“The best laid-plans of mice and men often go awry.” -Robert Burns
An often quoted maxim usually used to refer to the fact that no matter how well you plan to avoid disaster, it will still find a way to get you. This same idea can be found in Murphy’s law, which basically states, “Anything that can go wrong, will go wrong.” Given enough time, I’ve found this to be true.
Now this isn’t to say that things will always go wrong so it’s all hopeless. It’s more pointing out that if you’re involved in any field at all for a significant period of time, you’ll eventually experience unexpected setbacks, unforeseen problems, or even major catastrophes. Any time you are investing money, you are assuming risk. The wise investor learns to be ok with this fact, and devises strategies to minimize that risk while attempting to maximize returns. So often, the literature written on real estate investing is written from the perspective of maximizing returns. There is so much to write about! The opportunities are nearly limitless to do so. I believe a large reason this is so is because we recently have come out of one of the worst recessions in our countries history and opportunities to buy income property have been ripe for the picking. Naturally there was a lot of interest in acquiring properties and growing wealth. Now that we seem to have climbed out of this hole and prices have risen above pre-bust levels in many parts of the country, it wouldn’t be a bad idea to begin shifting our mindset toward wealth preservation and not just wealth accumulation.
Which brings us to today’s topic!
While I always approve of aggressive tactics when made wisely and researched well, I also believe that in every single deal you need to have multiple exit strategies. Yes.
If it’s a good deal, why do I need multiple exit strategies?
The answer is because it always looks like a good deal, until it doesn’t. Anyone who has been in real estate for any significant period of time can attest to this. So many things can go wrong. For example:
- Your agent neglected to tell you property taxes include special assessments, bonds repayments, or high Mello Roos fees.
- The HOA you bought into has rules that prevent you from doing what you wanted because you didn’t read the documents fully.
- The city won’t issue permits for the plans you intended on using for your reconstruction.
- A large apartment complex is being built nearby and offering amazing new amenities you can’t compete with.
- Your rehab crew gets too busy and can’t get to work on your property in time.
- Unexpected expenses pop up in your life for reasons outside of your control and the money you intended to use to upgrade the property needs to be used for something else.
- Your home inspector missed something big and you don’t have enough in the budget to cover it.
- You misjudged demand in the area and homes are sitting on the market much longer than you thought.
- The upgrades you thought would really push the value up, really didn’t, and now you’re really in the hole, really bad.
- There is rent control you didn’t expect.
- The quality of tenant you get applying is not what you expected.
- You’re in an area that is considered high hazard, and you cannot get insurance to insure the property.
- A huge employer in the area closed it’s doors and tenants cannot pay their rent.
- A great opportunity comes up elsewhere and you need the money from this property to take advantage.
You see what I’m getting at now.
The experienced real estate investor knows this is eventually going to happen and plans accordingly. I’d like to share a few tricks of the trade, as well as some insight into how to think differently to help minimize your risk and avoid major setbacks in your real estate investing journey.
Unexpected expenses contingency.
One of the common mishaps in real estate investing is going over budget on rehabs. This is true for flips, and true for rehabs on rentals. The wise investor knows to allow for at least a 5% contingency buffer in his budget to not get caught unprepared. I’ve found additional costs to be much more likely to happen the bigger the renovation becomes. When you just throw paint and carpet and maybe some new fixtures into a home, there is much less likelihood you will discover unexpected items that need repair than when you are doing major reconstruction. Tearing down walls can reveal asbestos. Moving walls from one area to another can require additional support be added to the roofing system, which can reveal dry rot or shoddy, unsafe work in the roof structure. Pulling out cabinets can reveal water damage from leaky appliances or gas and electrical lines not installed to code. Rebuilding showers can reveal dry rot in the wall or rusted out plumbing. You can see how these issues begin to rise exponentially as more work is done. The wise investor knows that when doing big projects, he/she doesn’t know what they don’t know. Always budget at least 5% extra to be able to afford to do the job right.
Making a flip a rental, or a rental a flip
A common exit strategy when entering into a contract to flip a home is to make sure you can rent it out if the market changes on you and you can’t sell the house for what you need to. Many a flipper has found himself so over budget, or in such a buyers market, that he is forced to rent the home until conditions improve. Same thing goes when someone is a little too optimistic about their after repair value. While it is never ideal to have to rent a house out until conditions improve, it can still be better than losing money. Real estate loans are generally pretty easy to come by, and you can often take out a loan for close to or more than the amount of money you put into a house and rent it out until it appreciates enough to the point it makes sense to sell. The opposite is true for a rental. I’ve bought rentals and improved them through construction work and floor plan changing. Sometimes it doesn’t get any takers for the rent I had hoped I would get, but the home with all the new upgrades is now worth much more than I thought it would be when I first bought it. Selling the home (which would now make it a flip) when I intended to rent it will get me my money back and then some, and I can use this money to now try again on a different property that will get me higher rent. Knowing your options, and having plans in place in case things go wrong can help salvage a deal gone bad and keep you in the game, even when things look bleak.
