6 Most Costly Mistakes Apartment Investors Make
6 Most Costly Mistakes Apartment Investors Make
1. Hiring Ineffective Management
2. Don't have a Viable Business Plan
3. Excessive Leverage
4. Not Making a Good Deal
5. Lack of Local Market Knowledge
6. Poor Market Timing
By looking at all 6 most costly mistakes, you will see that apartment investors are in control of their destiny by making a decision to avoid these most common mistakes. As mentioned in my book, "How to take an Apartment Building from Money Pit to Money Maker," eight out of ten businesses fail from internal controllable problems. All 6 mistakes mentioned in this special report are controllable, thus putting it upon apartment investors to do everything possible so that they do not shoot themselves in the foot. It is tough enough out in the apartment jungle competing against others finding, buying and operating good solid investments, so let's not do ourselves in by committing these mistakes.
Hiring Ineffective Management
Apartment investors find many ways to get themselves into financial difficulty, but hiring ineffective management ranks as the number one mistake apartment owners make that drives their properties to trouble. There are many business leaders that represent themselves as reputable and experienced, but do not have a history or proven track record. Ineffective management is like having an inexperienced and unproven pilot flying a plane or captaining a ship that you are a passenger on. Ineffective management is like having an operation done by an inexperienced doctor. You might get lucky reaching your final destination or reaching your goal, but there is a high probability you will have serious problems along the way.
Ineffective management is a manifestation of many other problems that business leaders exhibit. Not having a superstar business leader immediately places the property at a disadvantage. With that, many property management challenges are related to not having an effective leader. Without an effective leader, an apartment building staff will operate with a lack of property and market knowledge, poor financial controls, no directions and poor marketing and sales skills. All these many shortfalls lead over time to a property that begins to have financial problems.
Don't Have a Viable Business Plan
Not having a viable business plan is a very serious mistake that many apartment owners and managers make. Unfortunately, this step is too often skipped. It is an American dream to own a business. But sadly, according to the U.S. Department of Commerce, only 1 in 5 businesses are still in business 5 years after it opens.
You dramatically increase your chance of success with a game plan. According to a Price Waterhouse Coopers survey, over half of the fastest growing firms not only have business plans, but also have separate game plans to keep them focused on what must be done day-to-day.
A business plan gets you in the game. A game plan keeps you in the game. To use the sports analogy, it's easy to see how you are going to win the game from the locker room. Most businesses don't have a working plan that takes into account what actually happens on the field once play starts.
A business plan is a sales brochure and a game plan is an instruction manual. You send a business plan to potential investors and others to excite them about a property investment. A business plan is about strategy. You create a business plan at a management meeting. A game plan is about tactics and is created by and for the people on the front lines. A game plan talks openly about the good, the bad, and the ugly in the business and is used by people in the business to make decisions every day. It talks about what to do in the event of a crisis. As Peter Lynch an investment guru said, "Know what you're investing in, and why."
Excessive leverage is a common mistake made by property owners who fail to adequately measure the risks of their investment. A high level of debt on a property with unrealistic financial projections is a property destined for future cash problems. Cash problems are typically brought on when a property experiences some kind of unplanned problem that affects the cash needs of the property. With a high percentage of debt service relative to revenues from operations, a property has little room for error.
The reality check for apartment owners is that controllable and uncontrollable miscalculations and mistakes happen. Apartment properties with excessive leverage tend to have financial problems because they fail to plan for mishaps. In fact, the number one reason that apartments go through foreclosure is too much debt without adequate resources.
Why do investors secure too much debt on their apartment investments? Many apartment executives and entrepreneurs load too much debt onto their property for many reasons. In theory, more debt with a smaller cash down payment creates higher investment returns. More debt means less cash out of pocket. More debt means owners can purchase a larger property or more properties. More debt means they can expand more rapidly. But, the way I see it from working with many struggling apartment buildings; more debt usually means troubleâ€¦
Leverage is one of the most misunderstood factors of real estate financing, and understanding it is a prerequisite to the application of apartment ownership. Often it is thought that leverage and risk go hand-in-hand, and the greater you have of one the greater you have of the other. The concept of highly leveraged properties as being risky should continue to be deemed as investments to avoid.
Not Making a Good Deal
Many times investors become too emotional when pursuing the acquisition of a real estate investment and lose sight of reality. Emotions such as over-enthusiasm and impatience become a core issue for investors to learn to deal with when buying an investment deal. Over enthusiasm and impatience leads to making poor business decisions that can compromise the future success of an apartment investment. Things that can compromise the future success of a property include; over paying for the property, obtaining risky and too much financing, over extending ones financial resources, poor planning, under estimating capital improvement necessities, and lack of adequate reserves.
