I got a call out of the blue the other day. It was a real estate investor whom I’d never met before. She had seen one of my listings on the same street where she had just put a contract on a home, which was a foreclosure. I knew the home and I knew what it would sell for, but I never considered purchasing it myself because I knew there were many owner occupiers that were bidding on it and it would not be obtainable at a price that would be conducive for any kind of investor.
So, I was a bit confused by her call, by what she wanted and by her strategy. It quickly became apparent that I was talking to an investor who just made a big mistake on several different levels. The neighborhood in question is a well defined subdivision of newer but smaller homes, surrounded by subdivisions of similar aged, but larger homes.
She had never seen the home when she purchased it. She was not familiar with the area and she had clearly just done a radius circle of one mile, pulled the comps she liked, and determined the home was worth $400,000. Unfortunately, the subdivision was well defined, containing hundreds of homes with plenty of recent comparable sales. The home also backed to a busy street, which happened to be the city boundary; the homes on the other side of that street were in another town. This is a text book example of a situation where an appraiser is not going to look at homes outside the subdivision even if they are just across the street from the subject.
Trying to understand the deal, I told her that I knew she would have had to have offered in the $290,000 range on the house to have gotten it, and was told that her contract was higher than that. I told her that the highest comparable sale in the neighborhood was $320,000 — by now she was pretty aware of this fact and knew that she was in trouble.
She asked me if I would buy the home from her and what I would pay.
I said I wouldn’t pay more than $220k for the home; it needed substantial work.
Even by her math it was going to take $30,000 to fix up. I thought that was a pretty optimistic number. So, I ran through some of her options with her to try to mitigate the damage, and quickly found that she had really trapped herself.
The first thing I told her was to eat the deposit and walk on the deal, but she informed me that she had put down a $22,000 earnest money deposit. “Why, in the world would you put up that much of a deposit,” I asked. That’s just the way I do it, was her response.
I told her that she would have no problem renting the home, but she had a hard money loan on the property with a rate of 16% and 5 points up front. Holding the home was not an option.
She finally asked me if I would be her realtor and sell the home for a 1% commission. I felt bad for her but I had to decline that offer.
So here’s the damage:
Purchase price: about $300,000
Repairs (by her math): $30,000
Finance costs even if she was only borrowing $200,000 (I can’t see any hard money lender giving her much more than that.
Interest for 6 months: $16,000
Realtor commission of 4% (optimistic) on a $330,000 sale: $13,200
Total costs, not included, taxes, interest, transfer fees, title, binder, etc: $369,200.
Sales Price: $330,000 max.
Even on a best case scenario she’s looking at a loss of well over $40,000.
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Real Estate Investing Mistakes made and Lessons to Learn from This
Determining Property Value:
If you’re in a well populated area, do not do a simple radius search to get comps for your property. If the property is in a city or suburbs, I don’t go outside a half mile to start, and then I always check the neighborhood specifically. If you’re in an urban environment a quarter of a mile might be too far. Also, when I do a radius search, I map the properties I selected as comps and make sure I know where they are in relation to my property.
If you find that all of your comps are on the other side of a busy street or bunched together up in the far corner of your radius then you need to do some more research. Those homes may be in another school district, or a nicer street, or a subdivision with more amenities. I like the comps to be disbursed evenly around my subject. Also, don’t go by active listings.
There was a home listed on this street for $380,000. That is an unrealistic price for the neighborhood and was probably a factor in this realtor’s bad decision. I use active listings to validate my price, to estimate time on market, and to identify my competition, but not to determine the price.
There are times when you may offer a large earnest money deposit. There have been times that I’ve put up the entire purchase amount in earnest money deposits, but most times I just offer the standard 1% of the purchase price, but no less than $1,000.
Don’t get stuck in a strategy; each deal is different. I make offers on homes sight-unseen, but never do I put up massive deposits if I haven’t even seen the home. I’ve found major defects in a home upon a walk through many times, and several times I’ve had to walk away from a deposit. Sellers, even banks, will often be willing to come down on price, even after a contract is ratified, if you identify a major defect. Huge deposits make the sellers unwilling to renegotiate. Find the sweet spot though; you have to make a deposit big enough to show you’re serious but keep your ego out of it.
Throwing Good Money After Bad:
You can’t buy your way out of a bad situation. There’s something in business called sunk costs. This is money already spent. You need to take money spent out of your equations for the future decisions and pick the best option from the present forward. As bad as it sounds to walk away from $22,000 it’s still cheaper than any other foreseeable option.
Know Your Market:
Real estate is local. I don’t care how tired you think that saying is. It’s true. Live by it or die by it. Be daring but don’t be reckless. Go into new markets but be careful and do your homework.