Mistakes to Avoid when Buying Rental Property

Are you looking to invest in a rental? With the housing market in the dumps, many enterprising folks are looking to buy cheap rentals. Indeed, in this tight credit market, if you have cash available, you could pick up a small home or even a duplex at a decent price, which you can then rent out.

However, for those of you looking to jump in for the first time, you should understand the risks of owning a rental. Here is a real rental horror story my good friend Jay experienced that covers some of the mistakes many novice investors make. This isn’t meant to frighten you away. It is, however, meant to educate you on the risks with the intent of making you a savvy investor. If you know what to watch out for, you can avoid these mistakes my friend made.

At the end of 2004, Jay was desperate to get into the real estate game. He had been reading about real estate investing over the past year and was ready to jump in and get started. As we all recall, it was the height of the real estate market.

Jay found a large triplex in the outer areas of town. Only one of the units was rented, so he stipulated a contingency in the purchase and sale agreement that all units must be rented prior to closing. Unfortunately, he left the tenant decision entirely in the hands of the seller. Desperate to sell the owner rented the two to an 18 year with no credit history and an older woman with poor credit—both of whom were eventually evicted for failing to pay rent.

Mistake #1 – Not choosing the tenants carefully. It is imperative that you take measures to protect your investment by being careful during the rental process. While you must adhere to anti-discrimination and landlord/tenant laws in your state, you are allowed to require a good credit history as well rental references.

The inspection report indicated that repairs were needed to the roof, siding and furnace. My friend assumed however, that none of these items were urgent and that he would be able to take care of them later down the road. Additionally, the owner would only sell ‘as is’ so there were no negotiations. One day after closing, Jay received a call from a tenant in a panic saying his furnace died. The average estimate from HVAC contractors to replace the furnace was $3,000.

Mistake #2 and # 3 – Allowing the seller to call all the shots in negotiations and not being educated on the costliness of certain repairs. Make sure you know what typical costs are and whether you can afford them. Never pay full price for property that has deferred maintenance. Also remember that you can always walk if the seller is unwilling to work with you, whether the market is high or low.

Jay’s property and the adjacent triplex used to be on one tax parcel. Prior to the sale, the former owner subdivided the property—something that is more common than people realize with multifamily properties. The subdivision along with an easement granted to the adjacent triplex was recorded with the county. The easement was for the use of the parking lot. Jay owned the lot and was responsible for maintaining it (keeping it clear of snow and ice in the winter and fixing any potholes). However, the adjacent owner and his tenants have free use of the lot and Jay’s tenants often have to vie for a spot to park. There is no common area maintenance agreement or covenants, conditions and restrictions (CC&Rs) in place governing the use of the lot. There are no restrictions on stalls per tenant, stalls for guests or required maintenance contributions from the adjacent lot. Jay carries all of the responsibility with nothing in return.

Mistake #4 – Not conducting due diligence on special conditions of the property. Anytime you come across a property that has been subdivided out of an adjacent property, or any property that shares joint amenities or features, ensure that necessary common area maintenance agreements are in place prior to the sale. Ask the seller to provide all documentation and agreements in case they haven’t been recorded and closely inspect your title report.

In the 4^th year of ownership, the property still does not cash flow. There are many apartment turnovers, rents are difficult to maintain and reserves are running low. Jay also thought he would be able to manage the property himself in order to save some money. Soon after purchasing, he quickly realized he needed to hire a manager to collect rents and process evictions on the tenants who failed to pay. The management fee eats significantly into his monthly rent collections and Jay has to come out of pocket to meet some of the mortgage as well as property taxes.

Mistake # 5—Not analyzing the property’s cash flow projections. You can avoid overpaying for a property by creating a proper cash flow proforma. When buying any income property, you must analyze the income and expenses of the property starting with the actual figures provided by the seller and then making adjustments that factor in potential vacancy, credit loss and repairs. You should also factor in a management fee, because if you’re new at this, chances are, you aren’t ready to be a property manager. If the rents aren’t enough cover these expenses, ask yourself if you’re really ready to pick up the tab each month.

There is one final mistake that Jay made and it is one that has ensnared so many in this downturn. Mistake # 6—Taking out the wrong mortgage loan for the investment. Getting the financing right is so crucial to any investment you plan to make, whether it’s an investment in real estate or a new business. The topic is more extensive then can be covered this article. Plus, very few of the dangerous creative financing options are left these days. However, getting the financing right is crucial to your cash flow and the stability of your investment.

                                                             * * *

Jay is still struggling to dig his way out of his investment. He has listed it as a short sale at $49,000 below what he paid for it. He had already lost thousands in repairs, court costs and lost rents. If it does sell it will likely take another $20,000 to $30,000 hit. He would then face a potential deficiency judgment should the lender decide to pursue him for the difference between the outstanding balance on the loan and the sale proceeds. At the very least, he should expect to pay taxes on the “gain,”—the amount forgiven by the lender in a short sale.

Whenever Jay hears any of his friends talk about taking advantage of low prices and jumping into the game he he’ll invites them out for a coffee or a beer to share his experiences with the hope of dissuading them. My hope however isn’t to dissuade, but to urge anyone considering buying a rental to exercise caution and conduct due diligence. Familiarize yourself with your state’s landlord/tenant laws, research property management companies and know what cash flows you can expect. Apartment rentals can be a great investment and a good way to get into the property game. Just make sure you don’t get tossed out after the first toss of the dice.