The COVID-19 has either postponed or canceled many of the things we take for granted. Basketball and hockey games. Sunday mass. Birthday parties, Friday nights at the brewpub, and all but the most necessary travel.
And then there’s the cessation of so many business activities. From large meat packing plants to the neighborhood boutique, business of all shapes and sizes are shuttered for an indefinite period of time.
Entrepreneurs and real estate investors are feeling the squeeze, too. Today’s guest author, who blogs at Financial Wolves, was planning to become the proud owner of a triplex. Like so many other plans recently made, those plans fell through.
Personally, I think he may have dodged a bullet. He also learned a number of lessons from the deal gone wrong that he shares with us today.
A Real Estate Transaction Gone Wrong – Lessons Learned During A COVID Rental Transaction
Transacting with real estate should be generally straightforward… So I thought.
Unless you deal with an unprecedented pandemic and a nasty seller. Then, things can get messy quickly. That’s okay though because real estate is like a river. If one doesn’t work out, another one will float down the stream.
What Went Wrong?
Recently, I was under contract to buy a triplex in Minneapolis. I signed the purchase agreement in late-February before any of us knew how impactful the COVID-19 could be. At least coming from a person with limited-to-no medical background or experience.
Anyway, signing a purchase agreement for a triplex during a global pandemic is a great learning experience. Especially when you are dealing with a high maintenance and difficult seller. From signing to target closing, we went from having no cases of COVID-19 in Minnesota to a full shelter-in-place. The timing couldn’t have been any worse.
I asked repeatedly to extend closing due to COVID-19 since my wife was tested for it and the variety of changing elements around us. The seller’s “attorney” threatened suit and played the scare tactic game that I’d be in breach of the contract.
In the world of private investing, it’s usually seller and buyer working things out. Attorneys only get involved when absolutely needed or when legal agreements need to be clarified or improved.
Note: I was unrepresented so I had to go out and find someone after getting cornered by an “attorney” (I’ll get to it later). The seller was never involved in the process at all.
Ultimately, the seller did not close the transaction and I ended up learning more from this experience than I would have if the deal did ultimately close. I’ll leave the details to a minimum because I’m not here to vent. I’d rather give lessons learned.
Just because one transaction went wrong doesn’t mean I should close shop on my thesis that real estate is a great asset class to build wealth. I’m here to provide learning tips to potentially improve your perspective on acquiring assets during difficult global macro environments and/or difficult sellers.
5 Things I Learned From a Real Estate Transaction Gone Wrong
Here are some things to avoid on your next real estate transaction to avoid a disastrous situation as I went through.
Be Conservative on Any Purchase
Okay, global pandemics do not happen every single week. But, recessions, layoffs, natural disasters and so much more happen over time. Real estate is a great asset class because it offers pretty attractive risk-adjusted returns.
There’s also a ton of ways for you to develop an investment strategy such as fix and flip, affordable housing, capital appreciation, cash flow only, etc.
However, the moment you get beyond your skis is the moment you can lose your entire balance.
Things do come up and if you are buying a home without having 6 months of reserves, you probably shouldn’t do it. The best part about real estate investing is that each asset acquisition can serve as a base that unlocks additional financial flexibility for you in the future.
You can use a HELOC on a rental property to finance other repairs while you also have reserves. To be clear, I’m not saying use as much leverage as possible and none of your own cash.
I’m saying you can hold cash reserves while using other levers to finance higher returns on your capital. You get a number of low-cost options to use other people’s money to make money.
Use Financial Analysis (And Continually Update It)
My wife continues to tell me that I’m too obsessed with my spreadsheets. It’s probably a bit true. Even if you are buying a home for primary use, you should understand the financials and potential returns on your investment.
For rental properties, it’s even more important. I created a free rental property spreadsheet in Excel that will help you conduct scenario analysis. I built in a COVD-19 scenario into my financial model and it actually showed that I would breakeven on my investment. We don’t invest to break even, of course.
But the model had extreme vacancy rate assumptions (15%), declining rents, and increasing costs. It simply couldn’t get much worse from an assumption standpoint of what I could personally control.
