Today I'm giving the stage to Alexis Craig – a recent acquaintance who put together a great article for the REtipster Blog about how to get OUT of a bad deal.
This is a subject that isn't discussed very often on real estate blogs, because most real estate investors don't like to talk about their failures. We all love to tout the best deals we've ever done, which is great for learning what to do, but this leaves a sizable information gap for those who need advice about what NOT to do.
Right-sizing a bad investment decision is something most of us have either dealt with at some point, or we'll have to deal with at some point in the future – so in an effort to address this topic, I hope you'll check out these great insights on how to handle this dilemma when it comes up…
Fear cripples us. The single largest barrier for getting started in real estate investing is the fear of losing money because of a bad deal.
For many people, the fear of losing money FAR outweighs the potential for gains. Some of us would rather avoid losing $1 than making $5, so we sit out of the game. You can’t lose money if you never make a deal, right?
You tell yourself:
“I have tried. All of the sellers in my market are asking WAY too much. And nobody seems to be motivated to sell.”
“I will get started as soon as things slow down at work. I’m just waiting for a better time.”
“I’m just watching the market right now. I will jump in when I understand the market conditions.”
We ride the bench like a waterboy, convincing ourselves we will get in the game eventually. You read another blog article thinking this will be the article that makes everything click. The cosmos will be on your side and the stars will align. You've finally found the magic bullet.
The truth is – there is no magic bullet. There is no strategy that will instantly make you successful in real estate without any risk. If there was, everyone would be driving around in Ferraris.
No matter your strategy, you’re likely to make some mistakes. It may not be on your first deal – but you will make a few bad deals. That’s why I love investing in land. Even if you make a bad deal, your potential for loss is minimized because there aren’t the typical holding costs in rehabbing.
You can still lose money in land investing if you’re not careful. You might mistakenly buy a property that is used as a makeshift landfill or accidentally buy a property that doesn’t have any legal access.
Instead of being crippled by this fear of losing money, I’m going to share with you how you can get out of any bad deal so that you can save yourself from loss.
The Math of a Poor Exit Strategy
Why do you think so few investors talk about their losses?
We hear hundreds of success stories that make real estate investing sound so easy. I have probably logged 50 hours of watching late night infomercial where they told a story about the single mom of three kids, whose husband just left her, and she invested in real estate. Now, she spends most of her day with her kids. We never hear about how they lost $20,000 on a deal.
Luckily, I have had the privilege of hearing these. At the last real estate investing conference I attended, I met a guy who was investing in real estate full-time with his girlfriend. It took him four years to get to this point. He also let me know that he lost an accumulated $135,000 in his first two years. My mouth dropped when I heard that number.
He let me in on a secret. That’s what I want to share with you. It's a secret that almost every successful real estate agent knows, but rarely talks about.
He didn’t have to lose $135,000. He estimated that if he knew what I’m about to share, he would have only lost $25,000 and would have been able to transition into full-time real estate in his second year.
So, what’s the big secret? Calculating the math of an exit strategy on a bad deal.
All successful real estate investors know how to analyze a deal at any point in the transaction, evaluate potential losses and gains, and make logical decisions based on the outcome.
Let’s look at an example of a deal — one with a poor exit strategy and another one with a good exit strategy. For both, assume an investor acquired a rental unit for $100,000 and is now losing $225 per month with a 12 month lease on the unit.
- Poor Exit Strategy: Stay awake all night and worry about the negative cash flow of $225 per month. Hold on to the home and don’t do anything to correct the situation.
- Good Exit Strategy: Realizing that the potential loss is $2,700 per year. Create a strategy for minimizing loss. For example, pay the tenant $1,000 to move out after three months. Get profitable tenants to move in or sell the rental home. The realized loss is only $1,675 ($225 x 3 + $1,000).
Poor exit strategies will cost you a lot of money. This was a simple example and didn’t even calculate the costs of holding on to an investment property in a declining market.
Great real estate investors know when they are in a bad deal and get out as fast as they can, but too many investors like to hold onto their properties and hope for a miracle. Rather than sticking to hard numbers and facts, they would rather cling to unsubstantiated hope.
That kind of thinking will get you knocked around like an opponent backed into a corner by George Foreman. Someone isn’t going to come in with a bag of money to save you. It’s not going to get better. Sometimes you have to cut your losses.
