Real Estate investing is a numbers game – and a loss is a matter of statistical probability. Over time as you invest in deals you will become involved in a deal that turns into a loser. A loosing deal is no fun as it strains your relationship with investors, lenders and impacts your personal cash flow.
Real Estate investing is a high risk entrepreneurial effort. We as real estate investors go into a deal trying to mitigate risks by buying as prudently as possible. However, it is a fact sometimes real estate deals go bad. What are your steps and choices when a real estate deal does go bad?
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The Problem Scenario: A Story
Parties: A real estate investment operator, equity investors, and private lender.
The Investment: The property is a single family asset that is need of rehab within a blue ribbon suburban neighborhood. The real estate operator analyzes the investment opportunity and projects a $150,000 all in number with a projected resale value of $205,000 based on recently sold comparables. The operator projects a total timeline of 8 months and conservative profit of $27,000 after all expenses, carrying, and selling costs. The operator is raising the equity capital from private investors and will split the profit and losses with them 70% (Operator) and 30% (Equity Investors).
Setting the Scene: Real estate investment operator is in the business of locating, rehabbing and reselling residential investment assets. The real estate investment operator has successfully validated the investment strategy by successfully buying and selling multiple projects.
Private lender was approached by the real estate operator to invest into a real estate flip deal. The private lender and real estate investment operator come to an agreement on the loan terms, and the real estate operator raises his needed equity from an equity partner.
Equity Investor: The equity investor is a friend of the operator and is looking to invest his idle cash into a short term project. The investor is intrigued by the project given that the investment is local and projected return on his capital would be between 20-30% based on his calculation. The investor does need about $10,000 of his principal back to help pay for his child’s upcoming fall semester.
Lender: The lender analyzes the deal and provides a loan with the following terms:
$27,000 plus holding costs, points, and interest expense
What causes the problem: The market begins to cool down for real estate purchases by homebuyers arising due to changes in financing guidelines and the expiration of government provided credits. The target investment has been rehabbed but is unable to be sold at the projected sale price point targeted at the time of acquisition.
The real estate operator is running out of time as the lender loan is coming due and the market is not cooperating in terms of liquidity or value.
Valuation (Changed Market)
|Single Family Asset||
The real estate operator has an opportunity to sell the asset at the updated valuation and would wind up in the following position:
Sale Price: $165,000
Sales Commission: -$10,500
Closing Costs: -$ 2,000
Carrying Costs: -$ 3,500
Net Gross: $149,000
Loan Amount: -$123,000
Loan Costs: -$ 15,990 (Points & Interest)
Equity: -$ 27,000
The real estate operator and equity partner would experience a loss. So what can the real estate operator do to salvage this situation?
Real Estate Operator Choices
Real estate operator will face various choices (what other choices do you think that the real estate operator take; leave a comment below):
|Choice A||Sell the property, take a loss and make the equity investors whole less the return|
|Choice B||Sell the property, take a loss and pass it onto equity partners according to profit and loss splits|
|Choice C||Refinance the loan with another lender. Rent out the investment waiting for the market to turn before selling the asset. Discuss this option with your equity investor and convince them to work with you.|
|Choice D||Take over the marketing of the asset and try to sell it yourself to save costs and potentially break even.|
Real Estate Operator Dilemma
As real estate investor you may come across a scenario such as one the described in this article. What should you as a real estate operator do?
The hard thing is that there is no real answer to this question. The best answer I can give is that it depends on your lender, equity partner and how sound your investment thesis was at the time you made the investment.
I promised you a solution so I will give a step by step analysis on how to approach your choice selection.
A Tad Bit of Negotiation Education
Negotiation is a process that can be accomplished through a variety of methodologies.
