7 Signs a Deal Is Too Risky (Even If It Looks Good on Paper)

Ashley:
Today’s episode is all about those deals that look amazing on paper. The ones that make you think, this is it, this is my breakthrough deal. But actually they may have some risk hiding underneath them.

Tony:
And we’ve both had moments where a deal checked every box on the spreadsheets, but once we dug a little bit deeper, we realized it could have been a disaster.

Ashley:
So if you’re analyzing deals and wondering, how do I know when to walk away? We’re going to break down the red flags. That should make you pause and rethink the deal,

Tony:
Whether it’s your first property or your fifth, these are the traps you need to watch out for before wiring your earnest money.

Ashley:
So your deal only works when everything goes perfectly or you don’t go over your contingencies so there’s no vacancies, no repairs, full rent from day one. That’s a sign that it might be too tight because the chances of that happening on a deal that you’re never going to have any of that is really, really slim. So the first thing you need to make sure is that you are not accounting cashflow as just your income minus your fixed expenses such as the mortgage payment, the insurance, the property taxes, things that you’re going to be paying every month, any utilities. You want to make sure that you are accounting for the vacancies, the repairs and maintenance, and the capital improvements on the property. And that is a big mistake where you’re looking at the BiggerPockets calculator report and you’re saying, you know what? I probably won’t have repairs or I don’t need to save for CapEx because just if something happens down the road, the roof is newer, I probably won’t have to replace it for five years. I can just pull together a chunk of money that I’ve saved up and buy the roof then. But that is not giving you an accurate account of if this deal will work or not for you, and if it’s actually a good deal. Tony, what are some things on the short-term rental side that maybe you see as red flags that people are missing and not accounting for that’s not giving them the accurate look of a deal?

Tony:
Yeah, three things. First is not stress testing at different income levels. So it’s like, it’s fine if you want to project your best case scenario, but let that be your best case scenario, not your only case scenario. So for me, when we underwrite a deal, we’re looking at a best case scenario, a middle case scenario, and then a worst case scenario. And we want to stress test at all three of those levels. And if I am breaking even on my worst case scenario, I can probably live with that, right? But if I’m losing 10, 12, $30,000 a year in my worst case scenario, then maybe this isn’t a deal that I want to do. So I think that’s first is, and this is true for short-term, long-term flipping, whatever it may be, I think it’s good to stress test at multiple levels right now, specifically to the short-term rental space.
The second piece, Ash would be not accounting for the actual setup of the Airbnb. I see a lot of folks who mistakenly believe that their biggest expense is their down payment and their closing costs. And while it may be oftentimes setting up your Airbnb can maybe be just as much as your acquisition costs, if not more, depending on the size of scope and how much you put down. But where people get into trouble is they buy an Airbnb, especially when it’s an existing Airbnb return key Airbnb. Chances are even if you’re buying someone else’s Airbnb, there’s still a lot of work and improvement that needs to go into it. So what we typically tell folks is that if you’re buying a single family short-term rental, you should expect to budget at least $30 per square foot to set up your Airbnb at minimum. And then even more when you start talking about outside amenities and things like that, saunas, hot tubs and all those things, but just your core furnishing designs, maybe some murals, things like that.
$30 per square foot. So stress testing at different levels, making sure on the short-term rental side specifically that you’re budgeting for your startup. And then the third piece, and again, this is true for all asset classes, all strategies, but it’s making sure that you’re choosing the right comps. I see it so often. I’ll give you an example of a beach market. Say that someone wants to buy in a beach market and they’ve got a really beautiful home, but it’s two blocks back from the water and they’re like, well, hey, my house is really, really nice. It’s actually nicer than this property. But then you look at the other property and it’s literally sitting on the ocean, it doesn’t matter how nice your property is, it is two blocks back. No one’s going to pay the same for those two properties because being on the water is a premium.
Same thing if you are flipping a home and you could have the exact same square footage, even the exact same layout, but if you’ve got plain white shaker cabinets and they’ve got super luxury cabinets that go from the bottom all the way up to the ceilings, people are going to pay more for that product. So it’s really making sure that as you’re doing your research, the comparable properties you’re using are similar to yours in terms of size, location, construction, quality, layout, amenities, if it’s short-term rental. So those are the kind of three big buckets that I see people making mistakes on when they’re trying to underwrite their numbers.