You have to be like Aron Ralston in the movie 127 hours. If you’re trapped by a boulder, you need to make a decision. Is it going to be your arm or your life?
You need to have this same mentality in real estate investing. You can’t wish for the boulder to move or some miracle to happen. You have to decide how much you’re willing to lose on a bad deal, and seriously evaluate which options make the most sense over the long term.
Learning to exit a bad deal will allow you to minimize your loss, lick your wounds and get back into the game.
Most of us know this, but in the middle of a deal we get too emotional. Fear creeps back in and starts taking control. Since we’re so afraid to lose money, we refuse to exit a deal. I’m not going to sugar coat it. It’s hard to accept a loss.
That’s why your exit strategy needs to be a system that is built before you ever enter a deal and is executed by someone else on your behalf once you realize you’re in a bad deal.
How to Get Out of a Bad Deal
I had to learn the hard way about the danger of emotions in business decisions.
Before I ever got started in real estate, I tried making money from trading options on the stock market (which is similar to wholesaling). You don’t actually buy or sell the stock, you buy the option to buy or sell the stock.
In my first two weeks, I made a few hundred dollars. Then, it took a turn for the worse. After everything was over, I lost about $6,000, or about 20% of my net worth at that time. I lost all of this money because I was too emotional.
I didn’t have any exit strategy. If I had, I could have minimized my losses to something like $1,000. Instead, my strategy was invest and pray. I hated to lose that much money, but I learned a very valuable lesson in the process.
Investors should use a strategy for minimizing loss. When a deal hits a certain loss, they should understand how to exit the deal automatically and immediately, and the best time to create this loss limit is at the same time they are entering the deal.
I have taken this strategy and have applied it to real estate investing. I call this my “offload-loss strategy”. Before entering any deal, I create a strategy for improving a bad deal as quickly as possible, and the wheels go in motion the moment I hit the maximum amount of money I'm willing to lose.
The Offload-Loss Strategy
To implement an offload-loss strategy, you first need to determine how much money you’re willing to lose on a given deal. You can set your limit by determining the size of the deal, the probability of the deal resulting in a favorable outcome, and your risk tolerance.
For example, a large rehab deal that you don’t feel favorably about might have a loss limit of $25,000, but a wholesale deal that you don’t feel comfortable with may have a limit of $1,500 — this should be your maximum EMD (earnest money deposit) on a deal.
“How much can I lose and still sleep peacefully at night,”
…will help you determine your tolerance for risk.
How much you’re willing to lose is a matter of preference. I’ve found that a good minimum number to start with is a limit of 10% to 15% of your investment cost. Meaning, if you invested $60,000, you have to be willing to lose at least $6,000. Once you hit that number, you execute your strategy and exit the deal.
This rule can be used as a benchmark for the investments you should be making. If you’re only willing to lose $1,000 on a deal, then you won’t want to invest in a project that costs more than $10,000, because most deals will require that you’re willing to lose at least 10%.
Since you can only invest in project smaller than $10,000, it leaves you with an option that requires a much smaller amount of capital, like investing in land.
Now, the 10% to 15% is just a minimum requirement. On smaller investments, you might be willing to lose much more. For example, since the cost of land is much cheaper, you might be willing to lose up to 50% of your investment. As I said, it’s really a matter of preference.
Once you’ve set your limit for loss, you will need to create a plan for measuring your loss or profit along the way. On long-term deals, you can do this every month. On time-sensitive deals, like rehabbing, you need to calculate this weekly.
For some investments, it may be a simple calculation. For other deals, you’re going to have to make loss projections and account for the time to offload your investment.
Let’s take a look at a Rehab example:
Projected Selling Price: $142,500
– Purchase Price: $75,000
– Holding Costs: $3,500/month with five months to sale.
– Selling Costs: $8,000
– Repair Costs: $20,000
Profit Margin: $22,000
You set a loss limit of 15% on this deal. Since exiting will cost about 5% (realtor commissions and closing costs), you can only afford to lose 10%, or $7,500, of your investment costs.
A month into the project, let's say you learn your repairs are going to cost an additional $10,000 and it will take another three months to sell the home, which will bring your holding costs to $10,500. The deal is only profitable by $1,500 at this point.
