Why Are So Many Real Estate Investors Going Bankrupt?

They started investing in real estate 30 years ago... with so much hope for their future.

A rental house here, a duplex there... and soon they had a rental portfolio anyone would be proud of. They actively managed their properties and worked to make sure they were operating at peak efficiency. Several years ago both the husband and wife retired from their day jobs and eased into retirement – funded by their rental income and social security.

This year they are filing bankruptcy and losing a majority of their properties to foreclosure.

This is not some made-up example... this is the story of one of my best friend's parents, and they are not alone. In fact, 95% of the properties I've purchased have been foreclosures purchased from landlords who have failed and lost their properties in a foreclosure. Most of them, I would guess, will never again get into real estate investing. They worked hard for years to build a financial future for themselves, only to see it come tragically crashing down around them – dashing any hopes for lasting wealth creation.

This begs the question: why?

If real estate is as good of an investment as we all (on BiggerPockets) make it out to be... why do so many real estate investors fail?

Perhaps more importantly: how do I avoid this possibility in my own life?

This is the question that has been swimming around my mind for some time now. Each week on theBiggerPockets Podcast I ask our guest "what is it that sets apart successful investors from those who fail?" I'm intrigued by this idea and scared that I may end up the same way. After all, as Mark Cuban famously said "everyone is a genius in a bull market." Is that what real estate is? Do some people simply get lucky, and others not so? What are some of the trends that lead to this failure... and what are some trends that can minimize this risk?

I thought I'd take the opportunity to hammer out my thoughts here and get your feedback as well. Definitely jump into the comments below and let's talk.

Too Much Risk?

Let's talk about the elephant in the room first: risk.

Risk in inherent in every investment there is. After all, you know the phrase, "more risk, more reward."

However, there is obviously a tipping point where the risk becomes too great, as my friend's parents discovered. Perhaps it's over-leveraging properties by obtaining too many "low down" deals or maybe it's trying to buy too many, too fast. Maybe it's constantly refinancing the properties, pulling out all equity and investing it in more and more deals. Whatever the reason for their bankruptcy, it's clear that the risk became too great and they lost.

As rock 'n roller Nick Cave sang, "if you're gonna dine with them cannibals; Sooner or later, darling, you're gonna get eaten . . ."

So how should someone prevent this? Avoid risk altogether? Only invest in 100% safe deals?

Of course not. Risk is required for entrepreneurs, but learning to navigate that risk will define your success.

Like a team of white-water rafters braving the wild waves, you can't always see what the future will hold, where the rocks hide just below the surface, or where the next waterfall will be. However, by having the right people in the boat with you, keeping an eye out for potential dangers, working to avoid the problem areas, and wearing the proper life-saving jacket, you can avoid a premature death.

I would caution anyone reading this post, including myself, to think of risk as a dangerous, but powerful tool. Never forget that this tool cuts both ways.

Not Enough Education
Far too many people jump into buying real estate before understanding what they are doing. They simply decide that real estate is the right path, and they start buying properties. There is a big difference between being busy and being effective, and this is the case with a lot of real estate investors; they believe that because they are buying properties they are going to succeed. Never mind the fact that they bought the wrong property in the wrong area with the wrong financing.

The solution to this problem is proper education.

I'm not talking about the "Get Rich Quick" late-night TV kind of education. I'm talking about taking the time needed to build an educational foundation that can support your investing future. At BiggerPockets, our mission is to help you build this foundation through a variety of methods, like the Forums, the Podcast, the Blog, and more.

Furthermore, I encourage you to continue your education through books, meetups, and other low-cost sources. You don't need to spend tens of thousands of dollars to gain an education. Information has been democratized, so you simply need to reach out and grab it. No one can do it for you!

Not Enough Analysis?
When I first began investing in real estate I thought I knew what I was doing... but I made some big mistakes because I didn't do a careful enough analysis. Had I continued on that path, I would have been in the same boat my friend's parents are in.

You see, so many people buy properties without doing the right math. As I often say, "without the right math going into an investment, you'll never get the right profit coming out of it."

The future is impossible to know, but with a solid analysis – it's much easier to predict. It's for this reason that I began to invest a lot of time and effort into building an in-depth spreadsheet that I could run all my potential deals through. Soon after, we took that spreadsheet, added a ton of new features, cleaned it up, and turned it into the BiggerPockets Property Analysis Calculators that hundreds of people are using every week to analyze their potential deals. It's my hope that this tool will save tens of thousands of investors from making the same mistakes that millions of others have made.

No matter how you do your math, just make sure you are doing it – and doing it right.

Are You Working ON Your Business or IN Your Business?
Is real estate your investment or your hobby?

I believe one of the greatest reasons investors fail is because they don't treat their business like a business.

