7 Problems That Trip Up Real Estate Investors -- And How To Avoid Them

Back in the late 1990s, little old ladies became stock-picking experts. The local mailman was just as comfortable recommending Lucent and AOL as he was talking about the weekend forecast.

That's one of the most basic principles of behavioral finance. Markets are moving into bubble territory when outsiders become experts. So last week when I heard the girl who cuts my hair say she was thinking about buying a rental property, it made me wonder: Is this a bearish signal or is she just a misplaced real-estate guru?

Seven years after prices collapsed, speculators are once again rushing back into housing. Stories of first-time buyers, all-cash deals and multiple offers are flooding the Street. That renewed interest in housing is being driven by a big rebound in prices, with the Case Schiller/S&P 500 Housing Index up 12% from last year. Southern California, Arizona and Las Vegas have seen even bigger gains, with some areas up more than 30% in just the last year.

After all, while the outlook for housing and the rental-property market remains bullish, buying and managing a rental property is far from easy money.

I've put together seven potential problems with investing in real estate -- problems that can be avoided. (I'll tell you more about that later.) Here are the trouble spots:

Higher Interest Rates

Securing a loan for a commercial property isn't just more difficult -- requiring a higher credit score and more collateral -- it's also more expensive. Banks will typically charge a premium interest rate when you purchase a rental property, since it carries a different risk profile than a regular residential mortgage. I went into more detail about rental-property mortgages last week with my article; 3 Troubling Truths You Haven't Been Told About Rental Property Mortgages

Taxes

Every business has a silent business partner. This partner will contribute no capital, no labor and no intellectual capital but will be rewarded with a big chunk of the profits. I'm talking about Uncle Sam. Rental property owners get hit with a brutal one-two tax punch: hefty annual property taxes as well as income taxes on any profit derived from the rental property. '

Maintenance

Houses and rental properties have to pass an inspection before being bought and sold. But in spite of that contingency, rental properties are exposed to all kinds of natural elements from Mother Nature, including hail, rain, lightning, wind and snow. And that's not including tenants, who present another layer of operational challenges. That presents big risks to owners, who can be exposed to big capital outlays for new windows, a new roof or even just simple weekly or monthly property maintenance.

Insurance

A rental property requires two forms of insurance. The first is actual homeowner insurance to limit the owner's exposure to property damage or destruction. The second is actual business insurance, because owning a rental property requires some sort of corporate entity in order to properly account for any income from the property. And in order to protect that business from any potential lawsuits related to the property or tenant claims, it will need to be properly insured.

Regulatory

The regulatory infrastructure is intense for rental properties. Landlords must abide by a long list of rules and standards in order to stay compliant with local regulations. That can frequently include establishing separate bank accounts for each tenant's deposit and providing documentation of interest earned on any deposits. Non-compliance opens up rental property owners to extra fines and penalties.

Transaction Fees

Compared to buying or selling stocks, buying a rental property is ridiculously expensive, frequently carrying fees that total 5% of the transaction value. That means investors will have to absorb big out-of-pocket expenses just to gain access to a rental property investment. It's another line item in a growing expense report on rental properties.

Leverage

It's very difficult to make a small investment in a rental property. That's because homes are expensive assets, with median home prices above $200,000. And with rental properties usually featuring multiple units and qualifying as commercial properties, values usually head north from there. That's no different than telling a stock investor they can only invest in Microsoft (Nasdaq: MSFT) with a minimum of $250,000 and that it will cost $15,000 to execute. But making matters worse, rental properties are usually bought with a mortgage, making a rental-property investment highly leveraged and exposing investors to huge losses on even a small decline in prices.

The Investing Answer: So what's the solution? For investors interested in cashing in on rental properties, there is a much easier path than buying actual rental properties. Publicly traded companies called REITs (real-estate investment trusts) continue to invest billions into the rebound in housing, and their shares are available to be traded by anyone with a regular brokerage account.

Not only are they less expensive to buy and sell and much more liquid than an actual rental property, these REIT’s frequently carry dividend yields above 5%, creating an outsized stream of income for investors looking to cash in on growing demand for rental properties.

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