My "Go or No Go System": How I Decide to Do a Deal (or Not)
Real estate investors seem to gravitate to one of two extremes when it comes to doing deals:
- Analysis paralysis: frozen in fear of making a mistake
- Emotional exuberance: being too aggressive, too optimistic, and irrational.
I am not exempt. I have visited both of those places from time to time.
But I have settled into a “Go or No Go” system for doing deals that helps temper my own dangerous tendencies. Since my system is all about whether or not to invest money, I like to take cues from the best investor of money I have ever studied, Warren Buffett.
Buffett has 2 simple rules for his investment decisions:
- Don’t lose money
- Don’t forget rule #1
For Buffett and other value-oriented investors the primary consideration for investment decisions is to preserve the capital (nest egg) that has already been accumulated.
Ironically, many investors instead focus on returns or profits as the most important criteria. Profits are essential, but ONLY after we’ve taken care of rule #1.
So my “Go or No Go” system is just a method to help me apply Buffett’s rule #1 to real estate purchases. I am trying to mitigate the risk of losing the money that I, my partners, and my lenders invest. If I do that, the profits tend to take care of themselves.
So here is my little system in 3 parts with some brief explanations.
Filter #1: Can my deal survive at wholesale prices?
Residential real estate markets differ from stock markets in crucial ways. With stocks, millions of people buy and sell a company each day. With real estate, ONE person might buy a certain property every 5 years or more!
Stock pricing is very accurate based on constant “votes” from the market. Real estate pricing is a best guess of an appraiser or real estate agent.
Stocks can be sold in minutes. Real estate takes months or years.
Yet, even real estate, if priced low enough can be sold VERY quickly, in a matter of days. So at wholesale prices, and not retail prices, real estate behaves more like the stock market.
Think about your own house that you live in. The retail “value” might be $175,000, but it would take months to sell at that price. Isn’t there a price low enough that a cash investor in your area would buy it in a few days? What about $125,000? Or $100,000?
If your total investment is less than this wholesale price, you have significantly reduced your risk of loss because worst case (at least in the current market) you could just dump it to an investor and get your money back.
It’s not hard to figure out that wholesale price point for almost any piece of real estate. If you need help and want to sell your own property in days, just give me a call:)
Or better yet, ask your investor friends what they would pay for your residence or for some of your investments. Don’t be insulted. It’s just helpful information.
I use this wholesale price with my “Go, No Go” system. I want to know this price before I decide to purchase.
For example with a fix-flip deal, I calculate two different purchase prices.
First I figure out my higher, retail price that I hope to sell it for. I use this to back out a purchase price that will allow me to make my minimum profit goal. Secondly and more importantly, I also attempt to figure out the wholesale price. I want to make sure my total purchase investment will be at or below this lower price. If it is, I feel better about speculating on the retail price because I have a margin of safety in a worst case scenario.
I also would like to pay less than this wholesale price with rental purchases, but sometimes with longer-term rental properties I might still choose to pay more than wholesale if it also meets my criteria #2 and #3 (below). Even in those cases, however, I want to know the wholesale price going in so that I am aware of how much of my money is at increased risk from the start.
Filter #2: Am I investing with positive leverage?
Use of leverage (debt) is an integral strategy for many real estate investors, but my observation is that misuse of leverage is the number one reason investors lose money. I have some negative cash flow “scars” to prove this from my own deals.
Investing with debt should be treated like carrying a loaded gun. When my dad took me bird hunting as a little boy, he wisely taught me that a gun used carefully is a blessing but a gun uses carelessly can be a nightmare.
How do we treat leverage carefully? To start, make sure it’s positive leverage.
I did a 10-minute YouTube video on positive leverage, but it basically means the net income from your rental property is greater than the cost of your financing. In other words:
NET RENTAL INCOME
- FINANCING COST
= POSITIVE NUMBER
I invest in a lower-priced market than, for example, California or big cities. I have heard the complaint that in high-priced markets positive leverage is nearly impossible.
My answer is that it’s not impossible. If you own a property free and clear it will usually cash flow, won’t it? Or you can increase your down payment until you do have positive leverage.
In any market, leverage won’t make a bad deal become good. If a rental in a high-priced market is bad deal, don't buy it - with or without leverage. Leverage can make a good deal even better, but it can also make a bad deal even worse. So if you find a good deal in any market and you don’t have the capital to buy it with positive leverage, it’s just a matter of finding the right money partners to invest with you.
If positive leverage seems difficult with traditional banking sources, you can also use creative purchase strategies like lease options, options, and seller-carry-back financing. I have found it much easier to get positive leverage with these sources than with bank loans.
Filter #3: Can I conservatively handle balloon payments?
This filter is also related to leverage. Along with using negative leverage, the other fatal debt strategy is to have balloon payments due that you can not conservatively handle.
Balloon payments occur when your loan has a maturity date before it is completely amortized. For example, you could amortize your loan over 30 years, and your lender could require you to pay the outstanding balance at the end of year 5. By the way, this is the norm with commercial loans.
I don’t like balloons. I’d prefer to have every loan fully amortize. Especially if you personally guarantee the loan, your home and your personal assets could be at risk if the balloon pops and you can’t pay it off.
But if I do agree to a balloon, here are my “Go, No Go” questions. I need to have a “yes” to one of these questions before I move forward:
- Is the loan balance low enough today that I could pay it off by selling at a wholesale price? (see Filter #1)
- Do I have enough cash reserves to pay the difference between the wholesale price and the loan balance?
If the answer is no to both, it means I need to borrow less money and/or get a money partner who does have the cash reserves.
This filter led me and my business partner to bring in capital partners early in our career in order to cover our worst case scenario. The worst never occurred, thankfully. We could say that we gave away profits needlessly, but it helped us sleep at night and invest with more confidence.
Zero Risk Investing?
In the world of entrepreneurship, there will always be some risk. Even with my “Go, No Go” filters, I know I have made assumptions and taken risks that haven’t been addressed.
The key for me has been reducing enough risk so that I can sleep at night. From there I can energetically and courageously take the next step forward by purchasing another property.
Like me, you are bound to make mistakes and maybe even lose money at some point. But if you keep your mistakes small and if you proactively work to quickly correct them, you can still come out great in the end.
That’s what I love about our game of real estate. The risk equation can’t calculate the most important wildcard: YOU. Your energy, your enthusiasm, your creativity, your problem-solving ability, and your relationships all contribute towards mitigating problems and reducing risks.
So good luck with your next real estate purchase. I hope my “Go, No Go” system helps you decide to buy (or maybe not).
Enthusiastically your coach,