They never develop systems to help them as they grow.
They treat their tenants like friends.
They don't create clear policies for finding good tenants.
They simply approach their investing like a church picnic, and it shows.

If you want to avoid failing, treat your business the same way a CEO would look at a business, because that is what it is. Monitor your business' health, hire the right people to do the right jobs, and continually find ways to improve your bottom line and create a longer-lasting business.

Let's Sum Up
There are a variety of reasons that a real estate investor may fail. However, in my limited time on this planet, I've seen the above four mistakes played out time and time again in the lives of those who have failed in their investments. It breaks my heart to see someone so excited for what real estate could do – only to lose it all in a foreclosure or bankruptcy.

Don't be that person.

If you want to avoid losing all the hard work you are putting in (or the hard work you are about to,) pay attention to the four points in this article:

Understand that risk is a powerful but dangerous tool, so tread cautiously.
Build a solid educational foundation for yourself before getting in too deep.
Don't skimp on the math. Always understand the numbers for any property you buy.
Work ON your business, not in it. Treat your investments like the business that it is.

The article Why Are So Many Real Estate Investors Going Bankrupt? originally appeared on The Bigger Pockets and is Copyright 2014 BiggerPockets, Inc.

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Read/Post Comments (8) | Recommend This Article (20)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 19, 2014, at 5:21 PM, Vitabrits wrote:

    A long article that says a whole lot of nothing.

    The main reason "property investors" fail is that they are not handymen. When a tenant calls about a leak, a light fixture not working or a heating issue, do they know how to fix it or are they paying someone else to do the work? When you're paying someone else, that's money leaving your pocket and that fund for "maintenance" grows quite large.

  • Report this Comment On July 19, 2014, at 7:59 PM, duuude1 wrote:

    Vitabrits, duuude - it's more like *you* learned a whole lotta nothing!

    You say "The main reason "property investors" fail is..."

    Can I ask how you know this? Where is your data? How many failed property investors have you spoken with?

    Are you saying that property investment is as simple as doing the handyman work yourself - and voila - you are the next Donald Trump? Does The Donald snake his own drains - is that why he's "successful"?

    Education, analysis, a business mentality, and risk awareness are all useless in managing properties? A good wrench-hand is everything? Really?

    Duuude1

  • Report this Comment On July 19, 2014, at 11:05 PM, aliikane1000 wrote:

    I think over leveraging to point where it is difficult to maintain control. Some people were buying lots of real estate on minimum down and speculating on the appreciation. Then if unable to sell or rent they put themselves in very vulnerable position. Also, buying in areas not in solid markets. Real estate is long term investment and very few markets can you turn over fast for quick profits and speculate over short term.

  • Report this Comment On July 19, 2014, at 11:40 PM, altoonafish wrote:

    I own two properties and an about to buy a third. I am 40, and my goal is to own, in full, 7-8 properties when I retire in 20 years.

    My first house, I've owned for 10 years, and will own the deed in another ten. My second house, I own outright, it cash flows over 1k. It provides security for the other investments. The whole first year I've sunk all of the rent into repairs and upgrades.

    That said, when I buy this third house, I will consider myself an investor. I do a lot of analysis on the properties I conside r.I pass on most that come my way. I have enough data and experience now to know that the returns will be less than I thought the first 2-3 years.

    What I've learned is that it takes 2-3 years to get a property in shape, and feel comfortable. There will always be little things, and things you will have to decide on...

    My advice would be take a few years to buy your second property. You have to go through a few cycles. I got hammered this year on utility costs. It killed my ROI. I have separate meters, but I inherited my tenants. For my next property, I am looking for a property that, if rented, has the tenants pay...even if rent is considerably lower.

    In first house, it ran smoothly for years, but I've had to evict 2 tenants recently. That's expensive, but I leaned on the other property to cover lost rent. I was able to weather that storm.

    My vision is to purchase more houses, but not purchase the next property until the previous one has stable tenants, fixed deferred maintenance (from the prior owner), and have banked a little bit of reserve cash for the evictions (loss of rent), capital improvements, changes in tax assessments, etc.

  • Report this Comment On July 19, 2014, at 11:50 PM, notyouagain wrote:

    What? Robert Allen (No Money Down) and Albert Lowry (How You Can Become Financially Independent By Investing In Real Estate) were wrong?

    Yeah, in the eighties I had quite a collection of books on real estate investing. Then after I knew some people that actually were successful landlords I realized it would never work for me for a variety of reasons. I didn't believe in trying to 'flip' properties because I wasn't 'handy.'

    And I figured with my luck, as a landlord I'd wind up with all the belligerent drunks that were 6 1/2 feet tall, towered over me and refused to pay their rent, it would take 6 months to evict them, and tear the place up in the meantime.

    I threw the real estate books away. I still don't believe in 'flipping' properties, constantly having to hunt for the next 'bargain' so I don't do it with stocks either.

