Real Estate

First Time Real Estate Investors: Your Three Biggest Misconceptions

It is in markets like this where everyone wants to become a real estate investor. Values ​​are down, sellers are itching to sell, and everywhere you look, people are talking about “thefts” in the real estate market.

This may mean new clients for those of us in the real estate business, but it also means new students. It ends our responsibility to teach new people about real estate, and one of the most important ways to do that is to address any misconceptions they may have early on.

If you’re considering your first real estate investment purchase, you may have some of these misconceptions yourself. I hope I can help educate you a bit so you can make a more informed real estate investment decision.

Three BIG misconceptions that I run into over and over again are:

  • THE PROPERTY YOU WANT TO BUY MUST GENERATE A LARGE CASH FLOW TO BE CONSIDERED A GOOD BUSINESS.
  • This is difficult to address because, depending on the investor, this may be true. However, the first time investor often enters the game thinking that this is the law, without knowing exactly why he thinks this way.

    The truth of the matter is that, for the most part, cash flow is necessary. Nobody likes to buy a property that will cost them money every month. BUT, that doesn’t necessarily mean that the cash flow has to be fantastic from the start.

    If you have any questions or need any advice or guidance in your endeavors, please feel free to contact me via email at [email protected] or by visiting my website at http://www.philadelphiainvestordeals.com. I will be happy to help.

    I bought an investment property in Philly a few years ago for $40,000. The tenant paid only $250 a month in rent. My total monthly payment was $375, which meant I was paying $125 per month. Should I have walked away from that deal? Was I an idiot for buying it? The answer is no, and there is more to the story.

    The property needed repairs and the ARV (Value After Repair) was approximately $65,000. And the tenant was related to the previous landlord and her rent was $400 per month based on market rent for the area. So I made the necessary repairs to the property during the 3 months she was there (total repairs cost me around $4,000) and when she moved out I rented the house for $725 a month. NOW I was an idiot for buying it? Of course not! Within three months I made $15,000 in capital and was generating $350 per month in positive cash flow.

    To take the example one step further, would it have been a good deal if I had stayed with that first tenant for a year? How about two years? You see where this is going?

    Other error:

  • THEY CAN SIMPLY INCREASE RENTS IMMEDIATELY TO COMPENSATE FOR EXISTING LOW RENTS ON THE PROPERTY THEY ARE PURCHASING.
  • You’d be surprised how many beginners think this is the case. When I told one of my novice investors about the aforementioned deal, he immediately asked, “Why the hell didn’t you raise the rent as soon as you moved into the property?” When I told him that she had three more months left on her lease, he said, “That doesn’t matter, you are the new owner. You can raise the rents.”

    No, You can not. The lease agreement follows the property. Unless it is specifically stated in the existing rental agreement that the lease ends immediately upon transfer of ownership (which rarely happens), then the new landlord keeps the lease signed by the previous owner.

    Therefore, the length of the remaining lease could very well affect the buyer’s ability to acquire the property. If an investor cannot afford to maintain negative cash flow for several months until the lease can be renegotiated, then the property should be reconsidered or the deal negotiated differently (perhaps making the deal dependent on the seller gets rid of current tenant or raises rent before settlement).

  • THEY “EXPECT” TO GET THEIR MONEY OUT OF THE DEAL AS FAST AS POSSIBLE.
  • When a customer asks, “how long will it take me to get my money back?” I know I have some education to do. What they ask is “Nick, I’m spending $20,000 down to buy this duplex, how long will it be before I get that money back through rental income?”

    Seems like a valid question on the surface, except they’re not actually spending anything! The $20,000 is actually an asset swap from a liquid asset (cash) to equity in the property they are purchasing. It’s still an asset on your balance sheet and wasn’t actually ‘spent’ at all. The misconception that they have “spent” the down payment money is common.

    What they did spend was the closing cost money (if the seller wasn’t asked to pay for that) and I’ll calculate the amount of time it will take them to get that back… but it’s not as simple as taking the closing cost money closing and dividing it by the monthly cash flow. There is also an accumulation of capital at the end of the year that must be taken into account.

    Here is a real life example. Mike bought a 4-unit property from me for $120,000 and put down $12,000. He incurred $5,000 in closing costs (the rest of his costs were paid by the seller). He shelled out $17,000. The property generated a monthly net cash flow of $300 per month. The $12,000 remains yours. You just converted the cash asset into stock. The $5,000 in closing costs is what we want to look at. We could do a quick calculation like this: Closing costs divided by monthly net cash flow = # of months to recover $5,000 in closing costs divided by $300 per month net cash flow = 16.6 months. Not bad, you’ll get your closing cost money back in about 17 months, right? Wrong! How about the capital you accumulate at the end of the first year?

    (Bear with me…here comes the math):

    In this example, the average multiunit in the area appreciates at an average rate of 3.5% per year. So, at the end of the first year of ownership, the property will have an assessed value of $124,200 ($120,000 X 103.5%). So at the end of the first year, Mike had rental income of $3,600 ($300 X 12) PLUS an additional $4,200 in equity ($124,200 minus original cost of $120,000)…that’s it! $7800 in profit! That can be annualized to $650 per month in the first year ($7,800 divided by 12 months). And that cuts the time to recoup those costs from 16.6 months to 7.7 months ($5,000 in closing costs divided by $650)!

    There are more, of course, but I find that I see these three more often than many others. If you are a new investor thinking about buying your first property, I hope you have found this article educational.

    I deal with many beginning real estate investors in Philadelphia and Delaware County, and believe me, as much as you search for the best investment properties in Philadelphia, I insist that you first learn to appraise these properties to some degree. It is imperative that you, as a new investor, understand some of the basics so that you can make the most informed real estate investment decisions possible.

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