Are You Financially Ready To Buy Your First Investment Property?
BY CYNTHIA MEYER CFA®, CFP®, CHFC®
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Spend the time financially preparing for being a real estate investor before you begin. Direct investment in real estate can be rewarding, but it comes with substantial risks – especially when you’re just getting started. As a CERTIFIED FINANCIAL PLANNER™ and rental real estate investor, I know many people who invested successfully in real estate – but I have also met people who have blown up their personal finances because they weren’t prepared for the unexpected.
What drives me crazy about some real estate experts
Listening to the radio, watching late night cable TV or exploring online, you’ll find many real estate experts who want to teach you their systems for finding and financing great real estate deals. According to these self-described millionaires, people can make money in real estate if they just have the right system – their system. They will tell you can easily buy property with no money down, no special knowledge and a poor credit score.
Give me a break.
In finance, if it sounds too good to be true, it usually is. I’m all for someone who has succeeded in real estate teaching others their methods. What drives me crazy, though, is when these folks imply that direct real estate investing in individual properties is simple and easy for someone who isn’t financially prepared. That is just not true.
The truth is that buying investment properties has many risks
The truth is, each property investment has unique risks. When you are getting started as a real estate investor, you are probably going to start with one property. Later, as your investment property portfolio grows, some of the risks can be reduced with diversification and cash flow from other properties. However, in the beginning, when you are not diversified, the risks to your personal finances are highest.
A rental real estate investment could:
Remain vacant for much longer than planned but you still have to pay the bills in the meantime. We once had one of our properties – a beautiful single-family home in a great school district - remain vacant for nearly a year due to local market forces.
Generate large, unexpected maintenance bills. Our biggest ouch was when a tenant flushed wipes down the toilet and blew up the plumbing under the house. You might need a new roof, furnace or air conditioner sooner than planned.
Require repairs due to natural disaster, such as a hurricane, tornado or flood. Even with good insurance, you’re still on the hook for the deductible.
Have a tenant who stops paying the rent. You can evict a tenant for nonpayment, but you may try to work out a plan for them to catch up on the rent first or give the tenant an opportunity to leave voluntarily. In any case, there could be months of unpaid rent that you may realistically never recover.
Rent for less than your costs. Rental markets change. Despite your initial due diligence, rents could fall in your property’s neighborhood due to recession, the loss of a major industry or employer, or natural disaster.
If you’re flipping a property, the risks to your finances could be higher, depending on whether you’ve borrowed money to buy and rehab it. Leverage (borrowing) can magnify gains, but it will also magnify losses if the flip doesn’t work out or takes too long.
A flip could:
Cost significantly more to renovate than you have budgeted. You’ve seen this on TV, right? Halfway through the renovation the contractor uncovers a problem not found during an inspection, such as a structural issue, mold, termites, environmental contamination or other expensive issue. That’s more money out of your pocket in renovation costs and carrying the cost of the loan, if you have one.
Remain on the market longer than planned. The longer your renovated property remains on the market, the greater your costs to carry the investment. If you’ve borrowed for your flip, you’ll be paying that loan plus your own mortgage during that time. That can add up very quickly.
Cash reserves are critical
Building and maintaining cash reserves for your real estate business will help you weather these risks and minimize the likelihood of cash flow problems. Large, unexpected costs to your real estate investment be financially devastating if you can’t manage them. Without some cash reserves to pay unexpected bills, you might have to borrow on your credit cards, or take a personal loan or 401k loan – or even sell the property at a loss or lose it in foreclosure because you cannot afford to keep it.
Practically speaking, that means saving enough in short-term, low risk, liquid savings such as bank savings accounts and money market funds – before you buy anything -- to cover your:
- Down payment;
- Closing costs;
- Renovation costs;
- Legal costs, if you’re forming a corporation such as an LLC; and
- Business cash reserves.
Business cash reserves – build a year of expenses
As a financial planner, I encourage people considering investment real estate (either rental or flip) for the first time to build enough cash reserves to cover at least one year of the property’s expenses (mortgage, insurance, taxes, maintenance, property management, etc.). If you’re starting with less than a year’s worth of expenses in cash – and you’ve got a tenant already -- make sure you save your net rent in your cash reserves until you’ve got at least 12 months’ worth of expenses in cash reserves.
Yeah, I know that sounds like a lot. It’s certainly a lot more than many internet real estate experts and course providers will say you need. (In fact, some of them say you don’t need any, which is ridiculous.) And I’m certainly hoping you don’t need to tap into all of it.
Work on your credit score and pay down debt if needed
A strong credit score is 740 or higher will help you qualify for lower rates on a mortgage, if you plan to take one. It’s not essential for investing in real estate, but it will help significantly. See my Forbes post on How To Improve Your Credit Score Quickly. If you have credit card debt or other high interest debt take care of that first before you begin your search for an investment property.
Don’t forget your personal emergency fund and your retirement savings
There’s a tendency among some real estate investors to think that real estate is the answer to every financial question. They invest in what they know, and may avoid traditional investments in securities (mutual funds, ETS, stocks, bonds, etc.), and may fail to take full advantage of tax-advantaged retirement savings accounts like their 401k, Roth IRA, HSA or SEP.
Before buying an individual rental property, consider:
- Building a personal emergency fund of 3-6 months personal expenses (12 months if self-employed);
- Contribute enough to tax-advantaged retirement savings so that your annual retirement projection shows that you are on track for your retirement goals given a moderate rate of return. For 2020, the IRS limits are $19,500 for 401(k) or 403(b) (plus $6500 catch up if 50+), $6000 for IRA/Roth IRA (plus $1000 catch up 50+).
The bottom line: real estate investors can benefit from financially preparing for direct investment, in order to minimize the substantial risks.
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