The Biggest Mistakes In Real Estate investing that I see are… Thinking it is a get rich quick scheme… Just dabbling in investing… Buying in a market you do not know well… Thinking you have to do this business alone… Giving up too fast and being too impatient…
Maybe it was in a hotel conference room as some “celebrity” investor promised you 7 easy steps to getting rich in real estate. Or, perhaps, it was on television, sandwiched between late night re-runs of Mash and Hogan’s Heroes.
Here’s the truth: “buy low, sell high” is a terrible way to make money in real estate!
With so many experts on either side of the question, trying to time what the market will do in the short-term seems crazy to me. Call me lazy, but instead of rooting around for my crystal ball, I’d rather make investment decisions that don’t ride on my ability to predict the future.
By focusing on acquisitions of multi-family properties with healthy cash flow, you can build a portfolio that, could care less about whether the market swings up or turns down.
The only timing you would have to worry about is when to bring a stack of rent checks down to the bank.
3. Cash Flow Begets Cash Flow
Here’s an important question to ask any value-based strategy: where do you get the capital to fund further investments? I can all but guarantee it’ll have to come from selling off assets.
The strategy might look something like this.
1. Buy property A for $100,000.
2. 5 years later, sell property A for $127,000 (5% per year return).
3. Buy property B for $127,000.
4. 5 years later, and so on…
Not only does that kind of a strategy suffer from the two shortcomings I raised above, but it almost guarantees you’ll never put enough assets in your portfolio to generate a stable source of income.
So, let’s say you’d rather not wait to sell property A before you purchase property B. Well, if you’ve paid more attention to hoped-for appreciation than present cash flow, your debt service coverage ratio (DSCR) on property A will probably be too low for any decent lender to trust you with a loan.
Run as far as you can from value-based investing. Instead, focus on properties with healthy cash flow numbers, and you’ll have no trouble building and sourcing capital to put towards further acquisitions. That’s how you’re ultimately going to win in real estate investment.
As a general bit of advice, “buy low, sell high” makes a ton of sense. As an investing strategy, on the other hand, it’ll get you into a lot of trouble. Focus on cash flow, and you’ll set yourself up to steadily build a portfolio full of fantastic properties—all without having to worry about an unruly real estate market.
When I first started out in real estate investment, value-based investment was the name of the game. Find a property under market value, get it in your portfolio, and pray that it appreciates enough to sell for a decent gain a couple of years down the line.
Then do it over and over again.
I followed that formula that and it worked… for a while. In 2006, I saw my portfolio skyrocket by $17 million. Unfortunately, I didn’t have much time to get comfortable at the top of that mountain. That gain—and a whole lot more—completely vanished in 2008.
The way I see it, the old way of investing in real estate makes three big assumptions:
1. Real estate markets behave predictably.
2. Your can reliably time the market.
3. Appreciation will consistently provide enough equity to fund future investments.
As I learned firsthand in 2008, each of those assumptions is shaky at best. Worse, if a single one of them doesn’t pan out, your entire strategy takes a significant hit.
So, if this is a losing strategy, what do you need to replace it with? In what follows, I’m going to give you three reasons why I strongly believe that a strategy based on maximizing cash flow blows value-based investing right out of the water.
1. Cash Flow Knows How to Behave
Economist like to talk about something called the Efficient Market Hypothesis (EMH). EMH generally holds that, in markets like the New York Stock Exchange, everybody knows everything there is to know about every publicly traded stock. There are no deals to be had on the stock market. With the rare (illegal) exception, you can’t get the inside line on a bundle of Wal-Mart shares at under market value. In that way, the stock market is highly efficient.
Real estate markets, on the other hand, aren’t very efficient at all. Nobody knows everything there is to know about a property because no two properties are identical. Every buyer/seller interaction is unique. You may be able to snag a $150,000 property for $120,000 simply because the seller needed the cash today and you happened to be the first guy he saw.
Another way of saying the market is inefficient, however, is to say it doesn’t know how to behave. We can do our best to analyze value and make informed decisions about what we think values will do, but at the end of the day, we’re subject to the same market misbehavior we’re trying to capitalize on.
Buying a property with the hope that the market will behave in your favor, then, is like slapping a saddle on a wild horse with the hope that it’ll get you where you need to go… in one piece.
Cash Flow, on the other hand, knows how to behave. It’s not indexed to the whims of the market. Instead, it’s tied to rental income, taxes, operating expenses, and debt service. Buy prudently, keep your property occupied, and you’ll have a steady stream of income that could care less about what the market is or isn’t doing.
That sounds like a much more reliable plan to me. Wouldn’t you agree?
2. You Don’t Have to be a Prophet to Make a Profit
I’ve already mentioned my experience with the Great Recession of 2008. The jury is still out on whether we should expect another downturn in the near future. Some say no, but offer a fairly modest outlook on future growth. Others offer a more pessimistic—some would say alarmist— take on the near-term housing market. I’m in the latter camp. Real estate has always moved in cycles just like life and we are due for a contraction.