Lack of Local Market Knowledge
There is no national real estate market, but only local real estate markets within the national market. Each local area has different economies, laws, industries, and demographics from other areas making each local market unique. Thus, understanding the dynamics in a local market is important to the success of an apartment investment. Unfortunately, many investors that purchase out-of-state real estate without local knowledge find themselves with many unexpected problems. As Gomer Pyle was known for saying in his TV show, "Surprise! Surprise! Surprise!"
Poor Market Timing
A big mistake many rental owners make is buying investment properties when real estate pricing has reached unrealistic levels. Investors become over enthusiastic and optimistic when purchasing rental investments and believe real estate pricing will never go down. Many rental properties are purchased on the speculation that rents and prices will be much higher in the future. This psychology comes from the herd mentality, which usually leads to cash strapped rental properties when buying with the herd.
You should buy rental properties in supplied strained markets where demand is outpacing the supply so that you have optimum market timing. Don't run with the herd of investors where emotion and over enthusiasm lead to high real estate prices. Become an independent thinker doing your own research making your own decisions.
Research the local market that you decide has good market timing opportunities. Hire the best local guides to give you advice and direction on the best locations to purchase rental property. Understand the local market dynamics, economy, demographics, population, job market, industries and legal system. And, don't be rushed as you learn the local market. If you decide to purchase outside your local area, then hook-up with a local partner that knows the area to help reduce possible risks and surprises.
Look at many properties for sale before deciding on a property to buy. The more properties you look at, the better understanding of the real estate values in the market you will have. Make sure you find a good deal by; finding a property you can add value to; crunching all the numbers using a realistic financial model; executing full due diligence on the property and local trade area; purchasing with enough equity in the deal so that your debt burden is not too risky; creating a viable business plan with investment goals; having a comfortable cash reserve fund; and hiring a top notch local management team.
You need to put enough equity into the purchase so you don't put too much pressure on the property to cash flow. If you don't have the equity, find a partner that does. Usually 20% or more cash down payment will allow for the property to cover all the monthly bills including cash reserves and a very small net positive cash flow. Put together a financial model that includes your realistic breakeven point to give you a good indication of the amount of equity you'll safely need. The only rare occasion that it makes sense to put less than 20% cash down is when you are purchasing a property substantially under value where extensive renovations may be necessary.
Create a business plan that realistically forecasts the goals and objectives of the investment property. Make sure this plan outlines what you are investing in and why. This detailed plan will help you stay focused and eliminate many surprises.
Finally, hire a top-notch local property management company. Make sure the property management company is one of the best at managing your type of property, and has proven results doing so. Get many references before hiring a management company. Go walk and shop many of their current properties under management to get a feel for the quality of the management company. You could have a great property with a good business plan, but if you have a poor management company your investment will be doomed.
Over a period of many years, real estate experiences periods of excess demand ("hot" markets or seller's markets), and invariably is followed by periods of excess supply or lower demand ("slow" markets or buyer's markets). These swings define a market real estate cycle. If new supply of space could be produced or withdrawn instantaneously, the market would always be in equilibrium, which would basically eliminate real estate cycles. But in reality, a considerable lag exists between the time demands for more housing or office space is identified and the time new space becomes available. This lag is a major part of what creates cycles.
Consider what happens when a local industry expands. Population grows as people are attracted to the area from other parts of the country. As local companies expand, they need more office or industrial space to grow their companies. Demand increases for real estate, disrupting the balance of supply and demand. It takes time for developers to recognize and respond to the increased real estate demand, and even more time to plan, finance, approve and complete new real estate projects such as office buildings, industrial building, retail centers, apartment communities, and/or houses. This is the "expansion phase" of the cycle.
Building too many new projects eventually catches up with and then surpasses the demand for these projects. Psychology plays a role in this over-correction because market expansions typically reward risk takers, increasing the developer's tendencies to overestimate potential demand. This "contraction" phase brings the market back toward equilibrium. If new supply continues to come into the market after demand has begun to diminish, the cycle may enter a down or recession phase, driving down occupancy along with rental rates.
Why the Herd Mentality leads to Over-Enthusiasm
Over-enthusiasm and emotional thinking leads a herd of investors to poor market timing where real estate pricing is very high causing many of the six costly mistakes mentioned herein. A herd of investors become followers that listen and do what everyone else is doing without independently thinking for themselves. The herd mentality is comprised of many noticeable traits.
Following an extended period of strong expansion and prosperity, the "herd" adopts the psychology of affluence and its byproduct, economic optimism, wherein they enjoy life, have fun, and become economic risk takers. The "herd" mentality of optimism, once set off, takes on a life of its own and continues until the "herd" becomes excessively optimistic.
