The Three Most Common Mistakes Passive Real Estate Investors Make
Mistake No. 1: Investing Emotionally
Instead of making a multifamily real estate investment based on balance sheets and merit, some investors make what I call an “emotional investment” in a property. Some investors see a property and become emotionally attached to it because it’s a beautiful new building, or because it’s located in a trendy neighborhood and they want to be a part of it.
This is a situation where emotion takes over and common sense goes by the wayside, which is a huge mistake. The problem is that emotion clouds judgment and, often, people ignore the signs that they may be overpaying for the property simply because they like it. Unfortunately, an emotional investment often ends up costing the investor money.
When you buy a property, focus on what the numbers are telling you: how much upside the deal has, how much will it cost to manage it and the rent growth in the submarket. Avoid focusing too much on how pretty the building is or how “trendy” it is to buy in a certain market.
Mistake No. 2: Counting On Appreciation
When investing in a multifamily property, investors earn profits from two main sources. The first is income or cash flow (rents and other income the property generates, such as fees on reserved parking, etc.); the second is appreciation (the profit you make when the property sells). When evaluating a multifamily investment, it’s important to look at the cash flow because that’s where the income will come from prior to selling the property.
Some investments have little cash flow but have the potential for strong appreciation. This is generally in core markets like San Francisco, New York and Los Angeles, where properties have a 1% to 3% capitalization (cap) rate and negative or zero cash flow. On the other side of the equation are properties in the Midwest, where there's high cash flow but minimal property appreciation. (Cap rate is the ratio between the net operating income, or NOI, and the purchase price. The lower the cap rate, the more you'll pay for the property, which is why sellers try to sell their properties at the lowest possible cap rate).
The mistake that some investors make is to count on very high appreciation where they hope to make a “killing” on the property when it sells. However, that’s a risky proposition because you really never know when or if there will be an option for appreciation when it’s time to sell. For example, if there’s a recession, there could be zero appreciation.
There are ways to increase the cash flow from multifamily properties. One way is by upgrading or renovating the property and then increasing rents. Another way to increase cash flow is to reduce operational expenses. Whichever option is used, it’s beneficial to investors to have additional income.
The key for investors is to have a well-balanced market that generates both appreciation and operational income. That way if one of the potential income streams is weak or changes, you can have income from the remaining one. For that reason, I like to buy properties in markets that provide both positive cash flow of at least 7% and appreciation, such as Atlanta; Jacksonville, Florida; and Dallas.
Mistake No. 3: Focusing On The Wrong Market
Many investors choose a market simply because they’re familiar with it. For instance, they buy properties where they live because they know the city and the surrounding area. However, counting on familiarity when it comes to buying properties can cost you money.
There’s another problem if the property is located in a smaller market. Smaller markets may have higher cash flow due to lower purchase prices and higher cap rates, but those properties won’t be able to sustain prices if there’s a recession. Solid markets like Orlando, Florida, or Atlanta would be able to sustain prices. (That’s why I choose to invest there.)
Markets with a CoC of 7% to 8% are preferable to smaller markets that now offer investors 10% CoC. (CoC is the cash-on-cash return used to evaluate the performance of a real estate investment. It takes the property's annual net cash flow and divides it by the investment's down payment.)
While I live in Southern California, I only purchase properties in Texas, Florida and Georgia, and I'm constantly flying out to those areas to find and evaluate deals. That's where I find properties with a CoC of 7% to 8%. Research each market to ensure there are new jobs coming into the market and that vacancy rates are dropping. Those are benchmarks for a good market to invest in. Once you acquire a property, hire a local property manager to manage the asset.