Ashley:
And that really leads us into sign number two is to the weak or unverified comps. And this goes for any strategy as to when you’re looking at comparable properties, how are you defining similar so that it’s a similar property? So I had an investor friend who bought this property, got a great deal on it, and he’s like, it’s in a great neighborhood, great market. It ended up being, and he didn’t even realize this until the house was listed, that it ended up being in a different school district. It was right on the borderline than all the other houses in that neighborhood, and it killed his listing. That was the main thing from every buyer. It was a big house with lots of bedrooms, so built for a family and that was his buyer was a family and nobody wanted it because it was not in the school district.
So making sure when you’re looking at comparables, you’re looking at all the data of the property. Another thing that I see a mistake, especially in markets like mine where it can take 45 to 90, sometimes even longer to close on a property in New York State is when that property shows what it’s sold for, that property could have been offered on three months ago. So that means that that comp is three months old. That’s what people were willing to pay three months ago. So that makes it more challenging to really get an accurate picture of what your comps should be. So James Zaner, who has always taught me, don’t go pending, don’t go off a pending listing because that’s not sold. So that doesn’t mean it’s what it’s going to sell for, but because I’m in such a long period of waiting to close, I am looking at what’s going pending.
So not necessarily for price, because I don’t know what the pending price is. It could be way lower, it could be higher, but I’m looking at days on market. So did it go pending right away then? It’s probably usually close to the purchase price or above if the purpose and accepted the offer right away. But I’m looking more at what types of houses are selling? Is it luxury high-end homes? Is it starter homes? Is it fix and flip homes? I’m really looking at that when comparing comps, but also we also have a tool. If you go to biggerpockets.com/resources, it’s a comparables property and you plug in your properties and it tells you each thing that you should be looking at. So it’s just a spreadsheet you can fill out and use, and it’ll say like, okay, what’s the square footage? And I built this based off of looking at appraisals because comparables will matter for appraisals if you’re refinancing or the comps will matter to see what prices our properties are selling for if you’re going to resell the property. So it just gives you a list of things to look at and making sure that you’re taking into consideration.

Tony:
Yeah, couldn’t agree more ash on the recommendation to review the appraisals, because every market’s going to be a little bit different. Like Ash, you’re in a more rural area. We have properties in Joshua Tree near the National Park where just a lot sizes seem to be a little bit bigger out there. But then where I live, I’m in a newer subdivision that was built in 2018, within a quarter mile radius, there’s going to be a lot of homes in that area. So every market going to operate a little bit differently when it comes to how those comps are chosen. And the best way is just to go ask your agent to say, Hey, can you send me some old appraisals that you’ve seen or recent appraisals that you’ve seen? And then that’ll tell you how far out are they going from the subject property? Are they keeping ’em within half a mile? Are they going out five miles? How much are they adding or subtracting for variations in bedroom count or a lot size or square footage. And as you start to piece those things together, you start to get a better sense of, okay, here’s what my comparable property should look like. And I think that gives you a lot more confidence as you choose the right comps because the wrong comps can derail your deal, right? If you don’t have the right comps, everything else starts to fall apart.

Ashley:
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Okay, welcome back. So sign number three is too much rehab for your skill level. So Tony was way more adventurous in his first rehab than I was, but I had very cosmetic rehab starting off. So a little paint, a little vinyl plank flooring, things like that. Nothing extensive, no ripping out walls, no pulling out bathtubs, things like that. And that was where I was comfortable, and I did that for a very long time. So really think about what your skill level is in your experience. So in Tony’s example, he didn’t fly out to Louisiana and do any of the work or even oversee it. He built a team out there. But that still means you have to have the capabilities to oversee that project and understand that other things could come up in that scenario. Tony, if somebody wants to do a larger rehab, what are the key elements they need to make sure they have in place before they take that leap into a bigger rehab?

