Not all real estate deals are good. In fact, if you analyzed all of them, the majority would probably be bad real estate deals. And that’s what I’m going to focus on in this post.
I’ve shared insider deal analyses of all of the investment properties that Selenid and I have at this point:
- Insider Look: Deal Analysis of Investment Property #4
- Insider Look: Deal Analysis of Investment Property #3
- Insider Look: Deal Analysis of Investment Property #2
- Insider Look: Deal Analysis of My First Investment Property
But today what I am going to share is a bad real estate deal. It involves a property that Selenid and I were very tempted to buy. But we didn’t. Thankfully.
I think this is just as, if not more, important to share because it demonstrates that everyone, even experienced investors like us, can get distracted by shiny things. Despite all of my advice to follow the numbers and not your heart, I was really keen to get this property.
Until Selenid reminded me of our rules and criteria and that this property was not meeting them. That it was a bad real estate investment despite being an interesting property.
This also serves as a great reminder of the importance of having an accountability partner and being on the same page regarding investing with your actual partner!
So, let’s do a deep dive into this investment property, why I was tempted by it, and what made it a bad real estate deal.
First, a primer…
As always, before going into the investment property deal analysis itself, I’d recommend you read this post on my analysis strategies first if you haven’t already.
But, I’ll give a quick recap as a refresher.
- We invest in multifamily cash flowing rental investment properties using a Buy, Fix, Rent, and Hold model
- To screen investment properties, I use the 1% rule (Monthly rent/Purchase price >/= 1%)
- If it meets criteria, I move forward to more analysis
- If it doesn’t meet criteria, I move on to another property
- To analyze investment properties, I use cash-on-cash return (Annual Net Income/Money Out of Your Pocket >/= 10%)
- If it meets criteria, I lock up the property by placing an offer based on your criteria
- If it doesn’t meet criteria, I move on to another property
- To valuate investment properties, I use NOI (Annual Income not including financing)
- Estimated Sale Price = NOI/X% (based on local market data, usually 8%)
This was a 4 unit residential property being sold by the owner. It was not located in the city of Buffalo but rather in a suburban area not too far from where we live. In fact, the way we found out about the property was from driving by it on my way home from work!
Anyway, we were curious enough to call and schedule a showing with the owner. Walking through, the 4 units were all ranging from 2-3 bedrooms and in pretty good shape. They all needed varying degrees of work but were on the nicer side for sure. All were already occupied on year leases for well below market rent.
If this is all that the property was, I don’t think the temptation for me would have been as high.
What made it more tempting for me was that there was a building behind the 4 units that was included in the sale. As it currently stood, this building was essentially a large open office/storage space. In fact, it was rented out to a restaurant to store their extra equipment.
While the building was bare, there was already electricity, running water, and sewage running to it. A working bathroom was evidence of this all.
Converting this building into another 2 units would be very interesting…
The deal analysis
So, we went home and ran the numbers. Here is the spreadsheet…
For the seasoned readers, you will immediately note an expected cash-on-cash return of 3.9%, well below our goal of at least 10%.
That should have made this an immediate “no” for us.
Regardless, let’s examine how we got to this number…
- The asking price was $500,000. The owner was very clear on our showing that they would not accept lower than this. So, $500k became our starting point
- Down payment and closing costs were standard since we would use traditional financing
- Amount for renovations at this point did not include adding the 2 new units to the back building…this was just to fix up all current units to our standards
- We determined our expected interest rate from a recent property we bought
- We included 5 unites based on the fact that the rear building was rented out
- Property taxes and insurance were based on county data and information from our insurance agent
- You will notice that taxes on this property are much higher than our typical property in the city of Buffalo…one of the big reasons we love investing there
- Monthly gross rents represent the current rents for all units
- Note here that all units were on a year long lease with >6 months remaining
- The remainder of the values are standard for us based on our experience managing our own properties
What were the red flags here making this a bad real estate deal?
I’ll list them out:
- Poor current cash flow (See: 4 Reasons That Cash Flow Is King in Real Estate)
- Inability to increase rent for >6 months due to current leases
- Expected huge expenditures to create additional units
- High taxes that would be re-assessed immediately after purchase and go up further (unlike for properties in the city of Buffalo)
- Dealing directly with an owner on the sale
Yup, that oughta do it…
Except, I still worked to rationalize the property as a good one. But why?
Why was I so tempted by this property?
There were a few main reasons.
For one, I loved the idea of having a property closer to us. So close it was actually on my route to and from work. This minor convenience sadly blinded me to a lot of these red flags.
Second, I became enamored with the idea of adding those two back units. I just thought that would be such a fun project. And it would be.
Except for the fact that the cash flow without those units was already very poor. And constructing new units would cost a lot of out of pocket cash. Even if the new units cash flowed amazingly, the out of pocket costs rose so much that our actual cash on cash return would barely budge…
But the biggest reason that I wanted this property so bad is because it was 4 units
Since Selenid and I bought our first duplex, we have been on the look out for larger properties. We felt we needed to do this in order to “scale.”
However, it has proven difficult to find cash flowing larger multifamily properties in our market.
On the contrary, we have a ton of success with our bread and butter investment property in this market. We have shown that we can get a 2-3 unit property in Buffalo cash flowing not only 10% but much higher.
And this is what finally turned me off to this bad real estate deal
Why were we going to stretch and reach for a property with poor cash flow that was dependent on multiple things all going our way to create adequate future cash flow?
Why wouldn’t we stick with what works? What we had proven we were very good at? Isn’t that also “scaling?”
Was my perceived need to scale a form of “keeping up with the investing Jones’?”
Selenid actually asked me all of these questions. And they were jarring. She was totally right…as usual!
We have a system that works extremely well. In fact, we also went to a showing on a duplex with an expected CoC return of >15% the same weekend that we saw this property.
Why in the world would I pass that up for something so much more risky and not meeting our criteria? It just didn’t make sense.
And, upon reflection, I absolutely was keeping up with the real estate Jones’ who are always boasting bigger and bigger properties. That’s great for them. And I would not turn down an opportunity for the right larger property that did fit our criteria. But I didn’t need to!
Recognizing this, we walked away from this bad real estate deal feeling pretty good that we had learned some important lessons along the way.
And, as I write this, that property remains on the market…
I usually leave some additional resources here…
But for this post, instead I want to really encourage an of you who invest or are considering investing in real estate to read this: The Real Estate Flywheel Effect for Successful Physician Investors
As I allude to above, successful real estate investing (and even stock investing) is not necessarily sexy. But if you create a plan, stick to it, and ignore the outside noise, you will be successful!
That is what the real estate flywheel is all about!
What do you think? Have you invested in bad real estate deals? What tempted you? Any narrow misses like me? Share them in the comments below!