What I Wish I Knew Before Investing In Rental Properties

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Includes: IYR, O, PLD, PSA, SPG, VNQ
by: Jussi Askola
Summary

A lot of investors turn to rental properties in their pursuit of financial freedom. I was one of them.

Mistakes are inevitable. The most important is to learn from them and evolve.

Today, I allow you to learn from all the costly mistakes that I made in my first Rental property investment.

Some discussion on my updated real estate investing strategy and how I seek to maximize performance to achieve financial freedom.

The best way to learn how to invest money is to make mistakes and then to learn from them. The problem with rental investments is that even small mistakes can be very costly! Every investment ties up a large amount of capital, often leveraged up with a mortgage - creating significant liabilities from interest payments, to property taxes and maintenance.

You better do it right on day 1, or you may soon be yet another real estate investor filing for bankruptcy. And don't think a second that I exaggerate here. Bankruptcies are a very common outcome in rental investing and often the result of stupid mistakes that could have been avoided with better education.

I was lucky enough to be born in a family of savvy real estate entrepreneurs. From going to construction sites as a teenager to eventually working in the private equity real estate field; I can say that I have been immersed in real estate my entire life. I have made mistakes; I have lost money, but most importantly, I have learned from my past missteps, and become the (hopefully better) investor that you are today reading on Seeking Alpha.

Today, in an effort to pass along some of my costly lessons, I present a few points that "I wish I knew" before investing my hard-earned capital in my first rental property.

The Path to Financial Freedom (or Financial Hassle)

Most investors turn to rental properties in an attempt to achieve financial freedom. Here it is important to ask yourself how do you define financial freedom to set the expectations right.

Financial freedom in my mind is when you earn enough passive income to be able to maintain a desired lifestyle with very minimal work. It is also the freedom of mobility and travel without being stuck in a specific location for a job.

With this definition in my mind, it is quite clear now in hindsight that rental investing is not my path to financial freedom. Rather, it quickly became what I refer to as "financial hassle" once the reality of being a landlord started to manifest.

There is a lot of misinformation online on what rental investing is about. There is an army of self-proclaimed real estate experts selling courses online on how to achieve financial freedom and get rich-quick through rental investing. While this is certainly possible, you need to know that:

  1. It's a lot of work.
  2. It's a lot of worrying.
  3. It's not passive.
  4. You will have sleepless nights.
  5. You won't have total freedom of movement.

Sooner or later toilets will get clogged, tenants will cause problems, rents will get unpaid, you will need a lawyer, and roofs will leak. I do not mean to pointlessly scare you. This is just the reality of being a landlord that you must accept if you decide to move forward with rental investing.

To me, this was not financial freedom…

You could delegate the managerial work to someone else, but this would significantly reduce your return while increasing risk - often turning what may have first appeared to be a profitable investment into an unworthy venture.

Lesson: If your goal is financial freedom, investing in rental properties will most often be a mistake. It is a ton of work and worrying that often gets closer to running a real business rather than a passive investment. Rental investing can be profitable, but you need to have the right expectation and be ready to put in blood, sweat and tears, quite literally.

Don't Overleverage

The same self-proclaimed real estate experts who sell you on the dream of financial freedom will often preach the power of leverage with zero regards to the risk of it.

They argue that they can earn much higher returns by financing their investment with an 80% LTV and putting down only 20% in equity. There is no doubt that if you buy a property at an 8% cap rate, and finance it with cheap debt at 80%, you are set for high returns in the immediate term. But how safe is this?

Investors have a short memory, but just 10 years, thousands of property investors lost everything by using this much leverage. If you finance your rental with 80% debt, all it takes is a 20% price decline to wipe out your entire equity - putting you at 0.

Source: Stock photo

During the last recession, property prices declined by way more than that, and yet investors are once again using high leverage with no fear of a potential recession.

Lesson: There is no magic in leverage. It boosts returns in good times and crushes investors in poor times. It can be a powerful tool, but you need to use it with caution. 20% down is too little from my experience: it can work out well, but it adds a speculative nature to the investment since it may sink the ship in a Black-Swan scenario. As Warren Buffett likes to say:

"There is only three ways a smart person can go broke: liquor, ladies and leverage. Now the truth is - the first two he just added because they started with L - it's leverage."

I have personally never lost a property due to leverage; but I have seen it happen many times in my private equity days. Rather than reaching for maximum leverage; I would much rather make sure that the debt load is enough to boost returns; but not excessive to risk losing it all in a downturn. Most often, the appropriate LTV is then at closer to 50% in my experience.

Everyone, Always, Underestimates Costs

Underestimating costs in real estate is so common that it has almost become a joke. If you think that something will cost $1,000; plan for $2,000 - and you will still likely end up paying more than that when it is all said and done.

Source

My property was in fairly good shape; but shortly after buying it, the Homeowner Association (HOA) decided to ramp up renovation projects and replace roofs.