Tony:
Yeah, I mean, I think a lot of us have skills just in our everyday lives that oftentimes translate into real estate investing. And I think part of the reason that I was comfortable taking on a project like that was because my day job, my entire responsibility was managing operations and making sure people were on time and on budget and doing those different things. So for me, it was a natural kind of progression. So if in your day job you kind of have some of those skills, even if you haven’t necessarily applied them to rehabbing, maybe there’s still some overlap that you can focus on. But to Ashley’s point, I do think what really gave me the confidence, Ashley, was that I was able to build a team that had the experience that I was lacking. I had a general contractor who came highly recommended that did a lot of work for investors specifically in that market, those who were his primary clients was working with investors.
So he was someone that knew what we wanted and how we like to operate. I had a property manager who’s helped me oversee the construction as well because they were like, Hey, well hey, we know what we want this property to look like to get it rented. Well, so here’s some of the things that we need. So I was really able to tap into the knowledge and the skillset of the people who are in that market to help give me the confidence to do it myself. So if you are a rookie and you do want to take on a rehab that maybe is outside of your normal skillset, it’s not necessarily that you can’t do it, but how can you go align yourself either through contractors, PMs, even partners who do have those skill sets that can bridge that gap for you?

Ashley:
And sign number four, over reliance on market appreciation. Tony and I actually just recorded with Thatch Gwen and James Dard, and this is one of the topics that we talked about is banking on appreciation, especially in a short period of time where maybe if you bought during COVID March, 2020 of COVID, I was lucky enough to buy a foreclosure home at that time for $29,000 and I put not a lot of money into it, and a year and a half later and 2021, it sold for $170,000. So yeah, that was a great appreciation in that time period. But should I have run my numbers off of that and banked on that? No, because you cannot time the market, so your deals should make sense for now. So if you think like, oh, in three years this is going to appreciate even in 10 years, this is going to appreciate.
Yes, it probably will. If you look over the last 30, 40 years, the housing market prices has increased. You ask your grandparents and what they originally bought their house for. It is very, very different than what a house that same type would be selling for right now. But you want to be able to have your property sustain that period of time that it actually takes for appreciation to happen. So I have one property that I bought for appreciation. It cash flows very, very little. I have reserves in place and I also have the means to cover any huge capital improvements or any vacancies from my reserves and from other income streams if in fact that property doesn’t perform and I have to wait longer and longer before I actually sell it. So really don’t bank on uncertainties. Bank on what you can actually analyze and know right now.
So if it is a rental for sure, you can rent it out at this based on market conditions and you are going to get X amount of cashflow per month. You can run the numbers on this deal, and yes, it may change, your insurance may go up, things like that, but you’re at least not guessing on what the appreciation is going to be on the property and what its value is going to be five years from now if you decide to sell it for flipping a property. Tony, what is the best way to run the numbers to not be banking on, oh, it’s going to take me six months. I feel like the market is going to go up a little bit and I’ll make even more money.

Tony:
I’ll touch on the flipping, but just I want to circle back. You made a really important point, but I just want to clarify what Ash is saying about not overlying on appreciation. We’re not saying that you can’t buy for appreciation because it is just like the stock market. If I buy a share in Apple today, and I bank on being able to sell it a week from now because stock prices always go up, there’s a lot more risk in this seven day period of whether or not it’s actually going to go up or go down. But if I buy Apple today and I assume over the next 30 years that there’s a reasonable chance that it will have gone up in value, I think that’s a much safer bet. And it’s the same thing for real estate investing. If you want to buy for appreciation, that’s fine, but make it a long-term appreciation play.
Don’t make an appreciation for next week or a year from now or two years from now, because who knows what the market can do in a short period of time. But over the history of the real estate market, things have generally appreciated above and beyond inflation. So it’s reasonable to say that if you buy a property in at least a somewhat stable market 30 years from now, you will have gained a decent amount of appreciation. So I think that’s what it is. And then more importantly, don’t buy a deal that’s not cashflowing that you’re losing money on unless to Ashley’s point, you’re willing to accept and you can fund that negative cashflow. Now, whether or not you want to do that, it’s a personal choice. If you just really like the house and you like the city and you like all these other things and you’re like, I can fund the 300 bucks a month because I’m a physician, or I’m a CEO or executive somewhere, then great,

