The Number One Mistake Real Estate Beginners Make When Searching for Real Estate Properties

There are a lot of mistakes that real estate beginners make. And these can cost you lots of time and money! Listen to this episode to learn the number one mistake that all newbies should avoid at all costs. It's not difficult to understand if you know about it!

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The Number One Mistake Real Estate Beginners Make When Searching For Real Estate Properties

At some point, there's always this balancing game between finding deals and raising capital to fund the deals. There’s always this imbalance. They have too much capital, not enough deals or great deals, but you need to find the capital. Speaking as a family office investor, where I've invested in countless projects, I am countless fund managers all across all asset classes, not just real estate but private equity, venture capital stocks, you name it.

The advice I would give, especially with regards to specializing, is you want to see that the person you are investing in knows that trade and can offer you something as an investor you can't get elsewhere. If I want to invest in multifamily across the US and am more likely to put it into a Blackstone or another big fund, whereas if I want to exposure to the ZIP code, buy your thesis and you have experience, and you can offer me something that no one else can, then that's compelling.

There are plenty of areas where the largest Asian investors will fail. One of those might be in the deal sizes, which we will talk about in a moment, especially that $10 million to $30 million purchase price range for something I've got a lot of experience with too, because I've done a lot of deals in that transaction size myself, or it may be that this person understands this particular newest asset class. I want exposure to that because I can't get it elsewhere. That's the advice to someone trying to break in, have a strategy, and don't play monopoly with the mindset of, “I'm going to buy everything I land on.” You've got to run out of money eventually. Have a strategy in mind and stick to that.

Buy those train stations, if that's what the goal is, and focus on cashflow. Go after the big one hits. You guys call it Boardwalk. In the UK, we call it Mayfair, the blue side of the monopoly. Let's talk a bit about, as people start to break into real estate, one common way they do it is they start buying single-family residential. That's the most typical way, most people break into real estate. They find a ZIP code and study that ZIP code for at least 30 days, whether it looks at every transaction that's going on, whether they have a broker's license or however they do it. They buy single-family rentals because the purchase price is low enough. They can get some type of good financing and do that a couple of times.

Eventually, you realize, “It's not so easy anymore to get access to loans.” People then try to branch out and are going to duplexes and triplexes. Multifamily feels like a completely different world because with residential, you might fix it, flip it, and you might sell it to someone who emotionally wants to live there, whereas now you're dealing with multifamily or with potential institutional investors. It seems like a jump that's impossible to make unless you have access to a lot of capital. Talk to the reader who wants to go down this path or is already down the path of owning a single-family and wants to graduate? What's your take on how to do that? Is it worth graduating even?

Something you alluded to that is very true is the fact that a lot of these people are looking for, “What's the secret sauce? How do I get an edge in single-family?” While it is the largest asset class in real estate or one of the overwhelming majority in single-family are owner-occupants. On one side, you have the pool from Wall Street of, “We allocated $5 billion to buy X thousand many homes across the United States.” The problem there is that home ownership in the United States, for the overwhelming majority of America, is the largest investment somebody is ever going to make, and they live in it.

You are competing with two buyers. You have the owner occupant who is buying this home to live in, as you said, then you have the institutional buyers sprinkled in. The sprinkles on top are the person who is trying to graduate into a larger asset class, these mom-and-pop single-family rental investors. Single-family rental investing has a very intriguing look. It's a bright, shiny diamond. Once you dig in and get involved, a lot of these things become very overrated.

You start thinking, “Why did I do this? What possessed me to do this?”

Single family rental investing is like a shiny diamond. Once you dig in and get involved, it becomes very overrated.

You start thinking, “Hypothetically, if my tenant leaves, my occupancy is now at 0%, and I have a 100% vacant property where I'm still paying property tax, insurance, and everything else involved.” It's a very inefficient business unless you are doing it at scale. To do it at scale, you need the institutional capital that, frankly and unfortunately for the small guy, has a very low cost of capital. You and I will never go do a 2% cap rate single-family rental deal because we could take our money prior to now but put it in the tenure treasury, not do anything and make the same return.

People are now looking at this asset class as an alternative to bonds. That's how bad things have become, and it has become an asset class that's in vogue and it's hard for you as an individual to make money without the scale.

A lot of guys do find success as merchant builders, but now, you are in the development space. You can buy a large acreage of an assemblage of land and build 50 brand new spec homes but that's not the business of SFR. SFR is a very grass is greener in this type of business where a lot of people fall flat on their faces because they think it's as simple as buying an asset and, “What's my rent going to be?” To the people who are looking to graduate, a lot of these people learn from their mistakes. They are in their third home. They get it. In clipping $250 or $300 per unit, it's a good little piece of cashflow, but you are not going to scale.

If this is a full-time business, it's very hard to compete in that. People who are graduating into small multi frankly that are looking at it the right way, that's the first step because that's where most people start to look, and that's the right approach. I like small multi because a lot of institutions have yet to touch it and there are a variety of reasons.