A. Positional Bargaining
Positional bargaining is also known as distributive negotiation. In positional bargaining, each side often adopts an extreme position, knowing that it will not be accepted, and then employs a combination of guile, bluffing, and brinksmanship in order to cede as little as possible before reaching a deal. Distributive bargainers conceive of negotiation as a process of distributing a fixed amount of value. Positional bargaining can also be likened to a model of haggling in the market.
The positional bargaining strategy implies that there is a finite amount of the thing being distributed or divided that creates a win-lose scenario. The win-lose scenario creates the perception that one person’s gain results in another person’s loss. Distributive negotiations typically involve people who have never had a previous interactive relationship, nor are they likely to do so again in the near future.
B. Integrative Bargaining
Integrative bargaining is a set of techniques that attempts to improve the quality and likelihood of negotiated agreement by providing an alternative to traditional positional bargaining techniques. Integrative bargaining is a effective means of negotiating an agreement as it takes into account the fact that no two humans are exactly alike. This understanding that two parties needs and wants are different is what gives integrative bargaining its comparative advantage.
While distributive negotiation assumes there is a fixed amount of value (a “fixed pie”) to be divided between the parties, integrative negotiation often attempts to create value in the course of the negotiation (“expand the pie”). It focuses on the underlying interests of the parties rather than their arbitrary starting positions, approaches negotiation as a shared problem rather than a personalized battle, and insists upon adherence to objective, principled criteria as the basis for agreement. Integrative negotiations often involve creative problem solving that aims to achieve mutual gains. Hence it is also called win-win negotiation.
Negotiation System: Step by Step
My ideal step by step negotiation framework is provided by Roger Fisher in his book Getting to Yes:
The analysis phase of the system involves finding and focusing on the other side’s interest behind the problems. Interests can be boiled down to one or more of five core interests:
Autonomy (Control over one’s life)’
Affiliation (Sense of belonging);
Role (Security); and
After defining the interests it is important to understand and formulate the other side Best Alternative to a Negotiated Agreement (BATNA) in case an agreement is not reached.
The planning phase goal is to develop one’s BATNA and invent options that meet the interests of the other party. The inventing of options can be accomplished in a number of ways:
- Circle Chart
- Joint Loss Aversion brainstorming sessions
Fisher advocates developing one’s BATNA by: Inventing a list of actionable ideas that would happen if no agreement; Selecting one of promising idea and converting them into practical considerations; and Selecting one alternative that seems best and make it better by taking proactive actions on it. This improves your power during a negotiation according to Fisher as a strong BATNA gives you the ability to “not fall in love” with any potential agreement that is weaker than your BATNA.
Fisher advocates establishing an objective standard on what to base your offer upon. It plays to the concept of fairness. Fisher advises the first offer usually anchors the negotiation hence it is important to devise multiple offers that can be utilized to negotiate off or if the other side makes an offer then it is important to immediately counter offer so that the anchoring effect of the first offer is reduced.
Equity Investor Perspective
|Planning||BATNA – Pursue legal methods to take real estate operator to court to state that he or she were misled (Yes this is a reality and can happen).
Take the loss and never invest in real estate again.
|Discussion||Objective Principle – Partnership agreement terms that state profit and loss will be distributed by established percentages.
Real Estate Operator Perspective
|Analysis||Interests – i. Not wanting to take a loss having spent nearly 12 months not getting paid a single dime for all efforts
ii. Not wanting to split the loss given the time and money spent sourcing, managing and now selling the investment.
iii. Maintaining a working relationship with equity partner for future projects
iv. Wanting to finish the issues and close out this investment due to other projects
|Planning –||BATNA – Hire a lawyer to defend against a potential law suit from the equity capital partner
Try to force the equity partner to stick to the partnership agreement of loss
|Discussion||Objective Principle – Partnership agreement that takes into account the fees owed to operator to help offset the loss coverage owed by the operator.
Utilize a fact finding-mediation or a private “judge” to reach a settlement rather than engage in formal litigation.
What is the correct choice?
This is something that I look forward to hearing from you fellow readers.