A little extra meat on the bone
The longer you invest in real estate, the more you start to learn that you want more than just the minimum amount of spread to make a deal work. You want a little extra meat on that bone. Many investors buy a property intending to save money and manage it themselves. They crunch their times and underwrite all the expenses without including property management. While they may be able to make this deal work, they find themselves in a tough spot later on when they’ve acquired several additional properties and no longer want to manage it themselves. The moment they hire a property manager, say bye-bye to cash flow. Don’t make the same mistake. Underwrite your deals planning on using a property manager at whatever the going rate is for property management in your area. While you may make a little more for managing it yourself, this is compensation for your time, and you should expect that.
This principal doesn’t just apply to property management. Making your offers a little (or a lot) better than the highest amount you can possibly make the deal work for is something many investors come to demand. Your resources are finite. You only have so much money, so much time, so much energy, and so many loans you can acquire and manage. While you may be willing to settle for a certain return on your money in the beginning, you may find yourself unhappy with those same returns later. Look for deals that are better than the bare minimum when possible. Don’t be afraid to walk away from a good deal to hold out for a great one. If you are able to get better terms on your loan than you thought, lower property taxes than you planned for, a cheaper purchase price than you thought was possible it can help make up for other parts of the deal that didn’t go as well as you’d planned.
Buying with equity already in the deal
You make your money when you buy. This is one of the most powerful statements in real estate. I never buy a property myself unless I’m acquiring it with equity already built-in. This can come from the purchase price being cheaper than market value, or my ability to change something about the property to make it worth more. It’s best when you can do both. I recently finished rehabbing a 3 bedroom, 2 bathroom house. I was able to convert two living spaces into additional bedrooms. Not only did I increase the square footage of the house, but the house will now be appraised compared to other 5 bedroom houses. Not extra 3 bedroom houses. This is a big deal. In addition to that I was able to purchase the house 20% below market value as it stood because it was a short sale. When these two factors were combined, I was able to add significant equity to the property before I ever made one loan payment.
Why is this important? Well, in addition to increasing your net worth, it also provides a safety net should I need to sell the property sooner than expected. Understand this, every time a property changes hands expenses are accrued. If you’ve never bought or sold a home, you may be shocked to realize how many things both buyers and sellers have to pay for. On the buyer’s side, there are appraisals, inspections, taxes, insurance, mortgage insurance, loan fees, points, and title costs. On the seller’s side there are taxes, real estate agent commissions, advertising fees, cleaning fees, title fees, and so much more. Due to the complicated nature of real estate transactions and the legal requirements in deeding and recording title, there are so many people with their hands in the pot it’s not funny. Your equity can evaporate faster than you ever thought when considering just half of these fees. Were you to buy a house Monday, then sell it for the same price Tuesday, you would lose your shirt after you paid for all these closing costs. Making sure you have equity in the deal the day it closes is absolutely necessary to protect your investment should you be forced to sell it under circumstances different from those you planned.
Creative uses for property
While it can be simple and pretty easy to implement, there are situations that arise where simply turning a flip into a rental won’t make sense. Generally speaking, the more expensive houses become, the less favorable their price to rent ration becomes. There is a reason you don’t hear of many people renting million dollar homes on a regular basis. The amount of rent these homes can generate is often a much smaller percentage than the value of the house compared to lower priced houses. This can come into play when you’re attempting to fix and flip a more expensive house. The numbers may just not work to make it a rental. When this happens, you need to get a little more creative to avoid taking huge losses.
One of the newest and most lucrative investment strategies has been the conversion of properties to vacation rentals. While there is a lot to discuss on this topic, the basic premise is you are renting a property out by the night as opposed to traditional lease periods like a month. By advertising a property in a desirable location for rent by the night, you can increase your monthly returns (often by 2 or 3 times!) greatly. This can be a great option for higher prices homes that are usually in more desirable areas where someone might want to vacation. I’m using this exact exit strategy in a flip I’m doing on an expensive river front property in California right now. Should values drop before the house is ready for sale, I can use sites like www.AirBnB.com or www.VRBO.com to offer the property for rent on a nightly basis. Other properties in the area rent for $400 a night! This can be a viable option should something go wrong with the original plan to fix and sell the house as soon as possible and should not be overlooked.
Protecting your investment
By now I hope you can see that while we should always hope for the best, we still prepare for the worst. Having several ways to exit a deal gone bad (exit strategies) is a must for every deal you enter and I hope I’ve got the wheels turning in your mind for how to come up with some.
Feel like I missed anything? Leave your comments in the thread below regarding exit strategies you’ve utilized and how it worked out.