TV shows and internet success stories often lead people to believe that active real estate investing — as opposed to passive investing — is easier and more profitable than it actually is. It’s true that many hopeful investors have earned enticing returns from their active real estate investments, but many others have also lost money. While it can be lucrative, real estate investing, whether active or passive, is by no means a “get rich quick” scheme.
Seeing homes transformed in HGTV shows has attracted many to invest in real estate without understanding the full scope of risk and responsibilities. This can affect the costs, time commitment, and overall profitability of a real estate investment. Active real estate investing in particular requires a great deal of financial and real estate expertise as well as large time and monetary commitments.
In this article, we discuss three common mistakes that first-time real estate investors encounter and the best ways to avoid them. Once you know what to watch out for, hopefully you can choose the real estate investment strategy best suited for you.
House-flipping is one of today’s most in-vogue real estate investment methods, but it’s also one of the riskiest. Many celebrity house-flippers have earned sizable fortunes from their flips, but countless ordinary investors have also lost money. If you have watched an HGTV show, then you probably understand how a house flip works. An investor buys a home in need of rehabilitation that they believe is underpriced, adds value to the home through renovations and additions, and then sells the home for a profit. While the process is straightforward, house-flipping involves many moving parts throughout, from beginning to end, which can positively impact or derail your investment.
What Can Go Wrong?
House-flipping comes with many uncertainties, which leave a lot of room for error. Investors who are able to purchase homes usually hit bumps in the road in the renovation and selling phases. While you can address any known issues of a home, you have little control over unknown or obscured factors, such as hidden deterioration of an old structure, mold tucked behind walls, unexpected acts of mother nature, or shifts in the housing market.
You perform due diligence on a promising single family home and believe that with renovations totaling no more than $150,000, you can sell the home for at least $200,000 above what you paid. You buy the home and supplies, and you contract a crew. You get to work, tearing down drywall and ripping up floors. Everything is going according to plan on the first floor; you move on to the basement. When you start tearing the drywall in the basement, the project hits a snag: you discover dry wood rot in the basement support beams and mold from a leaky pipe, previously concealed behind the drywall.
You know immediately that you will need to replace two support beams, a large undertaking for which you hadn’t budgeted. Before you can do so, you must hire a mold specialist to assess the scope of potential removal and remediation. He doesn’t have any availability until next week, and you need to pause all your renovation work until he’s finished his inspection. Finally, after the inspection, he says he needs to schedule a team to come in and safely remove the mold.
A week later, the crew announces they have successfully removed the mold. They also conduct an additional, full inspection of the home for further mold. Fortunately, it turns out that the rest of the home is clear. However, your renovations are now already several weeks behind schedule.
With the toxic mold removed, you can now begin to replace the affected wooden supports, and repair the pipes that caused the leak. You have to move up the plumber’s work schedule so he can finish his repairs, before the wooden supports can be replaced. As a result, you also need to shuffle the work schedules of your electrician and drywaller, so they can come at a later date. But your electrician is unavailable, and, to avoid further delays, you hire another one, at a higher cost. With the basement schedule sorted, you now need to determine what renovations you can do in the meantime and schedule the rest of your crew to work around the basement repairs in order to keep the progress going.
These unanticipated but necessary repairs, replacements, inspections, and delays have added thousands of dollars to your costs, and weeks to your timeframe. You now need to either skimp on attractive features, such as granite countertops, or absorb the cost and hope to sell at an even higher price than expected. Either way, as the issue becomes prolonged, your potential return dwindles — or disappears entirely.
How to Avoid It
House-flipping is a high-stakes, high-pressure real estate investment that involves a high level of risk. To avoid unnecessary risks and keep renovations on track, successful house-flippers often use the services of experts, including home inspectors, accountants, project managers, and real estate agents. A team of real estate and financial experts can mitigate the risks involved, but not eliminate them — where some risks are avoidable, others are out of your control. An expert might be able to help you identify a home with structural issues before you buy, but they can’t always anticipate whether you will encounter labor problems, permitting delays, or a bad snowstorm while performing roof repairs.
