There’s a term in business and investing known as a, “sunk cost.” When entering into a real estate acquisition, an example of a sunk cost could be money spent on inspections or on other due diligence, time spent in analyzing the property, etc. These are all examples of sunk costs. The rule with sunk costs is: Never throw good money after bad money.
Recently, a past client that we’ve funded deals for before came to us with a new real estate acquisition. After we analyzed the value, we discovered a property that had recently sold, located only a stones throw from the subject property. This newly discovered comparable sold far below where the real estate investor intended on reselling the property. We provided the real estate investor with this newly discovered value information. With much pain and deliberation, he tried to decide if he should proceed with the acquisition anyway. But why should he? He already spent a ton of time and money on the due diligence. But what if he doesn’t make money on the deal?
All of the monies spent to date on the deal are sunk costs. And what is the rule with sunk costs? Never throw good money after bad money. If this real estate investor decided to proceed anyway, he would not make money, or worse, lose money trying to save his sunk costs. When acquiring real estate, your due diligence is considered a sunk cost if it reveals that the deal is not as sweet as it looked before. Never throw good money after bad money on a real estate acquisition!
@Corey Dutton The very first property I had under contract was a 4 plex in Glendale, Arizona. I did a drive by of the property and didn't see anything major or glaring in terms of how it looked. I paid $900 for an inspection and I was surprised to find out that there were major issues with water leaks, major issues with the roof, and major termite damage. All of the units were occupied, but one tenant had no working appliances, and another had no A/C (remember that this is in Phoenix metro). Overall I could easily have spent $30,000 fixing all of the problems. At the time I thought the property was a good deal, but I found out that it was a money pit and it would be a long time before I recouped the repair costs.
I considered changing my offer, but decided against it because I didn't want my first investment to be a complete remodel. To make a long story short, I took the $900 loss and walked away.
Good for you!!!!
The doctors in the white coats have a name for this: fallacy of sunk costs.
It's interesting stuff.
Totally agree Corey. Too many people get desperate for the next deal and put on the blinders. Or even worse, they get emotionally attached!
Thanks Scott S., totally agree. Especially when another deal is not in sight.
Some sunk costs you can try to recover such as the inspector, appraiser giving you a break on your next property because this one didn't work out.
I have also seen on commercial deals lenders returning deposits and not charging for certain things because they want the relationship going forward. These are clients with very high wealth and not someone who is "one an done" buying something.
In addition to sunken costs we also have a saying in the business of "unwinding a deal" meaning how much to get out of buying this thing??
LOL Joel, I like that phrase about "unwinding a deal." Use it in a context for us please. Love it!