By a large institution or capital allocator like Blackstone buying 1,000 homes, they can allocate a big piece of change by 1,000 homes. If 200 of them are not in the condition they assumed, they write that off. It's very efficient to have a square box with one tenant inside of it know that, “We are going to replace the mechanicals, the roof in the kitchen, and we have this little ox that pays us rent.”

Whereas with small multi, one unit could be way below market rent. They are losing a lot of money on it. One could be the original renovation from when this building was built. I don't think these institutions have the efficiency to go in and look at these deals on a unit-by-unit basis in a seven-unit building. That creates a very large opportunity for these single-family investors who are already used to wearing a million hats. When you migrate into that space, you cut out a lot of the institutional smaller side owners, such as yourself, who operate in the $10 million to $30 million space. For somebody like you, you found scale and efficiency. There's no interest for you to touch an eight-unit deal.

The single-family rental guy who is used to flipping homes or has found efficiency in SFR is probably not going to play in that sandbox because he found his stride. Given the overwhelming majority of people who don't get what they want out of SFR and try to migrate into small multi, it's the right approach. My advice for those people is to start with a duplex. If you've done 1 unit, I promise you can do 2, and it's not that different. As you understand what it is to have 2, then you go to 4. Anything under five units is a very similar financing structure to single-family residential and becomes hard to finance. Anything over five becomes commercialized.

There are all these FHA, Fannie and Freddie, and debt brokers that can help you find this good debt. That's very favorable and allows you to scale. Without getting way too ahead of myself and people who are getting started, find a duplex, triplex, and a quad that is relatively turnkey, in your backyard, and manageable. When I say manageable, I mean the tenants are in place. The property is not falling apart.

This is a buffer. I'm talking about the property manager who will pick up the phone calls about the broken toilet and the rent, and you will start to understand, “How does this thing generate cashflow? How do I make it more efficient? How do I cut my insurance costs? If I replace the $500 and paint the hallway, all of a sudden, the building becomes more appealing and now I raised 4 or 5 units of rent for $25 a month.”

When you put a cap rate on that, that's a very powerful tool where you don't get that in the single-family. The problem with single-family that a lot of people don't talk about is that when these buildings are appraised, you can make this house the nicest house you've ever seen in your life with the coolest kitchen and bathrooms. It doesn't matter because when the bank goes to appraise it, it's going to go based on what the building of the house sold next door for.

Whereas when you are dealing with anything, five units and up, these are buildings that get appraised on their income. If you find a building that's in disrepair, the owner was out of state, they haven't touched the rent there in 5 years, and 1 bedroom is rented for $1,000 in a market where it should be $500, now you raise them to $500.

It's a lot harder than I'm saying. It's not as easy as it sounds, but when you go, and you do what it takes to rent 4 units for $500, that's $2,000 per month in additional income. When you annualize that and put that on a cap rate, that's hundreds of thousands of dollars in value and positive equity that you are creating. That tool and leverage don’t occur in single-family.

That's the mindset shift that's required. You could become an expert on single-family. I don't discredit that approach. It's a wonderful approach. It's worked a lot for many people. It's a safe approach. In some ways, if you eventually stick at it, you are patient, and not trying to get rich quickly, you will build a good-size portfolio that produces cashflow, potentially selling it due to appreciation or to an institutional buyer.

When you come in and you think, “I should repaint the walls this color. I should put granite countertops. I should put the best stainless steel appliances and plywood flooring, do this, do that.” You are not going to get rewarded for that in the multifamily space unless you push rents up. You then become ruthless, and you have to focus on the game is different. The game isn't, “What do I think this market likes?”

The game is, “These are renters. Are they going to pay the premium when I spend X dollars improving things?” Improve rents by X. Increase your NOI. You've got tremendous leverage because everything trades on a cap rate, and you built a fantastic multiple on your equity. Different game. I want to know your opinion on this. This is why I think residential real estate agents struggle with understanding how commercial real estate is valued. You will think that, “Let me get the opinion of our residential real estate agent. They definitely know real estate.” No, it’s very different asset classes and entirely commercial. Do you have a perspective on that?

I'm biased toward small multi, and I'm not bashing any single-family renters at all because I have a lot of actual friends in my network and people that I know that I've built a tremendous business off of single-family renters. I applaud these people because I would never have the patience to do what they do but I'm biased because I like shortcuts.

If you're not getting compensated for the extra dollars you're putting into your job, then there is no sense in doing it.

The leverage and the power of a cap rate and different ways of appraising these things, to me, are more appealing. To answer your question, something that I've seen that is a fairly common trait, especially with residential realtors, is I saw the deal where somebody said it was a duplex and, “There's so much upside if you renovate this and that. You can bump rents X and increase the value of your property.”

If I were to call on that property and say, “Do you understand the fact that it doesn't matter if I put nicer countertops or rents? Sure. I will increase my rent, maybe but at the end of the day, if I buy this thing for $300,000 and spend $25,000 per unit, making each unit the nicest unit anyone has ever seen, the question is, ‘Will I recuperate that CapEx,’ and the answer 99% of the time in this asset class is absolutely not because unless your neighbor's duplex sold for the same thing, then you are sinking money into this property. You will raise your cashflow a little bit but what you did is you set the clock back ten years for your return because you spend money that you are not going to recuperate.”