While a team can keep the operation running smoothly, the cost of their services can add up and eat away at a house flipper’s profits. This is why many flippers cut down on their expert team or choose to go solo. While this is possible, it requires extensive personal real estate and financial knowledge as well as hands-on management, because the success of the flip falls on the investor.
A rental property investment, while not as adrenaline-pumping as a house flip, can be an attractive way to invest in real estate for people seeking regular cash flow. However, the prospect of regular rental income also comes with myriad responsibilities to tenants and the property. As with other real estate investments, the investor must manage many different types of obligations, from finding renters and collecting rent to ensuring legal eviction and fixing broken appliances. With this wide range of ongoing responsibilities comes numerous possibilities for mistakes.
What Can Go Wrong?
The success of a rental property depends on many factors, including the relationships among tenants and the landlord, tenant income, market rental rates, and more. Because this type of real estate investment depends heavily on tenancy, an owner must continuously address the needs of the renters and rental property itself.
You purchase a duplex rental property in an area that your due diligence has led you to believe will yield a 12% rental price above your monthly mortgage payment. After taxes, insurance, and regular maintenance costs, you calculate that you will earn around 5% annually, not including any potential asset appreciation, which you estimate could be 2% or more per year. You purchase the property and get it ready to lease. You find applicants for each unit of the duplex and, after background and credit checks, you approve the applications of both, collect security deposits, and sign one-year lease agreements.
Both tenants move in, and you receive regular monthly rental income. You perform routine maintenance of the property and collect rent, and your investment is going well.
One day, your upstairs tenant informs you that he has bed bugs. The responsibility of exterminating pests falls on you as the landlord, because you cannot prove how the bedbugs were introduced in the building.
While you exterminate, you must find and pay for alternative housing to both tenants. Some of the cost is covered by insurance, but not all of it. After the extermination, the upstairs tenant finds that there are still bed bugs in his unit. He concludes that you have failed to address the problem, breaks his lease, and sues you for damages. Because you can’t prove where the infestation originated, you are still legally responsible for the infestation.
After a second round of extermination, the bed bugs are gone. The downstairs tenant is upset but decides to stay as long as there are no more bed bugs. After two months, you find a suitable potential renter to rent the vacant upstairs unit. She asks whether the unit has a history of past issues, such as mold, asbestos, or bed bugs. State law requires you to disclose the history of bed bugs and the prospective tenant withdraws their application.
You have now lost money due to multiple exterminations and tenant relocations, and at least two months of a vacant rental unit. Additionally, it may now be more difficult to find desirable tenants in the future, because of the building’s history and state law disclosure requirements.
How to Avoid It
Some landlording issues can be prevented and others come with the territory. Problematic tenants can sometimes be avoided with application screenings and reference checks. Background checks may weed out those with a history of inconsistent housing, bankruptcy, or criminal activity, which could put the property at risk of police raids or property seizure through civil forfeiture. However, some tenants can pass the application process and still pose trouble for you as a landlord: late rent, constant maintenance needs, or visits from the police. Worse, problematic tenants can pester other tenants, making them want to move. The main safeguard against problematic tenants is knowing your rights and obligations as a landlord, as well as grounds and procedures for tenant eviction in your state. Some states, such as California, give the tenant the right to continue living in the rented space during the legal proceedings, which can easily last a year.
Other issues, such as emergency repairs or bed bugs, are unavoidable in rental properties, especially over the long term. Insurance can help defray costs of some common issues, but not all of them. In addition to the costs, the responsibility of managing these issues falls on you as the landlord. You can hire a property management company to take some weight off of your shoulders for a fee. But, with this option, you also give up some control over your investment, plus a portion of your investment return each month.
Airbnb Horror Stories
Airbnb rentals can be a lucrative way to earn extra income and meet interesting people, but the home-sharing economy comes with its own set of risks. These risks leave room for issues that can not only affect your investment return, but your property as well. Like rental properties, the success of an Airbnb rental greatly depends upon occupancy. Unlike traditional rental properties, renters undergo less screening, which leaves the property owner with even more responsibility and risk.
