Real Estate Failure: My Story
I was 18 when I first started investing in real estate. It shouldn’t come as a surprise that I made mistakes…lot’s of them. I would say I was a real estate failure. I like to think that’s a good thing because these missteps help shape my current investment approach and will ensure we build a solid, long lasting, business. Let’s take a look back at some of my screw ups, if for no other reason than to laugh.
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I purchased my first property in Kirksville, MO as a freshman in college in 2003. My education cost less than my brother’s and my parents decided to equalize things. At first I wanted Mazda RX-8, but then we saw how cheap property is in bumble-f Missouri and changed tracks. Two months later I was a proud home owner.
As a sophomore I moved into the property and rented out rooms to some house mates. I saved all of the profits and worked a summer job to put together more scratch and bought another property. I did this a few more times and by the time I graduated I owned 5 units.
It's worth noting that I hated being a property manager. I was in college, and I had a lot more interest in how fast I could chug a beer than finding tenants, fixing a broken toilet, or chasing rent. So I searched for someone to help me out, found Carol and gleefully dumped everything in her lap before moving back to Chicago.
My summer job turned into a full time position and I became a high frequency trader at Getco LLC (now KCG). We did well through the 2007/2008 financial meltdown and I wound up with some extra funds. I used this money to grow my portfolio much faster than the traditional "reinvest profit" method. By 2009 I had ~120 units, many of these multifamily new construction built by Carol's husband, Craig.
Somewhere along the way I bought Carol’s property management company. I made up about 95% of her business and figured I would have to fold property management into the operation sooner or later. “Sooner” sounded more appealing than “later.”
In 2009 I discovered I could get much better returns in South Bend, Indiana. So I started dumping every extra penny I had into this area and stopped buying in Missouri. I stopped doing much of anything in Kirksville and left the operation to fend for itself. I even moved overseas.
That was the “rose colored glasses” version of the story. Now let’s chat about how all of this was a real estate failure.
Too Much Debt
My debt loan to value ratio (LTV) was never more than 80%. I remember trying to work with my banker to go over that number. My logic was simple: more debt equals less money down equals higher return. He let me down gently and I didn't press the issue too hard. Thank goodness.
In late 2007/2008 the real estate market tanked and my LTV dropped well below 80%, my first taste of real estate failure. To my surprise, nothing happened. Things kept plugging along, tenants kept needing homes, we kept making money (which I invested in South Bend). I knew I was underwater, but didn’t think much of it.
At the time I wanted all my debt on a long amortization schedule (25 or 30 years) so I could maximize cash flow. I got it, but only on 3 or 5 year balloons. I bought the bulk of my Kirksville property between 2006 and 2009. So…3-5 year balloons means I'm dealing with the repercussions FRICKING TODAY. The market is still down, but I need to get my loans refinanced. Thanks to other poor decisions, we'll discuss shortly, this isn't as simple as I would like.
Fortunately, my various other investments are working out well and it’s not as if everything is going to implode, I just need to cough up a bit of cash to drop my LTV and cut through some red tape. Not the “bankruptcy” sort of real estate failure, more of the major annoyance sort.
- Use conservative financing. There is no shortage of people who argue you should buy with no money down and use "creative financing." From what I've seen, 90% of them have been investing for less than five years! Experienced investors get that way by planning for the worst. Or in my case, having reality force a course correction. Plan for a real estate failure and be pleased if it doesn't happen.
- When things do go against you, don’t wait until you’re forced to act. Be proactive and address the problem early. If I had dealt with refinancing a year ago my life would be simpler at the moment.
- Keep it simple. One big frustration for me is the amount of paperwork I dig through. I can only imagine the nightmare of being leveraged to the hilt (2 or 3 loans on a property) and/or cross-collateralized.
After college I lived in Chicago (a 6 hour drive) for ~3 years. Then London (8 hour flight + a 6 hour drive) for ~4 years. In those seven years I visited Kirksville a grand total of four times. I wanted to make it down more, but life has a tendency to get in the way. I was fortunate to find a property manager I trusted to find tenants and keep up maintenance.
I made it even worse because not only was I a remote investor, but I stopped investing in Kirksville. I was getting better returns in South Bend, so I was putting any extra funds there. Let’s say I had $10,000 to invest. I could either fix $10,000 worth of deferred maintenance on an already old property or invest it for 10% cash flow. I always went with the latter.
Was this the correct decision? I’ve crunched the numbers and from an economic point of view it was about a wash. From a headache point of view? Let’s just say you never want to try and refinance a package of properties which has some uninhabitable properties in it.
With our current investing we are closer to where I live and I visit most weeks.
Here are some things I would have done if I had been present in Kirksville more often.
- Built relationships with everyone in the area: bankers, accountants, lawyers, sellers, realtors, etc. Knowing someone personally goes a long way…especially in a small town. When it comes time to deal with a problem, 3/4 of the battle is chatting with the correct person.
- Being more proactive about many things: selling properties in poor condition, refinancing loans, doing deferred maintenance, etc.
- Shut down the property management company. More on this in a second.
Growing Too Aggresively
Over the course of three years I grew from 5 units to 120 units and acquired a property management company. I didn’t do either of those correctly:
Getting to 120 units
When I first started out I tossed together a pro-forma analysis using “typical” numbers and estimating cash flow. I bought and built many properties based on these numbers. The trouble with pro-forma is that, by definition, it’s not based in reality. As I grew I needed to adapt these numbers to what I was actually seeing. Instead I was focusing too much on what could happen.
I assume I’m not unique in this (although I might just be trying to console). I’ve seen plenty of new investors use pro-forma numbers and either disregard or don’t ask what people are seeing in the wild. I just did it on a larger scale.
I was fortunate that the cash flow was break even and paid down some of the debt; however, the overall return on investment was about the same as my savings account.
Buying A Property Management Company
When I bought the property management company (three employees) I had ~100 doors split between two property managers. I knew that residential property management companies rely on economies of scale. When I crunched the numbers I came to the conclusion that once we had 250 units, we would break even. If I had continued to grow at the same rate, I would hit that point in 1-2 years.
Why didn’t I wait 1-2 years? I thought it would be cheaper and logistically simpler to buy it when we were small and learn the ropes while we grew together.
Instead I started investing in South Bend and stopped focusing on Kirksville. I wound up owning a company that wasn’t profitable and only had a trickle of third party owners coming through the door. The company has finally reached the point where it’s breaking even, but I did NOT enjoy feeding it every month for years.
Now I plan based on today’s numbers and plan for the worst tomorrow, not based on hope and expectation.
Wrap it Up: My Real Estate Failure
Turns out an 18 year old doesn’t make the best long term financial decisions. The strange thing was that even at the time I knew that. Countless times I decided to do something because the cost of it being a mistake was cheap. Many of these approaches did not work out. Many did (topic for another post). In the end I paid for my education, just not in the traditional sense of the word. My real estate failure taught me more than any real estate success could.
My experience in both real estate and finance has formed the basis for my current investment approach. In short it’s “be patient.”
Don’t be afraid to walk away from a deal. Analyze it from a number of angles. Don’t rely on approximate numbers, seek out something tested in the wild (in your area). Look at the worst case scenarios. If everything goes pear shaped will you be able to handle it? Once it makes sense across the board, invest.
Also, if anyone is looking for a bunch of properties in Kirksville, Missouri, let me know. I’ll make you a great deal! 🙂