They rationalize that what has happened will continue to happen, and thus come to see less risk than actually exists. Consequently, the "herd" becomes risk takers, which in turn creates the conditions for a big bust. This bust, or recession, then sets off a psychology of pessimism, which continues until the "herd" sees more risk than really exists. At that point, the "herd" becomes risk averters, and lays the foundation for a long period of economic expansion. (Stoken, 1993)
If investors consistently buy into fear and sell into euphoria or greed, they'll make money. It sounds easy, but in practice investors seldom do it. When everyone thinks that rents, occupancies and/or prices are going to crash, we tend to be afraid. When everyone is thrilled with the market, the excitement tends to rub off on us. Most of us don't like to stand-alone, clinging to an opinion that nearly everyone else seems to disagree with.
When people get caught-up in a crowd, they stop thinking rationally and allow themselves to be governed almost entirely by emotions. This state of mind prevails at nearly all important market tops and bottoms. Almost everyone is convinced that the market will keep going up, or down with no end in sight.
Unfortunately, the market never accommodates a crowd for long. It can't. If the market did what virtually everyone expected it to do, making money would be easy. As a bruised and scarred veteran of the "battle for investment survival" will tell you, life doesn't work quite that way. In fact, it's logically impossible for the market to follow the path that an overwhelming majority of investors believe it will take. A contrarian investor looks for important market reversals when the overwhelming majority of investors expect the prevailing trend to continue.
Real Estate Market Timing
Timing is extremely critical when buying real estate. As Roger W. Barson said, "In selecting the soundest financial investments, the question of when to buy is far more important than what to buy." The principal rule "buy low sell high" applies to real estate as it does to any type of investment. The best time to make a future profit is when the real estate is acquired. The ability to recognize real estate cycles gives an investor the added edge to make informed investment decisions on timing.
In the mid-70's during a very uncertain and difficult time in New York's history, rents and occupancy tumbled in the office market to the point the market reached bottom in late 1976. Many developers and owners of properties were washed out of the business, where new construction came to a standstill. Olympia and York an aggressive and successful real estate company from Canada saw this as an opportunity. They purchased several office buildings during the beginning of the Absorption Cycle from a large New York real estate developer for $320 million with a $50 million down payment. Many people in the real estate business thought they were crazy, as the market had been filled with a lot of pessimism.
Olympia and York was an independent thinker with a good understanding of the real estate market supply and demand conditions as well as seeing the beginning of the Absorption Cycle. They accurately realized the market had bottomed in 1976 because new construction had been greatly reduced; job growth had begun to strengthen as the economy expanded out from a recession, and pessimism was at an all time high.
In less than five years, the Olympia and York purchase had appreciated in value to more than $2 billion. Buildings that had been purchased for $75 or less per square foot, where in some cases, renting for more than $75 per square foot per year. By having the foresight and courage to buy during the Absorption Cycle at the seemingly most pessimistic time in a tough real estate market, Olympia and York increased their significant holdings into a vast fortune with one acquisition. Timing!
3 Most Important Things in Real Estate
Remember the universal real estate credo, "What are the three most important things in real estate? Location, location, location." Well, in my humble opinion, the three most important things in real estate are Timing, Timing, Timing! There have been investors that have had huge real estate portfolios reduced to almost nothing, and there have been investors that came from nothing that have built huge real estate portfoliosâ€¦Timing! What happened to many of the real estate developers and big institutional investors in the mid-to-late 80's? Well, we'll need to ask the government created organization called the RTC that liquidated many trouble assetsâ€¦Timing! What happened to all the entrepreneurial investors that invested in Southern California in the early 80's or in Phoenix in the early 90's when those real estate markets looked very dismal? Well, they made anywhere from 5 to 8 times their leveraged money in about five years. Timing! Here's something to think about. When are bad loans made, in good times or bad times? Timing!
Market Timing can Affect an Investments Success
Real estate cycles have a significant impact on the financial success and failures of real estate investments because of their pervasive dynamic impacts on real estate returns, risks and investment values. Because of this recognition, investors need to place increased emphasis on the identification, analysis and decision-making implications of real estate cycles.
It should be recognized that over a complete real estate cycle, most average investors guess wrong a large percentage of time because they "gallop with the herd" and follow conventional crowd wisdom. In contrast, successful investors that consistently outperform the market average are willing to follow a path contrary to that of the masses. Thus, good timing and a degree of contrarianism are key ingredients to successful investing that achieve above-market returns over a long period of time.
Investments must be bought and sold before cyclical trends are fully reflected in real estate prices and activity. An investor must be an independent thinker forecasting cycles and acting ahead of popular opinionâ€¦buying when popular opinion is still negative and most investors are trying to sell; and selling when popular opinion says the boom is on and speculative investor buying causes asset prices to increase beyond economic reason.
By Craig Haskell, Founder of Haskell Value Real Estate Investor and author of, "The Inside Game To Real Estate Value Investing" available for a limited time for free at http://www.TheInsideGameBook.com.