when moving between niches within real estate. And while you shouldn’t switch around willy nilly, it does make sense to add or switch niches sometimes. In fact, we had a lot of success switching from (or more aptly put, adding) student housing in Oregon to working-class and middle-class housing in Kansas City shortly after the Great Recession.

We wanted to get back into buy and hold, so I moved out from Oregon to a less expensive, higher cash flow market in Kansas City. Unfortunately, even here we took some of our assumptions with us.

For one, being used to student housing and middle-class housing, we weren’t prepared for lower-end areas and made some of the same mistakes those Australians made. We assumed a cheap property that looked good on paper actually made for a good investment.

Later, our screening criteria proved insufficient, as we had never had a problem collecting rent with student rentals (the parents co-signed the students’ leases) and rarely had problems with our middle-class rentals in Oregon. We had to significantly increase our criteria and take the lump of increased delinquency, an unruly tenant base, and an excess of evictions for close to a year.

Now, I should note that we didn’t explicitly take these assumptions with us. We knew that lower-end properties would require more attention and have more delinquency. We even paid much more attention to our screening criteria upfront. It just wasn’t enough. We still fell far short of where we should have been.

The same lesson could be applied to a relatively high-end flip we were doing recently. We don’t flip much, but this property just sort of fell into our laps and was a good deal, so we went with it. We made sure to make it shine substantially more than our normal rentals, but the fact it had been a long time since our last flip of this kind still hurt us.

The HVAC system was fine but rather old. On a rental, this is no big deal. On a higher-end property though, homeowners obsess over such things. And this fact held us up substantially, broke our budget, and cut into our profit because we ended up needing to replace the HVAC system even though I had not originally planned to.

Homeowners, especially in nice areas, expect substantially more than tenants. I knew this, but it didn’t fully ring true with me. Assumptions from one niche have a way of sneaking into your mindset when approaching a different niche.

How to Switch Niches

The big lesson here is that there are substantial costs in switching niches. You shouldn’t assume much, but one thing you should assume is that if you switch niches there will be a cost to it. Your first few deals are unlikely to be home runs and no matter how well you’ve studied the niche, you are going to make some costly mistakes in the process of learning it and should expect up front to pay for those.

This should reinforce to you that the “shiny object syndrome” is something to avoid. Of course, sometimes there are opportunities in a new niche that are so compelling you should jump at or it makes sense to add one or switch entirely. In such cases, though, you should make sure to spend extra time learning it and understand going in you will likely incur the costs of making “beginner mistakes.”

You should furthermore challenge each and every assumption you have. Put them on paper and make sure you don’t just know it—like we did with screening for lower-end properties—but fully embrace it.

You are bound to bring some assumptions with you whenever you switch niches—whether it be from wholesaling to flipping, flipping to holding, houses to apartments, apartments to commercial, rural to urban, low-income to luxury, properties to notes, etc. The only way to mitigate the expenses those assumptions will incur is to explicitly list them and challenge them from the outset.

And even still, you should plan on incurring the financial costs that come from learning pains.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.