What Can Go Wrong?
Unlike traditional rental properties, Airbnb rentals come furnished by the owner. This means that in addition to the home itself, the owner’s property within the house is also at risk of being damaged or stolen. An Airbnb host can request a guest’s government ID or social media account to verify their identity, but they cannot screen any other information such as criminal history or inconsistent housing history.
While Airbnb offers Host Guarantee insurance for theft and damages, the policy does not cover cash, or items in shared areas of the home. It also provides limited coverage for valuables such as jewelry, collectibles and artwork. To request reimbursements for amounts over $300, a host must provide a police report and may be required to provide further documentation such as photographs, proof of ownership and receipts to prove an item’s value.
Additionally, it is important to be aware of regulations in your area regarding short-term rentals. Homeowner associations can ban them completely, and, in some places, such as New York, there are existing city bans against types of short-term rentals.
You are renting out your spare bedroom for four days to earn extra money. You agree to meet your guests at home at 7 PM. They arrive much later than anticipated and wake you up at 3 AM to let them in. Although their stay is off to a rocky start, you show them around and explain the house rules.
The next day you go to work, and a few hour later receive a text message that the dishwasher and washing machine are not working. You are surprised, because they were working just this morning before you left. You arrive home in the evening and look at the dishwasher and washing machine and cannot figure out what is wrong. You also notice a large burn spot on the counter. You ask your guests what happened to burn the counter, and they say that it was like that when they arrived. You call a repairman for the dishwasher and washing machine. He’s able to fix the dishwasher, but he tells you that the washing machine must be replaced.
You contact Airbnb regarding the damages in your home, providing photos as proof. However, you do not have receipts of purchase for the items, proving the value of the dishwasher and washing machine. You also need to call a contractor to determine the cost of repairing or replacing the countertop. Because the damaged items are in common areas of the home, they are not covered under Airbnb’s Host Guarantee insurance policy. Also, if you want to make a claim for any property valued above $300, you will need to file a police report. Airbnb contacts your guests for a statement on the issue that you have reported. They deny any fault and are offended by the accusation and leave.
The costs to repair the damage done to your home are far higher than the profits that you earned from renting it out. Overall, you have lost money and gone through several major headaches.
While this may sound like an unusual scenario, many Airbnb hosts have experienced their own horror stories of bedbugs, house fires, prostitution, police raids, and more.
How to Avoid It
Due to the nature of guest screening on Airbnb, it is difficult, if not impossible, to determine the desirability of accepting a particular Airbnb guest. Property owners bear an inherent risk of property damage or loss when renting out their home on Airbnb. Some ways to deter theft and damage include storing all valuables in private areas and placing all important items such as birth certificates and jewelry in a safe. Also, prohibiting the use of electronic items, such as kettles, televisions, and washing machines can protect you if an item breaks during a guest’s visit. However, responsibility for proving that the Airbnb guest caused the damage falls on you, the property owner.
Some Airbnb hosts use cameras to ensure that guests are abiding by house rules, and to catch proof on camera if they are not. However, it is important to ensure that you abide by state laws if you set up cameras yourself. For instance, in California, it is illegal for a property owner to film occupants inside a home, so cameras must be pointed away from windows and transparent glass doors so as to not violate this law.
With many active real estate investments, the investor carries an array of time commitments, financial responsibilities, and sets of risk. While real estate investing can be a useful source of income, it is important to understand what each investment entails and weigh the risks and rewards before getting started.
If active real estate investing is not right for you, you can still receive many benefits of real estate, including income, appreciation, portfolio diversification, and tax advantages through passive investments. The traditional barriers to real estate investing have been lowered dramatically thanks to advancements in technology and federal regulations. With as little as $500, you can invest in a diversified portfolio of real estate easily, online through Fundrise and skip the hassles and pitfalls that have traditionally gone hand-in-hand with real estate investments.