Irs Rental Property Rules
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How To Avoid The Five Common Mistakes When Buying Your First Property
You decide to take the plunge and buy your first property. You scour newspapers, websites and local realtors looking. After weeks of searching, you've found the perfect property with which to begin your investing career, or have you?
Have you done the due diligence necessary to minimize your risk or have you found a property that will keep you awake at night?
How will you avoid the 5 common mistakes that novice investors make when buying their first property?
Forewarned is forearmed. The first thing to know is what those mistakes are and how to avoid them. When I bought my first investment property, I made them all. I held onto that first property for 4 years, never made a dime and sold it at a loss when the expenses of sale were factored in. As I sat crying in my coffee after the close, my mentor said to me, "kid how much was a year of college?" When I told him, he replied, "for the cost of a year of college, you got an education."
Mistake number 1: Looking at a potential property as though you were going to live in it. Real-estate investing is a business and should be looked at that way. In my opinion your only real obligation is to provide safe-decent housing to your tenants. You will have to decide before you buy whether you will be investing in low, middle or high income properties. Part of that equation is not whether or not you would want to live there, but rather whether or not you would feel comfortable owning a property with a certain set of characteristics. My first rental property was a tri-plex. This particular tri-plex had a 1200 square-foot owner's unit. I envisioned wanting to stay there periodically when I travelled through town. With that mindset it became very difficult to rent that unit and half of the income that the building earned was tied to that unit. I could pay the property's bills as long as that unit was rented, if it was vacant, I couldn't pay any of them. By seeing myself living in a unit, I tended to make decisions that cost me money and made little business sense in terms of enhancing cashflow or tenant retention.
Mistake number 2: Failing to understand the investing formulas before you buy. Believe it or not, there are some simple formulas to remember when you are looking at a property. Look at properties with even numbers of units with the minimum number being 4. This means that you look at 4 plexes, 6 plexes, 8 plexes on up. Here is why. With a 4-plex, the basic formula is 2 units cover the mortgage, the third covers expenses and the 4th goes in your pocket. With an 8 plex it is 4 units cover the mortgage, 2 cover expenses and 2 go in your pocket. With a 6 plex, 3 units cover the mortgage, 2 cover expenses and the 6th goes in your pocket. With these basic formulas in your head, you can rule out certain properties or know right away what your margin for error is before you have negative cashflow. When I applied for the mortgage on my first property, a tri-plex, the mortgage broker, himself an investor, tried to explain these formulas to me. His explanation went in one ear and out the other because I had already made Mistake Number 1. Another basic but indispensable formula is this: properties are basically worth 10 times their monthly cashflow and you want to purchase at a discount to that cashflow. I shoot for 20%.
Mistake number 3: Not insisting on current income data from the seller. You can and should make financial disclosure from the seller, part of your purchase and sales agreement. They are not obligated to produce the data any other way and you could be walking into a pit of despair without it. As a teacher of mine once said, "a seller may lie to you, but they won't lie to the IRS." At minimum you should ask for rent rolls, schedule E's and current leases. Tax and utility data are also available online so that you can get a real picture of the expenses on the property.
Mistake number 4: Inspecting the property without an inspector. Understand that the inspection report goes to the person who paid for the inspection. You always want to cover that expense. One mistake that investors make is that they buy a property sight-unseen and are surprised after the close that the property is a pit. One other common mistake and the one that I made is walking through a property then having an inspector go through at a later time. I did it to save money. I mean why hire an inspector if I am ultimately not going to buy a property? While preparing this article, I went back and looked over those inspection reports. There were red flags all over it but because I wasn't there when the inspector reviewed the property and because I didn't arrange the inspection, those red flags got lost in translation. The end result for me? Two new coolers at 800 dollars each and a new roof at 4200 dollars all within the first year of ownership.
Mistake number 5: Not interviewing your property manager. Your property manager is part of your wealth-building team. Unfortunately there is significant turn over among property managers A good property manager will never make a bad property turn a profit, but a marginal or poor property manager can ruin the income prospects for a break even or positive cashflow property. Some of the things your should look for: references, total units under management, in-house maintenance staff and the hourly rate they charge, average length of time property owners remain with the company, time to turn over a property, time to evict a tenant (not what the law says, but how long does it take the property manager you are considering to evict a tenant, fix up and re-rent a unit?), up-front property management fees and figure those into your cashflow projections.
There are, of course, other mistakes you can make when buying rental property but these are the doozies. If you can avoid these, you may survive your first few properties to make real money and create real wealth in real-estate.
About the Author
Democrats, Nancy Pelosi, Charles Rangel, Pay go, and Turkey
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