There are a lot of important concepts to take into account both in your business and during due diligence, but one stands above the rest in importance and impact.
What Is Sunk Cost?
In case you were sleeping in your business class, it’s defined in a Britannica article as, “A cost that has already been incurred and that cannot be recovered.” The money is gone (except in the case of a deposit) and should have no bearing on your decisions moving forward.
There are a number of costs that may go into your due diligence. This includes your home inspection, appraisal, time, additional inspections, and—in North Carolina, at least—your due diligence deposit.
If you identify something of concern and can’t get the seller to acquiesce, you have a tough decision on your hands: Do I bite the bullet and move forward? Or do I back out of the deal?
The sunk cost fallacy makes you believe that you need to move forward because of the time and money you’ve already invested. This is why it’s considered a fallacy! The true answer to that question depends on whether or not the deal is still good, regardless of the money spent so far.
It is with that in mind that I share with you two examples of properties where despite spending $2,000 in due diligence, I chose to walk away from the deals.
Example 1: MLS Duplex
It was just staring at me—with a beautiful exterior, decent interior condition, and an extra plot of land to boot. This nice-looking duplex was sitting there on the MLS taunting me!
The seller listed it for $179,000, and I had it under contract for $160,000. Everything was in motion. My file was going through underwriting, the appraisal was complete, and the inspector was en route.
In order to understand the rest, let me explain the deal briefly.
It was a good deal but it carried a level of risk: I would be spreading myself pretty thin by closing without a partner, and my cash recoupment would not come from refinancing but rather from selling the vacant land parcel. (Unlike BRRRR, buy, sell land, rent, repeat—BSLRR—doesn’t exactly have a good ring to it!)
As a result of this added risk, it would only be worth my time if I were getting a great return on my money. With what looked like only minor repairs, this duplex appeared as if it would hit that mark.
So far the news was great, and I was feeling good as the small victories stacked up. I was under contract for $19K below asking price, and the appraisal came in at $165K.
What Went Wrong
As I was walking through the Atlanta airport, I got a call from my agent. The inspector identified a major issue with the gas packs (heating and cooling units). They looked to be leaking into the house when the heat was turned on, and both would need to be replaced before getting any tenants in the door. That introduced a capital expenditure of $10,000.
While that isn’t an enormous amount, for this deal, it was a very important number that dropped the return below what I was comfortable with. So, we went to the seller and explained that I liked the property and wanted to close on it—but only if they replaced both gas packs or provided a credit of $10,000.
They were willing to work with me, but only up to $5,000. I appreciated the show of goodwill and effort to work together, but here’s the most important thing: I knew what worked for me. That didn’t work.
It was as simple as that.
I had invested $500 into a non-refundable deposit, $550 into the inspection, and $600 into the appraisal (the order of operations was a $600 mistake on my part). These were all sunk costs that I would never get back (except for the deposit that would have been applied at closing), so they were irrelevant in my decision.
We walked away, never looked back, and it was a fantastic decision that I’m extremely grateful to have made.
Example 2: Wholesale Quad
Fast-forward two months, and we’re getting ready to ring in the new year. I had just closed on a different duplex and came across an off-market quad that looked great on paper.
My partner and I found this property through a wholesaler on New Year’s Eve. This property included a pretty sizable plot of land, and the quad was previously an old farmhouse. We locked up the contract at $140,000, with the seller carrying $120,000 of financing for a year.
Luckily the wholesaler didn’t require a non-refundable deposit on this one, and we were smarter about our sequencing. We scheduled a home inspection first, with the intent to perform a subject-to appraisal after the inspection report came back. (See, I learn from my mistakes.)
After seeing the property, my partner and I were already a little wary of the deal. The conversion to a quad was shoddy, the units looked like they needed a good amount of work, the tenants were difficult, and this wouldn’t be an easy deal. The numbers looked good but we were cautious.
What Went Wrong
The home inspector confirmed that our caution was well placed.
He was only able to make it through a couple of the units (some tenants were sick—this was at the onset of COVID-19), but in the units and basement he did evaluate, he identified a number of potential issues with the plumbing, the roof, the attic insulation, and most importantly, the electrical.
I use this inspector on a regular basis because of his no-nonsense approach. He called me after and told me that I shouldn’t do a thing until—at a minimum—I had an electrician evaluate the repair.
With all the issues he found, we estimated around $30,000 in repairs. This was before the actual rehab, which would cost $20,000. While the seller was willing to negotiate, he was only willing to drop the price as opposed to providing a credit or repairing it himself. As a result, the down payment, repairs, and rehab would have cost us $80,000 cash.
That proved too much for my partner and me on a deal we were already cautious about. While it may have been feasible with a rehab loan from a hard money lender, the onset of COVID-19 was causing many of them to pause lending, so that option dried up.
Ultimately, we made the decision to back out. We called the seller and ended everything very amicably, explaining the situation and that it just didn’t make sense to us. Luckily, on this property, the only cash we had spent was on an inspection—a hell of a price to save us from a rough deal!
Due diligence is critically important, as is understanding sunk cost. I could’ve continued moving forward on either deal because of the time, money, and effort invested up to that point. If I did, I would’ve ended up with two different very risky deals that didn’t meet my criteria, simply because I fell prey to the sunk cost fallacy.
Don’t be afraid to back out!
Know your financial situation, know your criteria for a good deal, and don’t hesitate to walk away. If the deal doesn’t make sense, take a step back. There will be another.
What made you decide to back out of a deal?
Share your story in the comments below.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.