By: Jeff Heybruck
Successful real estate investing requires patience and learning over time. For first-time investors, it’s especially important to choose the right deal type and investment amount to minimize risk and leave room for a few (inevitable) mistakes. Our team at Lucrum has worked with countless variations of these, and we put together tips for beginners looking to successfully start building out their portfolio.
1. Start Simple & Small – For first-time investors, the simpler the deal structure and smaller the amount invested, the better.
A first-time investor should start with a deal structure they can easily wrap their head around. For example, buying a single residential property like a townhome or condo with a partner where the deal structure is that the rental income and expense responsibilities percentages are split to match the percent of the investment owned. Buying into a syndicated multi-family deal (leaning on the experience of a sponsor with a solid track record is key here) could be a good first investment as well. Land plays, fix and flip and development deals are best taken on later in a real estate investing career, once the basics have been mastered.
Sole ownership of a property may not be an option for first time investors hoping to start out with a lower investment amount. Buying into a real estate syndication deal can help to lower the cost and risk of investing by splitting it among a group. (Read more on real estate syndications below) Most real estate syndications will require a minimum $50,000 investment, which, depending on the price point targeted, may be the same cash required for a downpayment on a single family property. Some developers or folks putting together their first deals will allow investors to buy in at an even lower amount. No matter how small the investment, make sure to clearly define an exit strategy before committing to a deal, putting down money, or applying for a loan. Investors should treat their investment plan just like a business plan, with actionable and specific milestones and goals.
Tip: Looking to take out a loan for an investment property? While down payments vary from lender to lender, lenders typically require a larger down payment (plan for 15% or more) for investment properties than a home mortgage. Interest rates are usually higher as well so be sure to do your analysis before committing.
2. The Local Market Matters Most – While national real estate statistics can be a helpful indicator of whether it is the right time to invest, residential and commercial real estate trends vary greatly across markets. When evaluating locations, investors should do their due diligence in researching the local market.
Data on population growth, job growth and quality of life rankings can all help to better understand the area. Consider crime rates, school districts, and proximity to neighborhood cores with attractive elements like restaurants, parks, grocery stores and shopping. Additionally, investors should look into whether the municipality has any future plans for the area and any planned construction.
Hyperlocal factors matter too. Unique aspects can increase or decrease the value of similar-sized properties in the same area. For example, a house’s location within a suburban neighborhood (typically closer to the front or entrance is considered more desirable) can impact its value. Similarly, two multi-family apartment complexes built across the highway from each other could vary greatly in value based on whether there is easy connectivity via pedestrian walkways between the units and surrounding retail, shopping and entertainment.
Tip: Residential deals are typically less vulnerable to economic downturns than commercial real estate deals. That being said, having a downturn contingency plan is good practice for any type of real estate investment. This ensures that the investor(s) can weather the storm and continue to hold onto the property in the event of unexpected market changes.
3. Consider Real Estate Syndication – Don’t have a lot of time to find and manage deals? Real estate syndications are a great option for beginner or busy real estate investors.
In a syndication, a group of investors pool their money and resources to invest in a real estate project. This lowers the cost of entry by spreading it among a group of investors, giving single investors access to deals that they could not have otherwise afforded on their own. These deals are typically run by a sponsor who spearheads and manages the deal for all investors. The sponsor can make or break a deal, so confirming the sponsor’s track record will be key. Ask to see documentation for past investments and get a good understanding of how many successful deals they have done in the past. Don’t be afraid to ask for references from those who have invested with the sponsor in the past. Past success does not guarantee future success but past shadiness usually guarantees future problems. Also make sure to ask about sponsor fees, deal structure, and what type of management reports are regularly shared with investors.
Note: While they may seem similar, real estate syndications are different than REITs. In a REIT, the investor owns a percentage of the REIT company (vs. the actual property). The REIT invests in a variety of real estate projects and distributes dividends to shareholders. Like stocks, if the REIT’s market value falls to zero, the investor risks losing all of the investment. With a real estate syndication, the investor owns a portion of the LLC that owns the land. The difference is that most syndications use one LLC for one property so unless there’s debt on the property, it’s rare the value would go to zero.
4. Run The Numbers – Investors should take the time to calculate and weigh a few key performance metrics for the investment being considered. Cash flow, cash yield, IRR and cap rate can all be used to evaluate whether the risk is worth the return based on the investor’s personal risk tolerance and goals. These metrics can also be used to compare two or more investment opportunities.
Cash Flow – Beginner investors can minimize risk by focusing more on an investment that will yield a healthy cash flow rather than one that will yield quick appreciation gains. It’s risky for a beginner to attempt to time the market by buying and waiting for the property to grow in value before selling. A safer first investment is a property that will cash flow immediately or as soon as possible after purchase. This protects the investor from relying so heavily on needing to predict market changes in order to generate returns.
If the monthly income from the property will not cover all expenses (don’t forget taxes, insurance, HOA dues, property management fees, maintenance/repairs, expected vacancy losses, and where it’s included in the rent, utilities), it might not be the best deal for a beginner investor.
Expected cash flow can also be a great metric to break the tie between two similar properties being considered. If the potential gain from appreciation over time is the same, the property that will produce the greatest monthly cash flow wins.
Cap Rate – A popular metric for real estate investors due to its simplicity, cap rate compares the annual return on a property to its market value. Cap rate is calculated by dividing the annual net operating income (NOI) by the property value . For new investors, cap rate can be a great indicator of the level of risk associated with two or more similar investments. A ‘safe’ cap rate for an investor purchasing a property would be around 4%-6%. A strong or ‘good’ cap rate is more in the 6%-10% range.
Cap rate only calculates the return at a specific point in time in the investment property’s lifecycle (ie. the projected income and current value of the property in the year it is calculated for). Thus, investors should also look at metrics (see IRR below) that take into account the return over the full lifecycle of the investment.
Cash Yield – Also known as ‘cash-on-cash return,’ Cash Yield calculates the cash income earned on the cash invested in the property. Divide the Cash Invested by the (pre-tax) Annual Cash Flow and multiply by 100 to calculate this metric.
Cash yield can give an individual investor a clearer view of the return on investment to them specifically. It shows how fast the initial investment can be made back, or the point at which the investor recovers their initial investment and really begins to make a profit. Similar to cap rate, cash yield provides a view limited to the specific year for which it is calculated, rather than providing a more holistic view into return over the life of the project.
Investment Rate of Return (IRR) – IRR is a more accurate evaluation as it accounts for the time value of money, taking into account the initial investment and timing of the distributions (returns paid to the owner(s)) over the lifetime of the investment (cash yield and cap rate do not). It looks at the annual growth rate of an investment and how soon the returns accrue to the owner(s). IRR is a bit more difficult to calculate and requires accurate forecasting, but is a worthwhile metric to know if the investor is considering a more short to medium-term investment where time value becomes increasingly important.
To get the most out of the above metrics, investors cannot overshoot their estimate on the amount of rent they will be able to collect or underestimate the expenses that will go into managing the property. Researching historical and current rents in the market using nearby comps will be crucial. Investors should also investigate whether a property will need any large repairs or upgrades in the near future. If a small property needs a new HVAC system in year one, for example, this could substantially cut into cash flow. Also consider occupancy rates which have a significant impact on both cash flow and accordingly, cap rate.
With the right amount of research and thought, real estate can be a great option for investors. We hope these tips will help a few new investors avoid some common pitfalls and position them for success.