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The Biggest Mistake Made by Real Estate Investors

There are many missteps that a beginning real estate investor can make. Fortunately, most mistakes are correctable once they are discovered. But, in my opinion, there is one mistake most novice investors make that can haunt them for years. In this post I will discuss this mistake and share the details of my first venture into real estate investing where I made this big blunder.

The biggest mistake most real estate investors make is that they invest in real estate for capital appreciation. In my opinion, if you want to be successful in real estate investing, while minimizing your risk, you should view real estate as an income investment and not a capital appreciation investment.

When you view real estate as a capital appreciation investment, you are betting on future appreciation that may never occur or may not occur for many years. This is similar to the way many people go about stock investing. I personally don’t think this is a good approach to stock investing either, as I discussed in a previous post on equity income investing, but at least a stock investment does not incur costs while you are waiting (hoping) for the capital appreciation to occur. I know that real estate property values have historically experienced significant appreciation. But future property appreciation rates are likely to be very modest compared to historical rates. In any event, real estate should be viewed as an income investment.

As a beginning investor, you will purchase real estate with a large portion of the price funded with a loan. Financing costs are incurred as well as property taxes, insurance, and maintenance costs. These costs mean that, for the investment to work, the property rental income is a very important consideration and needs to be seriously evaluated. You would think this would be obvious to anyone investing in real estate. But you would be surprised how often the mistake of ignoring the property income is made, especially by beginning investors.  To illustrate, let me pass on to you my real life experience of what can happen to you when you naively view real estate as a capital investment and ignore the income component of the investment.

At the beginning of my real estate investing life in the 1980s I was living in California. Real estate values had dropped slightly the year I started to search for my first real estate investment. I was not intimately familiar with the local market so I relied on realtors for much information. I remember working with several realtors and the conversation would always follow the same line of thinking. The realtor would tell me that a particular property had been listed at a 10% higher price 6 months earlier; therefore, the current price was a good value. With this approach, focusing only on real estate prices, I was evaluating each investment on a relative basis. I was not evaluating each potential investment on an absolute basis.

Eventually, I chose two properties that I thought represented good values. Not only did I not perform the proper evaluation of the potential rental income, I compounded this mistake by asking the realtor what he thought the market rent was for each property. The realtor gave me his opinion of what the properties might rent for. The rent estimates did not cover the costs of operating either property (as they never do in California). However, the realtor was quick to remind me that the monthly Negative Cash Flow (NCF is when the monthly property costs are higher than the monthly rent) from the properties was tax deductible against earned income as if this somehow made the investment viable.

I went ahead and purchased both properties.  When I went to rent the properties, I discovered that the estimated rents the realtor gave me were about 15% above the actual market rents. My NCF was now even larger than I expected when I decided to complete the property purchases. But I was not worried because the property capital appreciation would eventually make up the loss and I would be a big winner, right? Unfortunately, that is not the way it worked out for me.

I owned the two California properties for about 4 years even after I moved back to the east coast. I carried the combined total of about $1,000 per month NCF for the entire 4 years totaling about $48,000 in losses. The properties did not increase in value and I finally sold the properties at about the same price I bought them for 4 years earlier. I did gain about $15,000 of equity through principle reduction by making 48 mortgage payments, but this just partially offset my $45,000 down payment loss, so that my net capital loss was $30,000. I also did enjoy about $35,000 in tax savings through the monthly cash flow losses and the property depreciation, but the depreciation tax break must be “re-captured” when you sell the property. The total net tax savings was about $15,000.

So, in summary, I held the two properties for 4 years and lost about $78,000 in cold hard cash, although I did get about $15,000 in tax savings. Oh, I almost forgot, being a rookie property manager, dealing with the tenants did not go particularly well.  Needless to say, this is not how you create wealth with real estate. Other than lessons learned, the only good thing that can be said of this experience was that I was only 35 years old and still had time to recover.

After an experience like this, which may be similar to what many people are going through today, most people would probably never want to own real estate again. But that was not my viewpoint. I knew real estate investing was not the reason for my investing fiasco; my lack of knowledge and experience was the problem. I intended to learn from this experience.

Let’s list what I learned from my California real estate venture:

• The first mistake I made was not being very familiar with the local area I was investing in. Lack of local knowledge is not only a disadvantage in regard to market prices, but I also did not know the rental market. Real estate local knowledge is critical.
• The second mistake was that I bought a property where the rent did not cover all operating expenses. I learned to ignore the tax benefits of monthly NCF when investing in real estate. There is no way you will get rich by paying out $3 in order to save $1 in taxes.
• Third, even though a realtor may be trustworthy and knowledgeable about the local market, I learned I must do my own homework on every financial aspect of the investment.
• Fourth, I learned real estate is a long term investment; it needs to be held for 10 years or longer. In the event there is no capital appreciation, holding a property 10 years will almost assure that your loan principle pay down will be greater than your buying and selling costs.
• Finally, I needed to learn as much as I could about managing tenants through reading books and talking to other landlords in the area.

But the most important lesson I learned was how critical it is to accurately estimate the potential rental income of a property, this is how you evaluate a real estate investment on an absolute basis. I will explain this analysis in my next post.

Finally, I want to reiterate, no matter how undervalued you think a particular real estate investment may be, do not buy it if you will have NCF. You do not know what the market may be like in the future when you want to sell. If a property does not provide a net surplus of rental income on a monthly or annual basis, you should move on to the next property. No exceptions.

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