From a downside perspective, that wasn’t too bad. The upside was pretty favorable on the other end.
Know Your Seller
During this transaction, the seller painted a picture that (s)he owned $100 million worth of real estate assets. Turns out this was incredibly false. I only met the seller once and it was at closing. The seller didn’t even come inside closing and only allowed his attorney to be involved.
After doing some homework on his “attorney” and himself, it turns out they are roommates. They also once lived together in the triplex that I was contemplating purchasing.
Whoa. Probably not the first time that has happened in the world, but that is a huge red flag. The “seller” (what I would call likely the attorney and the actual owner together) really only owned 2 properties.
The property I was purchasing was completely paid off, which suggests they had a significant part of their net worth tied into it.
Seller due diligence is crucial. It should be conducted upfront because as you know more, your negotiating skills strengthen and you can understand what type of situation you are getting into. You can do so by looking up the property owner in advance of putting in an offer.
Find a Lender that is Aligned With You (Even If It Costs More)
The mortgage loan market continues to baffle me. In the professional investing world for private equity and private transactions, lenders usually align with other sources of capital to get a deal done.
Why? Everyone is going into the same deal no matter what. If a lender is senior to you, they should have even more comfort about the transaction than you. As an equity holder, you are taking on more risk. But lenders should view the deal with more scrutiny.
In the mortgage market, it doesn’t always work that way. FHA lenders will usually use the government as a backing to their criteria. Additionally, mortgage lenders will securitize your loan and profit. They are not the residual holding of your interest.
So how much do lenders really care about the property? I like a local lender that will view the property exactly the same way as you. You should feel like they are in the same deal as you. Because they are.
Start there and if it means that it costs you more that’s okay. The mistake I made was working with a lender that didn’t even live in my state. They had no concerns about my personal financial situation in light of COVID-19 because they simply couldn’t lose.
The lender had no interest in going to bat for me to ensure we were entering the deal with the same level of comfort.
Coordinate Between Inspection, Appraisal and Your Realtor
Just a quick note — like your lender, you should also have a very trustworthy realtor that will go to bat for you. Lenders and realtors are incentivized by reaching the finish line. Inspectors and appraisers just earn a flat fee for providing their opinion and review.
When you are working on a deal, find the toughest inspector you know. Again with the cost, I’d rather pay more for an intense review than be cheap and miss a massive issue. The moment you discover issues like code violations, miscounted bedrooms, a potential recurring issue, etc., you should coordinate it with your lender so the appraiser is aware during their valuation.
The bedroom count trick is one that way too many people get away with in selling properties. There are a ton of non-conforming bedrooms out there that, by law, are not compliant.
Finally, if you need to hire an outside appraiser not associated with the lender, go for it! It’s a small cost for a relatively large opportunity cost. Appraisals can cost $500-$600, so it’s a fraction of a single percent of the overall purchase price.
As issues come up, stay transparent with the team you’ve assembled. Everyone should act accordingly as a team to get the results that make the most sense for you.
Don’t let investing stress you out no matter the situation. At the end of the day, it’s only money. Our health and mental wellbeing should come first. Some might say they go hand in hand.
But if you don’t care about money too much, you might not let it get to you if it doesn’t go according to plan. Real estate remains an attractive way to build wealth due to the reasons I outlined above. These are a number of factors that we can personally control. Investing in companies on a minority basis doesn’t afford the same luxuries.
The same goes for real estate crowdfunding. You’ll likely end up solely evaluating the condition of the market. You may not have the full control to dictate rents, cost improvements, management fees, etc… I’m still a fan of real estate crowdfunding to diversify but perhaps taking a shot at direct real estate investing can open the door to financial autonomy that opens doors to new financial chapters of your life.
Having control over your own destiny is limited commodity in investing. A global pandemic of this magnitude only comes once every 100 years (let’s hope), so there are a ton of life long lessons that we can use to make better decisions as investors.
Author Bio: Financial Wolves is a blog focused on helping you make more money to achieve financial freedom. After repaying student loans, I’ve shifted my focus to make more money from side hustles, real estate, freelancing, and the online economy. Follow me on Pinterest, YouTube, Twitter, and Facebook.