Ashley:
Or you’re just really great with your money and live way below your means

Tony:
Or that, right? You just got a lot of extra income that you can put towards that. But I think the point is don’t over rely on it. Now, going back to your point Ash about flipping, I think that depending on when you started flipping, it’s probably influences how you feel or what your business plan looks like because for a lot of people that started flipping during things getting super hot, you could buy a bad deal and the market going up would save you. But now with the market being more flat and in some markets maybe even being down, you’ve got to almost bank on the opposite of appreciation, right? You’ve got a bank that maybe I’m buying this today and what the comp say today is one number, but six months from now it could be maybe something even lower. And we recently interviewed Dominique Gunderson and Henry Washington, two flippers in different parts of the country, and they both echoed the same thought on this where they said that if the comps say that I could probably sell this for 300, I’m going to list it 2 95, I’m going to write this deal at 2 95 because I want to make sure that it moves.
And I think that’s the step that we probably need to make in a market like today where things are shifting and the short-term appreciation is definitely not guaranteed.

Ashley:
So we’re going to move on to sign number five, and that is high vacancy or poor tent space. And this is something I learned along the way. I was like, wow, this is awesome. I can buy a duplex between 20,000 to $70,000, and that was the majority of my portfolio. Some of those turned out great, some I still have, but some of those $20,000 properties, I realized why they were $20,000 and it was just headache after headache. So a property can have great cashflow on paper, you can get it for a low price, you can charge a good amount of rent, and your mortgage payment is low because you bought it right? And this looks great, it’s a cash cow. But sometimes there are reasons for that to happen that don’t show up in the deal analysis. So the first thing can be the location, the neighborhood, the market that it’s in.
So it could just be that this is a DC class neighborhood. So what you can run into in those neighborhoods is first of all, more crime in the neighborhood. Second of all, you can run into a lower quality tenant who maybe isn’t taking care of your property or making late payments or just ends up not paying at all. And all of those combined can kind of give you headaches. It also could be that the property is just in this area, and I bought into an area like this where no properties are really completely renovated and nice, at least the rentals, it is a smaller town. There’s a lot of drug use going on in this area. And a big part of this town is that the rentals are just plain Jane, but there’s also a lot of lipstick slapped on a pig. And I bought one of those for 37,000 where I was like, oh yeah, this is actually not that bad inside.
It’s nice, it’s very decent for the neighborhood, but it was issues with plumbing, issues with, it was just D-I-Y-D-I-Y right after each other for all the owners that had it. Nobody ever actually replaced anything. It was just like fix after fix. So I had headaches with the tenants. Constant turnover. That’s another thing that you can see sometimes in the lower class neighborhoods, like c and d is more turnover in your properties and just the maintenance, the constant maintenance that was needed on these properties. And unless you could go in and do a full gut rehab and transform the whole property and make it all brand new again, you can eliminate that, but then you’re probably not going to be able to increase the rent to what you would need if you completely renovated the property. So there’s that give and take there. But that was my experience, and I ended up selling those properties. Luckily I bought them 2018, 2017, 2019, and I was able to offload them for triple price in 20 21, 20 22. But that was just so lucky. That was not any kind of planning or anything like that. So I think really not only looking at the numbers on paper, but also looking to what kind of neighborhood you’re buying and what quality of tenant and what headaches and what time is you going to have to put into this deal. Tony, what about the short term rental side of things?

