How NOT to Invest in Real Estate… A Case Study
Here lies Walter Fielding. He bought a house, and it killed him.
–The Money Pit
If at first you don’t succeed, try, try again. Then quit. There’s no point in being a damn fool about it.
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The saying is that it takes the successful entrepreneur three tries before he gets it right. The first two businesses fail, and then he figures it out, and goes on to success from there.
I am living proof that the number three is an average. I played on the high end of the curve before figuring things out. Were it not for me, the saying would be that the successful entrepreneur requires 2.9999999 tries before he gets it right.
I’ve had the real estate investing bug since the late 1990s, when I stumbled into a Russ Whitney seminar. No money down, slap on a coat of paint, flip that bad boy, and PROFIT! What could go wrong? Russ acted like he owned half of Florida, and, at that time, my Monkey Brain (what I call my limbic system) was strong. Tag team those two together, and they were off to the races with me being dragged in tow.
My real estate investing career started with Cavalier Properties. There was a guy who ran a coffee shop who said that heíd done construction in the past and could help with renovations if I could do the funding.
Yeah. Stop right there.
Lesson 1: Never Trust a Coffee Shop Barista who says He Does Construction on the Side.
We wound up doing a few small jobs, left one person in a lurch which required lots of yelling and screaming from me and darn near ruined a friendship, and ended up with me owning a rental property that somehow, miraculously, managed to make a profit when all was said and done.
Still, it was nowhere near the real estate empire I envisioned.
Actually, I did learn one key lesson from that little adventure.
Lesson 2: No Money Down Never Really Means No Money Down. You Have Expenses Which Get Paid from Somewhere.
In business school, I decided to take the leap again. I’d taken the real estate investing elective course, and, surprisingly enough, by then, I’d accumulated enough book smarts that I actually didn’t learn too much in the course which I’d not already found out through reading everything I could get my hands on at Barnes and Noble.
I had classmates who were interested in real estate and I was darn sure not going to get in a situation where we were cash poor and house rich. I’d been down that path already and wanted to make sure that we were properly funded.
So, I started asking around and found about 15 people who said they’d pony up $10k to go in and buy and renovate a house in a historic district in Richmond, Virginia. I spent many a weekend in Richmond scouting out houses, and we found one that we wanted to make an offer on. We could get the house, renovate it, and then sell it for a pretty nice profit.
Thus was born Monumental Restorations.
However, once it came time for people to actually pony up the money, there were a lot of cold feet. Suddenly, everyone had other ideas, except for two brave, intrepid souls who committed along with me. Our slashed budget meant that we couldn’t go for the nice house renovation route.
We decided instead to go to another historic district in Richmond. It was on the other side of the tracks. We got a nice house in a crappy neighborhood. It needed a lot of work. We hired a contractor to do the work.
The problem with the contractor that we hired was that he had grandiose ideas of creating a perfect masterpiece when all we needed was for him to get it up to a rentable condition so we could either flip it or rent it. It was in a historic district, so there were renovation tax credits available which could have significantly lowered our basis in the property.
Unfortunately, we were all in Charlottesville and he was in Richmond and we did not supervise him like we should. It took him seemingly forever to rehab the place and he ran WAY over budget.
We had created the nicest house in a bad neighborhood.
The good thing was that one of the people in on the deal was married to a Richmond policeman, so it did become a convenient headquarters for the cops to do their weekend stakeouts.
We decided to rent it out to Section 8 tenants. They were supposed to take reasonable care of the place because their Section 8 status depended on being good tenants.
We waited for a rental check.
It never came.
We decided to go in with the agent and check what was going on.
We found evidence of several people living there and bags of pot everywhere. My impression of Section 8 has never recovered from that scene. I’m sure there are great Section 8 renters and it’s a good program, but I saw zero evidence of it as those people trashed our property.
Thus, we had to invest a few thousand more to make it habitable again. This time, we decided to fire sale the house just to get out. I was tired of making the drive and having the drug dealers on our same street look at me and wonder if I was a narc. It was a good thing I drove a hoopty, because otherwise, they might not have been kind enough to let me drive through their drug deals unscathed. By the time we sold it, everyone had lost their initial investment and then a little more as we had to cover the mortgage payments once our initial money ran out.
0 for 2.
So far, I’d failed because of lack of capital and lack of supervision. Remember, all of this happened while I was either in between being in the Army and grad school or grad school, so I had very little income. Each time things didn’t work out, it was painful. You’d think my past performance would make me a little more risk averse in real estate investing.
Once I graduated from grad school, I started working at Capital One. Several people invested in real estate there, and since I finally had a good income to support myself, I started talking to people. Furthermore, I knew a builder who actually made really nice houses. I had seen some of his homes and was very impressed. They were nice. He was (and is) an excellent builder. I started putting two and two together. I could get some people together, and we could fund this builder to build nice homes and make a little profit. He'd put in the sweat equity and weíd be his funder.
Thus was born Bridlewood.
I again had two more partners. This time, both of them, along with me, had real jobs, so we had the income and the capital to back our ventures. We decided to buy a lot in a ski resort and let the builder build a reasonable home on the lot. This was in 2004, when the market was hot. The builder sketched up plans, and we worked with a Realtor to put the house on the market.
It sold before we even broke ground.
Whoo whee!!!! Jackpot!
