Butt-Bites from Things You Don’t Know You Don’t Know:

The Power of Questions

If you are thinking about investing in real estate, you probably have done some research and learned about the basics of the business.

You may have heard about the benefits of passive income, leverage, appreciation, tax advantages, and diversification. You may have also learned about the different types of properties, such as single-family homes, multifamily units, commercial buildings, and vacation rentals. You may have even found some potential deals and analyzed them using tools like the 1% rule, the cap rate, the cash-on-cash return, and the internal rate of return.

But do you know what you don’t know?

That creates a bad situation in the mid-term as you can’t ask questions you should have asked. If you don’t know that they are the questions that can massively impact your overall goal for investing in the first place.

As a real estate investor, you will face many challenges and risks that are not obvious or easy to anticipate. These are the things that you don’t know you don’t know, and they can make or break your success. In this article, I will share with you some of these hidden pitfalls and how to avoid them or mitigate their impact.

One of the most common mistakes that novice investors make is to underestimate the true cost of owning and maintaining a property. This is especially true if you are buying a property that has been recently renovated by a turnkey company. A turnkey company is a business that buys distressed properties, fixes them up, rents them out, and sells them to investors who want a ready-made income stream. While this may sound like a convenient and hassle-free way to invest in real estate, there are some drawbacks that you need to be aware of.

One of these drawbacks is that you may not know the age and condition of every system in the property, such as the water heater, the windows, the air conditioning, the kitchen appliances, the faucets, and so on. These systems may look new and shiny on the surface, but they may be old and worn out underneath.

Frequently turnkey providers, who should be seen as experts and renovate and or manage hundreds of properties, decide how “deep” the renovation should go.

They use terms like “Premium”, “Gold Category”, and “Top Level”. For each of these terms they claim that they have, based on their experience, thoroughly explored and investigated the property they bought to renovate. Based on that investigation they determined all the things that need renewal and put them in a document called SOW (statement of Work).

The turnkey provider is balancing the cost of renovating pretty much everything that would create a substantial cost for the new owner (often also called CAPEX items), and the sales price they can achieve when selling to investors. Obviously, investors, especially those who finance the deal will not pay more than the appraised value of the property. That can lead to compromises in what does and does not get renovated.

If any of these systems break down or malfunction after you buy the property, you will have to pay for their repair or replacement out of your own pocket. This can significantly reduce your cash flow and your return on investment.

A recent example of one of my properties illustrates this issue. I bought a property 4 years ago. It generates about $300 net cash flow each month for a total of $3600/year. Last month I was notified by my turnkey company that both the water heater and the air conditioning will have to be replaced. The total cost will be about $10000. The water heater was 4 years old when I bought the property, and the A/C was about 6 years.

I assumed that the expert opinion applied during the property investigation indicated that both these systems would still be good to go for many years to come.

In the 4 years of ownership, I had made about $14500 in net cash flow and now I am losing $10000 of it for CAPEX repairs. That means I only made about $93/month in net cash flow.

To avoid this problem, you need to do your due diligence before buying any property from a turnkey company. You need to ask for detailed information about the age and condition of every system in the property and verify it with receipts, invoices, warranties, or inspection reports.

You also need to hire your own independent inspector to check the property thoroughly and identify any potential issues or defects. If you find any problems, you can either negotiate a lower price with the seller or walk away from the deal.

Another thing that you don’t know you don’t know is how to manage your property effectively and efficiently. Many investors assume that they can just hire a property manager to take care of everything for them, such as finding tenants, collecting rent, handling maintenance requests, dealing with evictions, and so on. While this may be true in some cases, it is not always the best option for every investor.

In our model where we look for turnkey providers that find a property, renovate it, and then manage it for us, we hope to have an advantage. I have always assumed that knowing that the same company will have to manage the property they just renovated would be a good way to mitigate some of the issues. Obviously in my example above I still make a little money, but the turnkey provider did not replace the systems during the renovation.

What is often forgotten, and I believe not even considered by turnkey providers or regular seller is:

When we add $10000 or even $15000 to the sales price, assuming the property will still be appraised, we will get 80% of that money from the bank and it will be paid back over 30 years by the tenant’s rent payments.

In comparison, when the investor must cover the repairs out of pocket for 100% of the price, the investor cannot really use the cash flow for new investments (even with the same turnover provider) or consumption.

Trunkey companies and property managers are not created equal. Some are professional and reliable, while others are incompetent and dishonest. Some charge reasonable fees for their services, while others charge exorbitant fees or hidden costs. Some communicate well with their clients and tenants, while others are unresponsive and rude. Some follow the laws and regulations regarding landlord-tenant relations, while others violate them or ignore them.

To avoid hiring a bad property manager, you need to do your homework before signing any contract.

You also need to monitor their work regularly and hold them accountable for their results.

For me, one of the worst situations still to this day is the fact that many turnkey providers have renovation teams (sometimes outsourced to contractors) and staff to manage tenants and internal operations, but do not grow properly.

As a company starts adding all the new departments and people is a big expense and covering it out of operation is hard. That’s a good reason to work primarily with vendors for repairs that are in town. The electrician, plumber, Painter, etc. do work on issues an investment property has and the investor must pay for it. All the turnkey company or property manager do is account properly for these expenses.

As the company grows, which is an indication of success, they should develop their own teams. I have always said that a good size or large turnkey company should have a full team of employees with handyman skills covering many skills. I advocate charging the investors 10% management fees than 8% but having an internal team for all repairs.

Nothing is more frustrating than paying a $100 fee again and again for each repair just so a company sends an expert to evaluate the issue and repair it.

But what are some other hidden pitfalls that you don’t know you don’t know?

One of them is the legal aspect of real estate investing.

As a real estate investor, you need to comply with various laws and regulations that govern your property, your tenants, your taxes, and your business. These laws and regulations may vary depending on your location, your property type, your tenant profile, and your business structure.

If you fail to comply with these laws and regulations, you may face lawsuits, fines, penalties, or even criminal charges.

To avoid legal troubles, you need to educate yourself on the relevant laws and regulations that apply to your situation. You need to consult with a qualified attorney who specializes in real estate law and who can advise you on how to protect yourself and your assets.

You also need to keep yourself updated on any changes or updates in the laws and regulations and adjust your strategies accordingly.

Another hidden pitfall that you don’t know you don’t know is the market risk of real estate investing. As a real estate investor, you are exposed to the fluctuations and cycles of the real estate market, which are influenced by various factors, such as supply and demand, interest rates, inflation, employment, population growth, consumer confidence, and so on.

These factors can affect the value of your property, the rent you can charge, the vacancy rate you can expect, and the demand for your property type and location. To avoid losing money due to market risk, you need to do your market research before buying any property.

These are just some of the things that you don’t know you don’t know as a real estate investor. There are many more that you will discover as you gain more experience and knowledge in the field. The key is to always be curious, open-minded, and willing to learn from others who have been there and done that.

By doing so, you will be able to avoid or overcome these hidden pitfalls and achieve your goals as a successful real estate investor. As you can tell, it’s a continuous learning approach that will reduce negative experiences. On the other hand, I have learned the most from negative experiences. That’s why I love mentoring so much. That way, only one individual has to have the experience and the people getting mentored can avoid them.