They went for the cheaper option with an inexperienced contractor who did a poor job and end up fighting the case in justice for months on end - increasing the cost to probably 2 to 3 times more than initially anticipated.

Lesson: Don't be the naive real estate investor who makes optimistic assumptions when accounting for expenses. Trust, but verify. Real estate is full of sharks and shady people looking to make a buck off inexperienced landlords. You will nearly always spend more than anticipated. Don't go for the cheapest contractors; go for the most reputable ones - even if it comes at a premium. In the end, you will often save money in the long haul by avoiding poor quality work.

Before Buying, Consider Alternatives

Perhaps the most important lesson that I learned from my initial rental investment is that rather than blindly buying a property, it is worthwhile to consider alternatives. Real Estate Investment Trusts (REITs) as an example can make a great alternative, that 9 times out of 10 outperform rental investments from my experience. I know that many rental investors are very skeptical about REITs, but please have an open mind and consider the five following points:

  1. Professional management: All the unpleasant work is managed by professionals in a highly cost-efficient way thanks to economies of scale. These are people who do this full time, have great resources, and are likely to do a better job than you.
  2. Liquidity and low transaction cost: Unlike rentals that are highly illiquid and involve up to 10% in transaction costs on day 1, REITs are publicly listed, and shares can be traded in one click of mouse at minimal cost.
  3. Diversification: When you invest in a REIT, you own an interest in a portfolio of 10s or 100s of properties. As such, your risks are well mitigated as compared to owning one or two rentals.
  4. Passive Income: REITs must, by law, pay out 90% of their net income in dividends to shareholders. In this sense, without putting in any work, you will be earning very consistent income from a passive investment.
  5. Better long-term returns: Research shows that REITs (VNQ, IYR) outperform private real estate by up to ~4% per year in the long run, thanks to scale advantages, cost efficiencies, better management practices, and higher cash flow growth:

Source

If after your calculations, you realize that you can earn a similar or higher returns with REITs, you would be fool to invest in rentals instead.

Rentals are illiquid, work-intense, highly leveraged, involve personal liability, and concentrated investments. You need to get a hefty return premium to make it worthwhile. How much? In my opinion, if you can earn 10% with REITs, you better target at the very least 15% with rentals.

Lesson: Be aware of your opportunity cost. By investing in rental properties, you are passing on the opportunity to invest elsewhere. If you are able to earn similar or even better returns with a passive, lower risk, liquid investment such as REITs; you better reevaluate your rental investment strategy.

Whether You Invest in Rentals or REITs, Never Lose Sight of Your Limitations and Objectives

All in all, my rental investment was pretty good. I earned a good amount of cash flow and managed to even sell the property at a small profit three years later.

Still, I would not do it again. Why?

It's a huge hassle that was not worth taking once I learned about REITs. They have historically produced better returns than most private real estate investments with lower risk and greater liquidity.

Even better, they are totally passive investments once you have done the job of researching the right opportunity and built a diversified portfolio. For me, personally, this was a much better option that helped me get closer to my goal of attaining financial freedom.

That said, analyzing REITs and designing a portfolio yourself is no walk in the park either. It requires specialist skills that are not widely available and there is a strong need for professional research to sort out the worthwhile from the wobbly.

I have been investing in REITs for 10 years now and in my early REIT investing career, I made the common mistake of being overconfident. I thought that since I know real estate, I would have a competitive advantage over most other REIT investors and beating indexes would be easy peasy. I was overly concentrated in a few risky bets and a single mistake end up costing me a lot in performance.

Lesson: The lesson here is to keep a realistic view of your limitations and objectives as an investor. Whether you invest in rentals or REITs, you need to remain mindful of your limited resources (expertise, capital, time). Looking back, I should have never invested in rental properties. And when I started investing in REITs, I should have been more passive and invested in indexes instead. Today, my situation is very different as I work full-time for High Yield Landlord - a REIT investment newsletter, have ample resources and access to REIT management teams to conduct interviews.

Closing Notes: Real Estate Can Be Wonderful (If You Know What You're Doing)

Since I started investing in real estate, I have greatly profited from it and enjoy high dividends from my REIT portfolio to this day. I have made mistakes, but most importantly, I have learned from them and now you can also benefit from my transparency to avoid falling into the same traps.

Whether you decide to purse rental investments, or go for undervalued REITs (like me) is a personal question. Nonetheless, you will note that knowledge and education is what separates the great investors from those who never seem to get ahead.

To illustrate this point, consider that the average investor generated only 2.6% per year over the past 20 years:

Clearly, the average investor does NOT know what they are doing. In comparison, passive REIT indexes returned 12.5% per year and outperformed almost all other asset classes including stocks, bonds, and real estate:

Source

Then taking it one step further, active and more entrepreneurial REIT investors who target market inefficiencies have managed to reach up to +22% annual returns over the same time period:

Source

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.