Tony:
Yeah, I think maybe a little bit different because no property is fully booked all the time. There’s always, you don’t want to be a good occupancy is probably somewhere around 80%. So I think it’s a slightly different mindset, but I think the notion of attracting the right kind of guests is probably what’s more important here. For example, if I have a four bedroom property in Vegas, that’s a very different demographic of guests than having a four bedroom property in, I don’t know,

Ashley:
Orlando,

Tony:
Yeah, Orlando, right? A lot more maybe partying and raging going on in Vegas, and maybe a lot more families go into Orlando. So I think it’s just making sure that as you put your property together, that you’ve got a good understanding of the avatar of guests that’s coming to your listing and then making sure that you’re either trying to attract the right person or deter. We just had Jamie Lane from Air DNA on, and he said that he likes specifically put a jungle gym in his backyard because he wanted to deter bachelorette parties. So it’s like how can you set up your listing to make sure that you’re attracting the right person and then repelling maybe the wrong person. But I think one follow-up question for you, Ash, is we talk a lot about neighborhoods being a class B, class C class, D class, and obviously it’s part art, part science, but what are you looking at to gauge when we move from one class to the next? Is it just crime rate or is it some combination of other things as well?

Ashley:
Yeah, so it’s also retail restaurants. So what type of retail restaurants are in the area? So there’s the dollar General rule of thumb is if you are not close to a target or a Walmart, dollar General wants to be there if you’re not within so many minutes of one or whatever. So that’s definitely more rural. And then as you get closer to a target, it may be a nicer area depending, but I think looking at just driving the streets first of all I think is so important. Or walking on Google Maps, your little yellow guy, but looking what types of restaurants are in the area? Are they nicer quality restaurants? Are they a lot of just dine and dash places, little diners, things like that. So I don’t mean D to dash, people are going in and eating and leaving. I mean, you get quick service and it’s cheap, but I look at that a lot, the retail and the restaurants that are in the area.
But then you’re also looking at the school district, so what’s the school rating on it? And then also if you’re local, you can probably get other people’s opinions on what’s actually the good school district around here that people want to be in. And then also the income in that area too. So is it a higher income or is it lower income? And then just market rents. If you compare market rents for two different neighborhoods, you can kind of gauge like, okay, this two bed, one bath is getting a thousand dollars in this market, it’s getting 800 in this one and it’s getting six 50 in this one. Then that kind of ranges like, that’s my A, B, and C too. So just comparing to other neighborhoods I think helps a lot that’s in the surrounding area. And then you can kind of stack them as to this one has the best stop the next.

Tony:
I love that breakdown, right? We’re looking at a few different data points to help make that decision. But I also just love the fact that you admitted to committing a crime on the podcast here. I’ve dined and dashed once in my life. Ashley and I was in my young twenties and we were actually in Las Vegas. And only because it was the absolute, she literally just did not come back. And we were just sitting there waiting for her and we’re like, all right, should we just leave? We’ve been waiting forever. And then we just left. So waitress in Vegas, I’m sorry that,

Ashley:
You know what? I wish that BP got a couple weeks ago that they would’ve had your facial recognition saved all these years and come after you as to take you down on stage. You died to dash the log, the casino camera caught you. I tried to think, I don’t think that I ever have done that, but if I remember, I’ll come clean on the podcast if I have.

Tony:
Alright guys, we’re going to take a quick break before our last two signs here. We’ll be right back with more after this. Alright, so let’s get into sign number six, which is complicated title ownership or zoning issues. There’s a lot that goes into this now. This is why whenever you transact on a piece of real estate, you want to make sure that you’re using a title company because their entire purpose is to make sure that the property doesn’t have any sort of title issues or liens or that anyone else could take a claim to this property once you own it. And Ash and I, we actually both known investors name is Derek aov. He’s been a guest on the podcast before, but he actually bought a property and after buying it, found out that there was a title issue. Someone else had a claim to ownership on this property that he had just purchased legally, and it turned into this whole ordeal. So whenever you transact on something, A, make sure you go through a title company and then B, make sure you get title insurance because if there ever is an issue down the road, it’s the title insurance and we’ll cover you to make sure that everything gets resolved without you having to spend a whole bunch of money on whatever it costs to get that done.

