Due Diligence Gone Wrong: Lessons Learned from a Tragic Tale
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But what about when it goes wrong? It certainly happens, and I’m going to share the time it happened to me.
This was perhaps my most dismal failure. It took place around seven years ago in Kansas City.
In my defense, I was just starting out. That’s still a weak excuse, though, as the actual cost of the rehab ended up being almost double my estimate.
The Due Diligence Process
Again, the due diligence checklist I use (nowadays) looks like this:
- Pre-Offer Due Diligence
- Area Analysis
- Value and Financial Estimate
- Rehab Estimate
- Post-Acceptance Due Diligence
- Physical Due Diligence
- Financial Due Diligence
- Legal Due Diligence
- Retrading (if necessary)
- Final Decision and Walking Away (if necessary)
Details About the Property
This specific property was located in Grandview, Mo., which is a market my company and I knew well. However, it was in a particular subdivision that was fairly depressed.
While I was aware of this, I didn’t fully take into account how risky this made the investment. In lower-end areas, there’s a much greater risk of “rehabbing out your equity.”
It’s something rental property investor Ben Leybovich has talked about a lot, warning people not to buy $30,000 houses because you’ll end up losing money.
And I agree for the most part. Unless you specialize in such areas, you should avoid them.
That being said, this specific area in Missouri wasn’t that depressed. The house looked like a decent little home.
Furthermore, we were able to buy it for only $25,000. Fixed up, I estimated it would be worth $80,000, so it made perfect sense—or so I thought.
Where I really screwed this one up, though, was not with the area or valuation analysis, but with the rehab estimate.
Take note: This is where most investors screw up.
The Ill-Fated Rehab Estimate
Back in the day, the scope of work I put together left a lot to be desired. In fact, here’s what my petty Excel document looked like:
The above version isn’t anywhere near as detailed as the ones I put together now, which look like this:
Lack of detail usually means you’re missing things. Long ago, I would just go through the property without really making it my mission to find everything.
I probably finished the simpler scope of work in 30 minutes. Currently, I spend as much time as needed, even if that means spending a couple hours on it. With houses, it’s almost never less than a full hour.
Regardless, here was my total estimate:
As you can see, I only put in $2,000 for extras and $1,000 for the “Systems Check.” Nowadays, I put in a 20 percent contingency for unforeseen items. And I write down the total number of blinds, outlets, and so on to more accurately account for those costs instead of just entering in a lazy “Extra” line item.
So, moving on to the bad part, here’s what we actually spent:
In total, our rehab cost $57,498, or 67 percent more than I anticipated. Furthermore, you’ll remember that I thought the house was worth $80,000. We were all into it for $82,498, which means we did all that work to be upside down!
Disequity is never fun, folks. I highly recommend against it.
What Went Wrong?
The short answer is a lot. As noted above, the first problem was that I skipped over a lot of small things, and those small things added up.
Secondly, the project dragged on longer than anticipated, which hurt us in terms of holding costs. (Back then, I foolishly didn’t account for holding costs on rehabs. Always put in an estimate of your holding costs!)
The next problem was that our contractor wasn't very good. I believe we were charged too much on certain items, and some of the add-ons were questionable. Lesson learned: even the best laid rehab plans can be ruined by a bad contractor.
Another issue was I acted too cocky. In the very, very beginning, we got inspections on each property we bought. But as we started to get more and more volume and experience, we stopped doing that and decided to rely solely on our own inspections unless we needed a second opinion about something.
Because of this, there were several key things I missed. For instance, I assumed the cabinets in the kitchen could simply be painted. However, we quickly figured out they were in much worse condition than I thought. If I had taken a closer look, I could’ve figured this out upfront. Instead we ate the cost of replacing them.
Side note: Admittedly, we don’t always get inspections now, but I’m much more experienced and thorough than I used to be. New investors should always get property inspections (and seasoned veterans should still usually get them).
Back to our oversights. I also wrongly believed the HVAC system had a little life left in it. It didn’t and had to be replaced.
Not only was this unfortunate, it was also a key newbie investor mistake. Even though I thought it didn’t need to be replaced immediately, I still believed the property would need a new one in a few years. Things like this must be noted, especially when it comes to rentals.
But the real cost overruns came from the basement.
The Finished Basement of Doom
When we were buying houses just after the Great Recession, it seemed that everyone and their brother was finishing their basements for some inexplicable reason. As mentioned in my article on rental property add-ons, it almost never makes sense to finish your basement.
For one, they are always getting water in them. Additionally, at least in Kansas City, appraisers give you very little credit for a finished basement.
Bedrooms and bathrooms down there might as well not exist. Appraisers certainly aren’t going to compare a 4-bed/2-bath ranch to a 3-bed/1-bath ranch with a bedroom and a bathroom in the finished basement.
I knew this, but I still didn’t fully account for it.
In this property, the basement was finished before we bought it. We thought all we needed to do was add an egress window, put in a separating wall, and make a few other minor fixes.
Here’s what my budget looked like for the basement:
Again, this wasn’t nearly enough.
Unfortunately, we found out the electrical in the basement was all screwed up. A few outlets didn’t work when we walked through initially, but we assumed it was just a small problem.
Why didn’t I have this inspected? I have no answer. We pretty much had to rewire the whole basement.
In addition, the plumbing didn’t drain nearly fast. This was because the pipes were basically horizontal instead of sloping downward. So, we had to replace a lot of that, too.
I don’t have any pictures from before we started the work. But even from the finished product, you can see it’s nothing to write home about:
And to get into the basement, you had to go down a fairly foreboding stairway to boot:
All of these mishaps caused this project to veer sideways. But even still, as painful as it was, it’s always important to review your projects after the fact.
This is how you learn those hard lessons. Indeed, the worse the project, the more important it is to review it.
Clearly, we should have never bought this house. But once we did, we should have just torn out the finishes in the basement.
In contrast, here’s a review of one of our better projects:
Sure, due diligence can be boring. But from what this tragic tale shows, it is more than worth it.
A wise person learns from his mistakes. A wiser person learns from the mistakes of others.
Learn from my mistakes, folks. Do your due diligence right. Don’t skimp on it!
Have you learned any due diligence lessons the hard way?