We’ve all done it. Anyone who invests in real estate is bound to make a clunker deal sooner or later. I’ve been in this business for over 25 years and have made plenty of mistakes, and am always reminded that experience is what you get right after you needed it.
The popularity of commercial real estate has exploded in the last few years, and the media is full of war stories from new investors who find themselves in deals with problems.
In almost every case the cause is traceable to a lack of knowledge about a few simple precepts that form the ground rules of successful investments. These are the basic practices that when used correctly will eliminate the most common causes of a bad deal.
My top 5 list of rookie mistakes:
1. Ignoring local market conditions. There are two levels of due diligence required to evaluate a real estate investment: the market and the property. And of the two, local market conditions trump everything else. A great property in a bad market can be a big loser. A poor property in a great market can be a gold mine. How do you know the difference?
Every market is different, and a deal technique or property type that is profitable in one market it does not mean the same holds true anywhere else.
Analyzing the demographic trends of population growth, income and employment in the local market will tell you where opportunity lies, or not. It will also show which property types are in demand, or oversupply. Those conditions will make or break your investment.
Investing in an area with declining demographic trends is destined for trouble. So learn your market. Then listen as it tells you how, when and where to invest.
2. Inadequate property due diligence. The second level of due diligence is the property condition, including physical items such as building systems, environmental matters and structural components. Just as important are the intangible items, such as title, survey, and zoning and land-use regulations. Knowledge of contract law, insurance, finance, accounting, and tax law is also critical to doing things right at the beginning to insure success at the end.
If you’ve never done it before, this is not a DIY project. The money you think you’ll save by doing it yourself can cost twice as much to fix, and may jeopardize the entire investment. Red Adair, the famous oil and gas field firefighter, said, “If you think it’s expensive to hire a professional to do the job, wait until you hire an amateur.”
Admit what you don’t know. Approach the property like an open book test. If you don’t know the answer to a question, find an expert who does know to give it to you. Get accurate estimates from professionals of what it will cost to fix what is wrong. The time spent inspecting the components is minimal, and can save thousands of dollars in unexpected repairs.
3. Botching the math. This is not rocket science, but real estate is a numbers game. Value is dependent on net operating income—gross revenue minus operating expenses.
That’s why it is so important to get the real operating numbers, not a projection of potential gross income and estimated expenses. Confirm and verify every element of income and expense. Value the property based only on present income, not projected income you have to produce.
Your profit is dependent on net income. Net income is the net operating income minus debt service. If you’ve overestimated revenue, underestimated expense, or have too much debt service, your profit will suffer or turn into a loss.
Understand that risk increases with every assumption made. Do not assume you can save expenses by cutting corners, or can raise rents the day after you take possession. Anyone who has ever prepared a projection of operations has realized that by tweaking the assumptions the bottom line can be manipulated into whatever is needed to make the deal work.
The problem comes when its time to make the numbers happen. It’s real cash then—your cash—and when the rents don’t go up or the expenses don’t come down as much as the projection called for, you take the hit. You might tweak the numbers to make it work on paper, but paper won’t pay the bills, and hope is not a plan.
4. Over-leverage. Borrowing too much money in this business is fatal. Highly leveraged deals do happen, but unless it’s backed up by a solid plan with sufficient capital it can be disastrous. Using 100% financing for entry level deals is like believing gravity doesn’t exist as you jump off a building: you can argue all you want, but you’re going to hit the ground—the only question is how hard.
The proper use of leverage is a function of deal structure and investment strategy. Every investment property should be evaluated in light of the break-even ratio. The break-even ratio is equal to the Operating Expenses plus the Debt Service, divided by the Gross Potential Income. [(OpEx + DS)/ GPI = BE]. When break-even exceeds 80%, the structure depends on perfection, and that’s dangerous territory.
5. Failure to have an investment plan with multiple exit strategies. An investment plan incorporates all of the due diligence findings and outlines all the possible outcomes of the investment, best case to worst case.
Ask yourself why you think you can do a better job running this property than the seller did. If you can’t answer that with specifics, you won’t do better, and probably not as well.
Your plan should answer the questions of how the property will be managed, what improvements are needed and their cost, how much money might be made (or lost), how long it will take, how to get out if things go wrong, and how to access the profits when it goes right. The answers will reveal a realistic plan to maximize value in the shortest possible time, with the least possible downside.
I rarely have less than three exit strategies, and usually a half dozen or more. I’ve learned that if I don’t have a plan to get my money out of a deal, I will soon be out of money.
Learn from those who have paid the price
I just read an article on Wall Street Journal Online about a young Colorado investor who made almost every mistake mentioned above. In 2005 he paid $269,000 for a four-plex, used 100% financing, in a market dependent on the presence of military personnel in the middle of a war with extended deployments. He had no management experience and didn’t screen new tenants, who turned into evictions. He planned (hoped?) to hold the property for cash flow, but over-leverage and inexperience produced average cash flow of only $100 per month.
Now he wants to move to another city, and put the property on the market for $285,000. With no takers he’s reduced the price to $265,000, offering a 3% commission, but not using a listing broker because he thinks he can’t afford it. This is not an isolated case. The dangers of these errors are real, and painful, and none of us have the time or the money to learn all the lessons the hard way.
Roy H. Williams, aka the Wizard of Ads ® from Buda, Texas summed this up. He asks, “Are you smart or are you wise? A smart man makes a mistake, learns from it, and never makes that mistake again. But a wise man finds a smart man and learns from him how to avoid the mistake altogether.”