Ashley:
Yeah, and I think just asking questions if there’s anything you are unclear about. So I was going to make this big mistake and I was going to buy this campground that I had no business doing, but I’m like, I need to grow and scale. I need to do something big. This is it. And I was in my due diligence period, I had put my a hundred thousand dollars earnest money deposit. I had 30 days to do my due diligence. And by the saving grace, the code enforcement officer called me and said, I have been trying to track you down. I heard somebody got it under contract, you need to know all of this. And he went through all of these violations, everything that wasn’t up to code. They had put in, I think it was 20 new RV pads. They looked great and everything. And he is like, they’re not up to code.
They never even got a permit when they were put in. So most likely all the electric, all of the plumbing that was put into these RV sites is going to have to be dug up, checked, and then put back together. The concrete pads had been poured, they would’ve been ripped up. So that was like, look, you need to really understand all of the mechanics, but also talk to the code enforcement officer, talk to the town, make sure there’s not anything outstanding. I bought a house once that we missed during due diligence where the person who owned the house had passed away and the estate was selling it, and there was actually $125 fine associated with the house for them not cutting the grass while it was under contract or something. It could have been way worse. So you got to watch out for that. But I think really making sure that you’re doing your due diligence, and especially now since we are going kind of into a buyer’s market here where there’s more flexibility, things are sitting on market longer, you can negotiate more is to making sure that you’re putting in some time to do your due diligence.
So putting your offer in and then making sure you’re getting all this done. And another big one that you should be doing too, in my county, they used to only require it if you were getting a bank mortgage because the bank wanted this done. But now you have to for every closing, but get the well and the septic tested because that could be 50 to $60,000 if you have to replace both of those. So really getting an understanding of the mechanics of the property and also the parcel itself as to are there any deed restrictions? So there was a parcel for the investor that I worked for that he sold to another investor and he didn’t want him competing with his business. So the deed literally states that you can never, ever put this type of business on that plot of land. So even 10 years from now, that’s going to be in the deed.
That restriction is that you can’t do that. And I don’t know how you actually get a deed restriction removed or whatever, but that was in the deed from the sale of that to them was that deed restriction put in. And then there was another parcel of land that I looked to purchase, and it had somebody who had owned it many years ago, had this big idea to build these plazas and things like that. And he started the utilities. Well, in most towns of villages, when you do utilities to your property, you assign the utilities over to the town if they own the utility. So in this town, the public works department did the water and the sewer. So we had to bore under the road for a property, and we had to hand over that to them. They performed the maintenance, they now own that, but we had to pay for it to be installed. So this guy had gone and gone and done this, and it was like a really prime location. But this guy had put easements in just all these weird directions because he had all these plans to do things, but he never did it. But it made it almost unbuildable to anybody because of all these easements that were granted to different people and different utilities on there. That would’ve been really, really difficult to have those removed.

Tony:
That’s crazy. I’ve never had to deal with that. I guess maybe the market that I made, a slightly different thing, but deed restrictions, that’s new for me. I literally did not know that existed.

Ashley:
Okay, so we’re going to go to the last sign here, and this is sign number seven. And this is if the deal requires you to stretch too thin. So who is listening and likes to asleep me, and I have stretched myself too thin before and I lose sleep over it. And it is a stressful feeling. It is not a good feeling. So now I’m very risk adverse and I do not stretch myself too thin because I don’t want to lose everything. And yes, I’m probably missing out on more reward because I’m not taking greater risk. But especially as a rookie starting out, if you don’t have a lot to fall back on and you are literally taking your life savings and putting them into this one property, and if it goes bad, what is going to happen? What’s your worst case scenario? And if that worst case scenario is actually pretty bad for you or for your family as far as financially, then maybe not take on such a big risk. Well, thank you guys so much for listening to this episode of Real Estate Rookie. I’m Ashley. He’s Tony, and we’ll see you guys on the next episode.