Why Joseph Should Continue in Real Estate Investing
Evan had a similar experience starting out in real estate as Joseph, but he applied the lessons learned to improve his real estate investing. Evan runs a home buying company that focuses on flipping single family homes and holding low income rentals.
Personally, I’ve been too busy in the past to consider any hands-on real estate investing, but have some prior experience as an accidental landlord and have gotten my feet wet with a handful of crowdfunded real estate deals.
The remainder of this post will be in Evan’s words. The floor is yours, Evan!
Joseph Hogue recently published an article on PoF entitled, “I Owned Six Homes and Lost It All With Real Estate Investing.” He gave a great account of his experience investing in real estate. When most people hear about real estate investing, they hear about the young couple making millions flipping houses or the retired landlord who built up an empire over a few decades and now spends his time relaxing on a beach in Florida.
Everyone loves the victory stories, but few share their blunders. The account Joseph gave is more common than not and should act as an example of real estate’s learning curve.
Hindsight is always 20/20. The mistakes we make are always due to an unknown risk, a miscalculated expense, or an overly optimistic view of the market.
When you first get started in real estate, it can be difficult to truly analyze a deal since you don’t have context for what can go wrong and what to expect in terms of a return. You can read everything ever written on how to ride a bike, but you’ll never truly learn until jump on that seat and give it a whirl.AE Home Group for years before deciding it was time to flip my first house. The market in Baltimore City had been getting hot, and I saw a number of smaller investment companies grow into large flipping operations. Everyone seemed to be making money and I wanted in. I gave my colleague, Jeff Miller, a call and convinced him that now was the time to pull the trigger.
It was about this time that I received a call from a wholesaler I knew. For those not familiar, a wholesaler is someone who puts a property under contract at a low price and then sells the contract to another investor for a profit in the form of an assignment.
The property he was offering was located in an up-and-coming Baltimore neighborhood called Hillen. I had seen significant developments in the area in recent years, and it was within walking distance to Morgan State University. He had picked the property up at a courthouse foreclosure auction and I was definitely interested.
When I ran the numbers, I projected a $55,000 renovation with a $165,000 after-repair value. Once I took into consideration other expenses such as holding costs, closing fees, and resale costs I projected a $20,000 profit on the project given the $60,000 purchase price. This was a reasonable spread and I was excited to get it under contract.
Showing up at the closing table we found that our closing costs calculation had been off. We hadn’t accounted for the $4,000 in interest owed to the city after accumulating between the time of the auction to the time of the closing. While we didn’t know it, this was one of many mistakes that started to snowball.
During the renovation process, we discovered an additional $9,000 in necessary repairs, causing our renovation timeline to stretch a month past our original optimistic estimate, which cost us $1,500 in holding costs.
Further, there was a misunderstanding with our insurance, which resulted in a more expensive policy that charged a $500 premium over our previously quoted policy.
When we finally did find a buyer, they weren’t highly qualified and required additional closing assistance in order to get the deal done. When all was said and done we walked away with $2,700 in profit, a far cry from our originally projected $20,000.
While we didn’t make much of a project we were fortunate in walking away from the project without a loss. Mentally, we felt defeated. Spending every day on site for months at a time had eaten into weekdays and weekends.
We found ourselves doing the tasks nobody wanted to do like making dump runs and doing the punch out list after all the trades were finished. It can be hard accepting $2,700 in profit after dumping hundreds of hours into a project.
When sitting back with the hindsight we gained, we see a lot of overlap with Joseph Hogues’ experience:
- We both purchased our properties at too high a price.
- We both took on too many responsibilities with the properties and ended up experiencing burnout.
- We both miscalculated particular expenses in projects. Most of these were due to overly optimistic predictions and not having a full understanding of all the costs that could potentially go into a project.
This is a common theme I see with almost every investor getting started for the first time. You don’t know what you don’t know, and there will always be a lesson to learned with each new project.
What I find makes a successful investor is perseverance. Tom Watson Jr. was CEO of IBM between 1956 and 1971. He was at the helm during the information revolution and was a key figure in shaping the computer technology that we have today.
During his time with the company, he had a young executive lose the company millions of dollars due to a few bad decisions. The executive then showed up at Watson’s office expecting to be let go and asked, “I suppose after that set of mistakes you will want to fire me.” Tom Watson, Jr., had an unexpected reply for him. “Not at all, young man, we have just spent a couple of million dollars educating you.”
What Joseph lost financially from his rentals he gained in education. Overpaying for a property or underestimating risks become less likely once you’ve lost hard-earned money and precious time to a poorly executed investment.
While he should not repeat the same mistakes over again, stepping away from real estate as a whole only shelves these expensively acquired insights that could make him more competitive in the real estate market down the line. At the end of his post, he laid out his lessons learned and the keen wisdom that showed he now understood. To paraphrase, these lessons were:
- Don’t try to tackle projects alone. Conducting a real estate investment requires an array of expertise that no one person can provide. Surround yourself with a team of professionals to handle each aspect of the investment.
- Start your real estate investments small and don’t invest heavily until you’ve proven success. There are so many pitfalls specific to different types of investments that you need to go through the process before taking on multiple projects.
- Always calculate your numbers conservatively. Never be overly optimistic about the execution of the project. Something unexpected always happens and you need to have some slack in the budget and timeline so that it doesn’t sink the investment.
- Only invest in real estate in areas in which you’re familiar. When you start stepping out of your comfort zone you lose your ability to accurately project risk.
- Financing is a great tool increasing your cash-on-cash return in real estate, but don’t over leverage. Make sure you are able to recover financially if the worst case scenario occurs.
