In my early days as a real estate investor, I experienced the harrowing situation of running out of funds on my first 32-unit apartment in Indiana. Although I managed to turn it around and generate significant profits, it was a close call. This article aims to highlight the critical mistakes that real estate investors often make, leading to depleted project funds, and provides actionable strategies to avoid such pitfalls.
Mistake 1: Underestimating Renovation Costs
One of the most prevalent reasons investors run out of funds is underestimating renovation expenses. Rough estimates and inadequate sourcing of labor and material costs can be detrimental. To mitigate this, follow these essential steps:
- Detailed scope of work: Walk the units with a general contractor (GC) to create a comprehensive scope of work. Never close on a property without inspecting each unit alongside the contractor. They’re able to take measurements (crucial), create an accurate count of how much material is needed, and identify specific requirements for the different layouts
- Multiple bids: Obtain at least three bids from separate contractors, providing them with the detailed scope of work. This ensures competitive pricing and avoids underbidding tactics.
- Factor in contingency: Mike Tyson once said everyone has a plan until they get punched in the face. Allocate 20% of the total renovation costs as a contingency fund to cover unexpected expenses or cost overruns.
- Seek expert guidance: If you don’t have experience with construction, it’s a good idea to have someone that can aid in quality control. In my first apartment investment I thought I had a rock solid GC. They had a good track record of projects just like mine, they were professional, and they were reasonably priced. However, they cut corners and failed to provide a quality product. They rebuilt our second story patios but left nails poking in all different directions and the inspector wouldn’t issue the certificate of occupancy. This resulted in costly delays to finishing the project and cost me a lot of money. This was partly my fault because I didn’t have the skills necessary to view their progress and ensure it was quality work. You can avoid this by having someone with experience walk the job site during and after the scheduled repairs. If they spot something it’s much cheaper and faster to get it fixed immediately.
Mistake 2: Inadequate Inspection
A thorough inspection is vital to uncover potential issues and avoid costly surprises. Take these measures to conduct a comprehensive property assessment:
- Qualified inspector: Hire a knowledgeable commercial property inspector who understands multifamily buildings’ unique requirements.
- Walk every unit: During the walkthrough with your GC, include the inspector to assess mechanical systems and identify maintenance needs. Pay attention to the condition and estimated life of HVAC systems.
- Sewer and drainage piping: Have the sewer lines scoped to identify any damages, roots, or collapsed pipes. Ensure the property has cleanouts for easy maintenance and blockage removal. I’ve spent $15,000 because an old clay sewer pipe collapsed. I missed it during inspection because we didn’t scope all of the lines.
- Review property records: Request property records, maintenance reports, and prior inspection records from the seller to identify any recurring issues or potential concerns.
Mistake 3: High Vacancy Rates
Vacancies erode cash flow and can jeopardize your investment. I purchased my first apartment deal, which was 32-units, with 4 units vacant when I took over. After closing, 2 additional units’ leases were expiring, so I chose to not renew them so I could expedite the renovations and get higher paying tenants in there. That immediately put me at 81% occupied and in negative cash flow. This left me bleeding money for two months while renovating those 6 units. Since that bleed wasn’t included in my underwriting it took funds earmarked for other renovationsAvoid these common mistakes related to vacancies:
- Sensible renovation pace: Avoid aggressive renovations that may deplete funds too quickly. Aim to maintain occupancy above 90%, unless you have planned for negative cash flow and adequate capitalization.
- Effective marketing: Many property managers are not quick enough to respond to interested tenants, and this leads to longer vacancy. If you’re property manager takes several days to respond to inquiries on the major listing platforms, like Zillow, you’re going to have higher vacancy and lose money. If your PM lacks in this area, consider finding a new one, renegotiating the contract and hiring out the leasing to a third party, or hiring a VA to handle inquiries on all the listing platforms.
Mistake 4: Relying on Cash Flow
Relying solely on cash flow to fund renovations is risky. Unexpected expenses can arise, amplifying the financial strain. Avoid this by maintaining sufficient reserves and planning for unforeseen costs.
Mistake 5: Lack of Contingency
Contingency capital is crucial to cover unexpected expenses. Take these steps to ensure you have adequate contingency funds:
- Cash reserves: Allocate a minimum of 20% contingency on top of construction costs and 5%-10% of total operating expenses for the year.
- Adequate insurance coverage: Obtain comprehensive coverage, including flood, fire, and earthquake insurance, to protect against unexpected events. These are separate policies, but if a once in 100 year flood occurs and you don’t have coverage your business plan is going down with the ship.
Mistake 6: Poor Financing
Having crippling debt payments often kill real estate investments and wipe out newby investors. These are common mistakes and how to avoid them.
- Overleveraging: Too many operators fall into the trap of getting the highest leverage possible. High leverage is attractive because it amplifies returns. However, it also stresses the asset more due to the increased debt service. If your margins are tight and things go wrong, you can find yourself in the negative and bleeding out your reserves
- Variable Interest Rates: This always seems like a good idea when they offer you better terms, but time and again operators find themselves in trouble when interest rates and cap rates rise, leaving them without enough value to refinance or sell. Fixed interest rates allow you to project expenses accurately and not run out of money
- Short-term debt: Also known as bridge debt, these are loans that are attractive because they tend to lend more money or lend on riskier projects. The downside is that these loans typically have a term of 1-2 years. This can hurt you if you reach the loan maturity date and interest rates and cap rates have risen. In that scenario, it’s possible the value of the property has declined and you know longer have enough value to refinance out of the short term debt. If this happens, your choices are to either do a CASH IN refinance, or sell for a loss. Short-term debt needs to be carefully planned with multiple exit strategies for getting out of the debt.
Not tracking expenses: Many operators aren’t tracking their expenses accurately and find themselves asking “where did all the money go?” It’s critical to look at the projected expenses versus actual in every category. Always know where you are versus where you thought you’d be and make adjustments to the business plan when needed