There's a very easy approach to this, “What is the market rate rent? What does it cost me to get there based on finishes and CapEx? Can I refinance all of the money I put in plus more?” The answer to that, but most likely, yes, assuming you are not in an overheated market where now it's a little bit more challenging to do that.

Something that residential and resimercial realtors, and don't get me wrong, there's a lot of good ones out there, is that they are doing a disservice to investors and sellers because there is no one who can hold their hand through the space that we are trying to play in. The value that we are trying to bring as Yieldeasy and once we are live is somebody who is graduating from SFR. Maybe it's somebody who already owns 100 units scattered through ten different buildings.

We did a poll on LinkedIn. It was like, “What's the hardest part of small multifamily in this universe? We had the options there as managing, financing, agents, and then sourcing and acquiring.” The overwhelming majority of it was 70%, voted for sourcing and acquiring. A lot of the problem is a lot of these deals go on the same platforms, marketplaces, listings and MLS services as a single-family residential home does.

The people who are seeking these deals are not looking there. There's almost this bridge of like, “Here's where the deals are but here's what the people are searching,” and they are in two different universes. Residential realtors, while I applaud their effort, I am one and was one. I think that somebody does need to come in, own this space, have an understanding of underwriting and how returns work to make this market more efficient.

The only thing I would probably debate with you about would be that you've got to be careful on spending CapEx on either side, whether it's residential or multifamily. If you do it wrong, you can set the clock back significantly. If you don't invest in CapEx and you tried to be too cheap, you are also shooting yourself in the foot there too.

The biggest naive mistake you can make, especially when you are crossing from one side to the other, is you are not dealing with buyers as much anymore. You are dealing with renters, and your buyer might appreciate all the landscaping and everything you do in a residential. This is often the story in America, even around the world. Someone lives in a home, realtor comes in and says, “You should invest some money to do it up and sell it.”

It's a shame because you've lived in this home. You should have spent that money anyway to enjoy it. Now it's working. If you do enough of that, eventually, it's very easy to come into multifamily and think, “These problems are in total disrepair. Let me bring my magic that worked in residential real estate. We want to make this stunning class say.” If the market doesn't support it, bones or amenities are not there, you are throwing your money down the drain. I've done this personally when I started out. It's a painful lesson to learn. You can also check your returns back significantly in the other direction in multifamily.

One of my earlier mistakes was, I remember when I would go into renovating and to Home Depot, I would almost put aside the fact that this is a business and, “If I were to live here, what would I like?” These costs add up very quickly when you are talking about something as simple as $2 or $4 a square foot of flooring, “Maybe in my family home, I would like the luxury one and feel I can afford it to myself.” At the end of the day, this is a business. You are there to make money and provide a positive tenant experience. If you are not going to get compensated for the extra dollars you are putting in, then there is no sense in doing it. I agree with that.

Jeff, this has been a great fun conversation. If anyone wants to reach you, what are you looking for from any of our readers? How can they help you?

We are gearing up for the launch of our startup Yieldeasy. Anybody can find me on LinkedIn. It's @JeffGopshtein. They can check us out at www.Yieldeasy.com. It’s a landing page with a signup sheet. For early access, we are going to be up for our beta and will be on a full launch. My email is Jeff@Yieldeasy.com. Feel free to connect with me and ask me any questions about potential listings.

We are going to be live in Philly. If you are in the PA Philly area, we are looking to get into Boston and New York shortly thereafter. We would love to connect. We would love to have a conversation with any Angel and PropTech, people in the space. As much as Zain, I don't think anyone is going to come close to the value that Zain's added to me. Anyone in this space love to network with, get feedback, and poke holes through my business plan. If there's anything I can help with giving my experience, if there's someone I can connect you to or something like that, we'd love to do that as well.

We have all types of people on the show. We don't often bring people as early stage as you are but your wisdom is great. It reminded me of a funny anecdote when I started my company, I was on a couple of early podcasts. You were about to launch, 2 years later, the company became huge, and 3 or 4 years later, even bigger. It might be a nice relic to capture, to see as you are launching to New York, Boston, and throughout the US who can follow your success. Best of luck, and thank you for coming to the show.

Thank you, Zain. I will talk to you soon.

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About Zain Jaffer

Zain Jaffer is an accomplished executive, investor, and entrepreneur. He started his first company at the age of 14 and later moved to the US as an immigrant to found Vungle, after securing $25M from tech giants including Google & AOL in 2011. Vungle recently sold for $780m.
His achievements have garnered international recognition and acclaim; he is the recipient of prestigious awards such as “Forbes 30 Under 30”, “Inc. Magazine’s 35 Under 35,” and the “SF Business Times Tech & Innovation Award.” He is regularly featured in major business & tech publications such as The Wall Street Journal, VentureBeat, and TechCrunch