Since we had one house under contract, we decided to get another lot in the same area. There was a lot which was very underpriced, and we jumped on it. The builder started building the house, and all was going well.
Until the buyer decided he wanted a few modifications.
What originally was only going to take a week started dragging. Finally, after three months beyond when the house was supposed to be completed, where we ate the mortgage, it closed.
Lesson 3: If a Buyer Wants Modifications, Include Your Carrying Costs in the Price for the Modifications.
We still made quite a significant profit off of the deal. After paying ourselves back some, we had plenty of money to fund the building of the next house.
That house was MAGNIFICENT. I wanted that house like nobody’s business. It was a little more expensive than the first one. It also took a little longer to build than the builder had originally said it would take. We were getting nibbles on it, but didnít have any concrete offers. Still, we were confident it would sell, because it looked great and was pretty reasonably priced for what it offered.
Our builder also mentioned that he wanted to keep his crew together and that if we started multiple projects at once, we could probably lower the overall cost per square foot of the build.
Let me stop for a lesson.
Lesson 4: If You’re Building a Spec Home, Tie the Builder’s Compensation to Completion Dates and Milestones. Time is Money in Building.
We found two lots in a proposed development of six lots and made an offer on the lots discounting from the listing price because we were buying two. After a little back and forth, our offer was accepted. We closed, using up the rest of the money that we had, anticipating the sale of the second house to cover us.
The second house did sell a couple of months after it was completed, and it, too, was profitable. We didn’t have to dip into our pockets too much to cover the payments, although, for a while, we were making two lot payments and one house payment. Ouch.
By that time, though, the writing was on the wall that the real estate market was slowing down. We had seen what it was like to be carrying a house and some lots out of our own pockets, and it was a painful, but not devastating experience. We certainly didn’t want to be in a situation where we were carrying two house payments, particularly when what our builder would build, and, thus, what we’d have as a mortgage, would not be covered by what we could rent these houses out for.
We made the decision that we’d wait. We’d list houses on the market to be built and then, when we got an offer, we’d build. The prospect of being stuck with two spec homes made our Spidey senses tingle.
Then our builder got remarried and moved to Richmond. Then he got divorced and moved to goodness knows where. We lost touch.
We decided to try to sell the lots as land.
Our problem was that by then, the market had tanked. Fortunately, we didn’t have homes, but, unfortunately, we had bought two lots to keep a crew together that had disappeared into the wind, leaving us to hold the mortgages. We had put a significant down payment down, but that was rapidly eaten up as the market crashed.
In time, the money from the sale of the two houses went into the mortgage payments for the land, and we started having to dip into our own pockets to pay the mortgage.
Lesson 5: Raw Land is Hard to Move in Most Cases. It’s Certainly Difficult to Move Quickly for a Profit if There’s not Something on the Land.
Raw land Doesn’t depreciate, so you can’t even recapture some of the losses when the market value tanks.
It took seven years before we finally sold both of the lots. Once everything was said and done, we lost tens of thousands of dollars. We were fortunate that we had solid jobs and solid financial positions otherwise so that we could continue to feed that monster. It was bad, but it could have been worse. We could have built two half-million dollar spec homes on the lots and been stuck with THOSE mortgages.
The experience was like being cut with a knife. It left a nasty scar, but didn’t cause a critical wound.
Eight long years. If we would have stopped after the second house, we’d have been well into the six digits to the good.
As it was, we were well into the five digits to the bad.
Has the experience made me completely shy away from real estate? No. We have rental properties now. They're all bought with cash. I may change my approach one day and use a little leverage (call me hypocrite now, since I say that there is no such thing as good debt!), but for now, we're all cash in our rentals.
Hereís how I now approach real estate:
- Carrying a Naked Mortgage Sucks. We actually started out the right way if we were going to spec build. We bought the first lot with cash and had enough cash in the bank to handle the construction loan payments while the house was being built. We sold the house before shovel met dirt, so we knew our costs from day 1. It was when we stretched ourselves too far and had mortgaged land that we lost our way.
- I Buy Property for Income Potential, Not Appreciation Potential. There are flippers out there in the world who know exactly how to apply three brushes of paint and add 50% to the value of the home. I am not one of them. I know how to model out cash flow. If I get appreciation, it’s going to be all gravy.
- Having no Mortgage on my Rental Properties Removes Desperation. If I absolutely have to have a renter to cover the mortgage, then I might lower my tenant standards and find myself with an even worse problem when the drifter ruins my place. Not needing to cover a mortgage leaves me time to make wise decisions instead of chasing a month or two of rent.
- Having Cash and Being Patient Means You Can Drive a Hard Bargain. I can be very picky in what I choose to buy, and when I make an offer, I can provide a very credible case. Nothing says relief to a desperate seller (the only type I buy from) like the offer terms I can pay in cash and close in 7 days. This is my first and only offer.
Would I ever invest in raw land or in spec building again? Probably not, even if I had the cash. The risk/reward is simply too great for my tastes. I can find better deals in existing houses because I can take advantage of specific situations to my advantage.
Is investing in real estate for everyone? No. You have to either have a) capital or b) know-how to apply sweat equity to make a deal work, and even then, sometimes the deals don’t work. When they don’t work, you have to have the financial wherewithal to weather the storms.
It’s taken me four times to get it right. I don’t plan on changing my approach again.
Do you invest in raw land or spec homes? What do you do? Tell us your thoughts and stories (good or bad) in the comments below!