Three months in, you realize the comps your agent pulled to estimate the ARV were way off, and the house will only sell for $132,500. At this point, you have a projected loss of $8,500 if you complete this project.
It’s time to exit. Most people would try to salvage the deal, but it’s not worth it. It’s time to exit and try to minimize the loss. Start looking for another real estate investor to buy the property from you. As long as you don’t lose more than $8,500, you come out ahead.
Since this is the part where most investor’s emotions take over, you need to have someone who will implement your offload-loss strategy for you.
The best way to do this is to find someone who isn’t financially or emotionally involved in the deal. Real estate agents can be great for holding you accountable if you find one who understands the investment aspect of the deal. Another great option is a coach or mentor.
As soon as you hit your loss limit, someone should begin implementing your strategy for exiting the deal. It can be you, as long as your judgment isn't clouded by your emotions.
You can’t afford to make emotional decisions – you have to focus on the numbers. The numbers never lie. Be honest with yourself. We want to make data-driven decisions, not emotion-driven decisions.
Now comes the hardest part. Talking yourself out of a deal.
Negotiating Your Exit
A big part of being successful in real estate investing is your negotiation skills. You have to be able to successfully negotiate an offer on a property, and you have to be able to successfully negotiate yourself out of a bad deal.
When exiting, your goal is to minimize your losses as much as possible – meaning, you want to sell your investment for as much as possible while paying as little as possible. You want to pay realtors a lower commission, get tenants to move out for free, or get investors to pay more for your property.
It’s important to understand that when you’re losing money on a deal and need to exit, you have effectively become a motivated seller. You are now negotiating from a weaker position and people will try to capitalize on this just like you did.
With that said – it is possible to negotiate a successful outcome.
I have friends who live in San Francisco, one of the most expensive housing and rental markets. They started renting a home in 2014.
About six months into their lease, the owner went to my friends and told them he was losing money. He projected in the next six months, he would lose $4,000.
So, he offered to pay them $3,000 to move out of the home. My friends agreed and found a new place to live. The owner was able to minimize his loss and my friends got two months of rent for free. Now granted, my friends didn’t have to accept this – so it's important to recognize that some people will be willing to work with you, and others won’t.
What Negotiation Looks Like
One place you can save money is by negotiating with an agent. Here is a script that could save you thousands:
You: “Everything looks good. I’d like to work with you, but about your commission… I understand you need to make money, but I’d like you to lower your rate.”
You: “It’s a bit too high for me, so I’d like you to lower it.”
(Never ask, “Can you lower your commission?” You have to end your sentences with strength. At this point, you have a good chance of the agent lowering the commission. Most want the work. In case you have a tough agent, follow the rest of this.)
Agent: “I don’t lower my commission. I’m sorry.”
You: “No worries. I’m an investor and do have access to other investors who do multiple deals a year and are looking for agents. I’d hate not to be able to refer you. What can you do to lower your commission?”
Agent: “Okay, I can do it this time as long as you refer me to some other investors.”
Count Your Losses as Tuition
There will be times when your attempted negotiations won’t work. At this point, you have to count the money you lost as tuition. It’s just the learning curve. No matter how many blog articles you read or courses you take, at some point you’re likely to enter a bad deal. It’s just reality. But this doesn’t necessarily mean you've failed as an investor.
That’s why it’s important to have an exit plan available to act on, but more importantly – it's important that you buy right in the first place. For example, in the land investing business, you should look at acquiring land for 10%, 20%, or 30%. To some it may sound unbelievable, but if you're following the right marketing strategy as a land investor, you'll find that these kinds of deals happen all the time.
The 70% rule just doesn’t provide enough cushion, especially when you’re new to the business. People have lost their shirt by following this model. It may be a suitable approach when you have more experience, because the 70% rule typically requires that almost everything to fall into place perfectly – which isn't likely to happen on your first time through the process.
If you find yourself in a bad deal because you bought wrong, you have to find a way to exit the deal. You should create an offload-loss strategy once your offer is accepted. Determine how much you’re willing to lose and a strategy for exiting the deal once you hit that limit.
Alexis Craig, along with her Lansing real estate team, is setting out to establish a new standard in the real estate industry. She is published all over the web. Her content has been seen by millions of investors, homeowners, homebuyers, and real estate agents. You can learn more at Mocha Homes.