These rules allow any investor to approach real estate in a way that outweighs risk with financial opportunity while protecting them from repeating history.
[PoF: To be fair, while Joseph did take a step back from real estate after his initial struggles, he has continued investing in real estate. Quoting his initial post, “I still own rental properties and love real estate as a long-term investment but there are a lot of traps you have to avoid if you’re going to make real estate work for you.”]
One of the greatest characteristics of real estate investing is the versatility that is available. There are so many niche areas of expertise that there is nearly something for everyone.
As a physician, your time is very valuable. You’ve spent decades of your life and invested countless amounts of money into your education. Your time is most efficiently spent applying the skills you’ve learned towards improving people’s lives.
While spending time in your profession doesn’t translate directly to real estate success it leaves you highly financeable with liquid cash available for investing. As a real estate professional, I would still agree with any stock expert that stocks are the best asset in which to passively gain long-term wealth.
Real estate will never be as passive as an S&P 500 index fund, but there are ways to approach real estate investing that will allow you to diversify without a steep learning curve or heavy time commitment.
A REIT (or Real Estate Investment Trust) is a traded fund where the underlying portfolio is typically made up of large commercial real estate assets. These have been a popular tool for financial advisors who wanted a way to diversify their high net worth clients into real estate.
These funds offer a lot of value in that they are easily liquidated, their value is unlikely to fluctuate since commercial real estate is a relatively stable asset, and they are completely hands-off as they are tightly regulated and operated by large investment firms.
In the recent years since the last real estate crash, REITs have shown a strong overall performance with some funds outperforming stocks. While there is a lot to learn from an asset’s historical performance, you can’t always use this to predict future performance.
The reason REITs have performed so well over the past 10 years is that both interest rates and commercial real estate prices have been at historical lows. It was relatively easy for a firm that had strong financing to acquire a low price asset at a low interest rate and have both strong cash flow and appreciation potential from day one.
In today’s competitive environment, commercial real estate has been squeezed to a point that many institutional funds are willing to accept as low as a 4% cap rate on commercial acquisitions. Combine this low margin of profitability with rising interest rates and you see a large number of REITs holding assets that have the potential of actually losing money in the years to come. This impact of higher interest rates on the ability of a REIT to grow was also identified in PoF’s recent portfolio performance update.
So what other options are there out there other than REITs for individuals looking to diversify into real estate? Enter crowdfunding, hard-money, and private lending.
Crowdfunding, hard-money, and private lending are all popular ways in which with available cash is able to act as a bank and provide funding for real estate deals. As the financier, your role is to vet the opportunity and allow the person or company you’re financing to handle the full execution of the deal. Your involvement in underwriting the project varies depending on what you’re doing.
Crowdfunding came into existence over the past 10 years when Congress loosened restrictions on how companies could raise capital from individuals. The way it typically works is that a crowdfunding platform will receive financing requests for anything from residential flips to large commercial development.
After a strict vetting process, the opportunity will be made available to the public through the crowdfunding platform. Terms of the deals can vary greatly. Some opportunities provide an equity stake while other investments are held as debt. You’re still required to vet each deal and company as the crowdfunding platform is simply a broker.
- Greatest amount of flexibility for those looking to own an equity stake in their investment
- Provides opportunities to invest in large commercial project since you’re funding alongside other investors
- Proven funding process that has been used for thousands of deals
- Only a moderate amount of time is required to research a deal upfront and the investment is typically hands-off for investors once funding is complete
- Allows you to easily diversify your funds among numerous companies to reduce risk
- Allows you to invest small amounts of money
- You are responsible for vetting each deal beyond the underwriting provided by the platform
- Returns on equity deals are only projected and have the potential to underperform
Hard-money lending is where a professional company will provide short-term debt funding to a real estate investor for a renovation flip or as a bridge loan before financing with a traditional bank. As the financier your role is simple: you provide the funds to a hard-money lender who will then pay you interest on the funds. This lender makes money by lending your money to investors at a higher interest rate and keeping the difference as profit.
- Less work than crowdfunding. Once you’ve vetted the hard-money lender, they handle the rest.
- Your returns are typically inline with crowdfunding.
- Hard-money lenders are typically experts in a local market and have a strong expertise in underwriting.
- Consistent guaranteed monthly payments.
- Institutional money funds are starting to approach hard-money lenders and are pushing down the expected rates for financiers.
- The amount you can invest is restricted by the lender’s bandwidth.
Private lending is where you finance deals directly with real estate investors. This is typically a good option when you have a family member or good friend who is also a real estate investor. It allows you to transition that trust into a working business relationship and reduces the complexities of underwriting.
- Highest return since you’re not funding through a middle-man.
- Greatest control since you’re the one determining lending terms.
- You’re fully responsible for underwriting your deals
- You have to handle the lending process. We recommend working with a lawyer to ensure you are protected when drafting contracts.
- The amount you can invest is restricted by the number of investors you’re able to find.
Honestly, we find that the best approach is a little bit of each. We typically find ourselves prioritizing our funds for private lending with investors with whom we’ve built a strong trusting relationship over the years. These deals provide us the highest returns.
Any remaining funds are then allocated towards any hard-money lenders offering a high rate or a crowdfunding opportunity with favorable terms. Our favor between the two changes frequently as opportunities become available and other opportunities go away.
As a physician, the trick is to keep it simple in the beginning, pick the one that makes the most sense in your situation, and determine whether you can make money there before exploring a different funding opportunity.
How do you invest in real estate? Single family rentals, multifamily housing, crowdfunding, private lending, hard money lending, or other? Or do you stick with stocks, bonds, or other alternatives?