    As a long-term dividend investor nobody threatens to fight me, and I get my rent when I'm supposed to, and concentrate on being 'handy' reading and evaluating financial statements to assess the safety of the dividend.

    I think for most of us, it's the best way to build a passive income.

  • Report this Comment On July 19, 2014, at 11:54 PM, millewk wrote:

    I've been in the rental real estate business for 35 years. We currently have 6 mixed use properties which contain 41 units. There is a simple reason some landlords go under and it because they take too much leverage. I have bought properties at foreclosure and seen first hand that owners don't do their due diligence regarding the market and realistic income and expenses. They think rental properties are a path to instant wealth. Well folks they aren't. Each property purchased should have sufficient equity, positive cash flow and cash reserves before one should even consider borrowing against it to purchase another property. But sadly, they are to quick to live in the now. It's a financial American failing. If you think you can buy an investment property and then flip it for a quick property you live in LALA land. Rental properties are a long term investment. Slow and stead wins the race. Of course it doesn't make for great cocktail conversation but it can and will secure your future is you have realistic expectations and are patient.

  • Report this Comment On July 21, 2014, at 10:51 PM, grosvenorgroup wrote:

    Some of these comments are on track but all seem to be avoiding the math. Here's our math: between 2008 and 2012 we bought 16 single family homes in a single county in Florida. Never mind why we chose SFH properties, what we did to them or where they were located - it's all very important but this isn't an essay about every aspect of our rental business. It's focus is the math. We paid cash for every property until we ran out of cash which we were willing to invest in this portion of our "pension" income. The math is almost identical on every property: the gross profit is 71.2% - that's the percentage of total gross rent left after deducting the property taxes, a 10% property management fee (which we pay our manager who is VERY handy and takes care of any minor repairs) property insurance and business liability insurance from the rent. But although that sounds like an impressive gross profit, it's only equivalent to an ROI of 11.55% on the original investment (which included the costs of restorations we decided to do for each property). So on a property costing $100,000 including restoration (if any), our gross ROI each year amounts to $11,550. We allocate 2% towards repairs and maintenance, and even if we don't use it in any given year, we put it aside in the knowledge that it WILL get spent at some point. That leaves $9,550. We have a few small overheads such as bookkeeping, annual accounts, phone, some auto expenses, licenses, office supplies, etc. Those add up to about $675 per property, leaving $8,875. Then we allow for 1 month of no rent - that's another $900, leaving $7,975. So now we're down to a net profit of 7.975%. We don't have any money costs, but if we did (say against 70% of the investment total, namely a mortgage of $70,000), that would add $3,850 to expenses at 5.5% - not including any closing costs and points when you first take out the mortgage, and not including capital paydown - only interest. Now how does all this look - your net net income on this property is $4,125, or 4.125% ROI. And the risks of weather damage insurance deductibles, major repairs (roof, major plumbing, a/c and heat, major electrical) could gobble up some or all of what's left, and you have to come up with that money yourself out of savings, or you may have to borrow it (more borrowing costs). These are not worst-case-scenario calculations - these are real, best-case-scenario calculations. Our average rent-per-property may not seem high at $900, but if your area demands an investment of $200,000 for a monthly rent of $1,800, most of the expense ratios will stay very close to the same. So if you think the rental business looks good because you just treat an annual rent of $10,800 ($900 x 12) as your 10.8% ROI, you're in for a painful shock. It works for us because a) we have no money costs at all, b) we have learned how to minimize our bad-tenant risks to as low as they can be, c) we have carefully chosen a specific formula for the types of homes we buy and d) we have carefully chosen a specific formula for how to prepare and present each property to the prospective tenant. AND, very importantly, we won't rent to anyone without a MINIMUM upfront of first, security AND last. If you don't have 2 months rent as well as the security deposit, you might as well assume your tenant will use the security deposit as last month's rent. That leaves you with nothing to recover for damages over and above reasonable wear and tear. And since it takes about 3-4 weeks to process a super-smooth eviction, that's more money gone. Some of our tenants are asked to pay 3 months rent + security deposit and if they can't come up with it all, we would rather leave the home vacant and keep looking than take the wrong tenant. It can be very tempting to inexperienced landlords to grab the first OK-looking applicant who offers up the cash. There it is. Do you think a $4,125 surplus is enough to justify buying a $100,000 rental home with $70,000 in borrowings? If you think that's a risk worth taking, you'd better hope that the capital value growth and a strong selling market will enable you to get out quickly if renting homes turns out to be too rich for your blood.

  • Report this Comment On July 23, 2014, at 5:42 PM, notyouagain wrote:

    See? So much... much, much, much easier to read and study to learn how to evaluate the safety of a dividend. Most of us just wouldn't be any good at the landlord thing.

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