Summary: This year, we made a lot of big moves in our real estate portfolio. In this two-part post, I reflect on our real estate investments this year and walk you through our decisions. In real estate, as in anything, there will be successes as well as challenges. Both are learning opportunities. That’s why we’ve chosen to share these stories at the end of this busy year. We want to give all of you an opportunity to learn from our experiences so that you can be better investors yourselves!
This is Part 2 of a two-part series. If you haven’t read Part 1 yet, make sure you do that here!
Six-plex in Oklahoma City, OK
Facts: Purchased for $302,500 in July 2018 and sold in Nov 2019 for $355,000
Let me just say this upfront. This property was by far our worst purchase since we started investing together. Fortunately, we walked away from it with a lot of learning!
That being said, I am confident that we could have turned this property around and significantly improved its performance over the years. There were still a number of areas of hidden value that we hadn’t yet tapped. For example, this property was made up of four plots of land, so we could have subdivided it and built on those plots. It was also in an awesome up-and-coming neighborhood with a high walk score, so I do think it would have appreciated. I also believe that rents would have gone up significantly as the neighborhood improved.
Despite this, we decided to sell the property this year. The main reasons were that a) we felt that our money could be working far harder for us in another property rather than this one and b) the property had a lot of repair issues. So, in the end, we decided to sell it at a small loss (after rehab, not taking into account the tax savings from the rehab) and 1031 it into our 32 unit property. Now let’s cover the background of this property.
This six-plex was built in 1905 and consists of a five-unit building and a single-family home. From the start, there were issues with this building. When we bought it, there was water in the basement that was attributed to the sump pump being broken. In the end, this actually ended up being a perpetual problem that required fixing leaking pipes and ended up resulting in a $2,000 water bill with the city (which fortunately they ended up forgiving). There were also issues with the foundation, which had to be repaired by the previous owners prior to sale. At the end of the day, just like with cars, you end up with a lemon. This property was the lemon in our portfolio.
What we learned
The main thing we learned from buying this property is that it’s sometimes best to cut your losses when it looks like you have a lemon on our hands. Rather than stick it out and try to turn around the property, it sometimes makes more sense to cut it loose and get your money working for you on a property that isn’t a lemon. Sometimes cutting a property loose is a harder decision than the decision to buy a property. And in both cases, it’s beneficial to be decisive.
During the buying process, we also learned how difficult it can be to get a small commercial loan. Since this property was a six-plex, we needed a commercial loan, but a really small one since the property was only $305,000. We initially tried to go through several larger banks, but couldn’t find anyone to service the loan. Some of them didn’t even tell us that until fairly late in the process, which meant Kenji filled out paperwork to get loans and multiple banks! In the end, our residential lender ended up helping us get a cash-out refinance on another property to pay for this property. The bright side of this process was that our commercial lender ended up finding a few banks that were willing to service smaller commercial loans for us (and our students) in the future.
Other problems
Another issue we ran into on this building was with our contractor. Our contractor, who was referred to us by our agents, actually ended up going overtime on the project by several months. This cost us significantly in lost rents. Reflecting back on it, even though we built in payment milestones, this wasn’t enough. We should have made him commit to being done on a specific date and then tried to include wording in our contract that stated that if he went beyond that date that we would start to reduce the amount he was paid for the project.
Also, I think we should have cut him loose earlier than we did. He would never commit to a completion date and as a result, kept pushing the finish date back. He would disappear and do other projects. He ended up being the worst contractor we’ve ever worked with, and this is despite the accountability he had with our agents (who referred him a ton of business). We later found out that the agents also fired him from other jobs and no longer use him so the accountability part worked, but to the benefit of future investors!
As I alluded to earlier, every challenge is a learning opportunity. We could let an experience like this one completely derail us from investing. Or, we could see it as an education and move on as better investors. We chose to do the latter.
Learning pearls: Be cautious about buying older buildings. It’s more difficult to get small commercial loans compared to large ones. Make sure your contractor gives you firm dates for every deliverable of a rehab and consider linking compensation to delays. When a deal doesn’t perform the way you thought it would or the property takes more time to deal with than is worthwhile, it may be better to cut your losses and just move your money into a better performing, less time-consuming deal.
Duplex in Arlington, WA
Facts: Purchased for $350,000 in Jul 2015 and sold in December 2019 for $484,000.
We purchased this duplex early on in our investment journey. Over the years, it’s been a great cashflowing property. It has also taught us a few valuable lessons.
What we learned
The first lesson is how important it is to know your numbers and to focus on cashflow. We purchased this property from a real estate agent who had bought it at the height of the market for $378,000 in 2005 and then sold it to us ten years later for almost $20,000 less and credit for a new roof! In fact, when she sold it to us, she wasn’t even cashflowing. So she took a loss at sale and was cashflow neutral to negative for 10 years. It’s a sad example of somebody not knowing what they are doing. And a good reminder to all of us that you must always know your numbers and buy for cashflow, not gamble on appreciation.
A second learning pearl that we gained from purchasing the property was the value of using a high bid for a repair of an item to negotiate down the sales price… and then doing the repair yourself for cheaper. In this case, the roof needed repair. During the due diligence process, we had a bid for the roof repair for $10,000. We offered to do the repair ourselves (saving the seller the time and energy of organizing it herself) for a $10,000 credit at closing. We actually ended up getting the roof repaired for less than $7,000, and that repair was a tax write off for us too (so it probably saved us another $2,000 or so in taxes)! So we made money by doing the repair ourselves rather than having the seller do it. A win/win for both of us.
When we went to sell this property this month (as part of our 1031 exchange into the 32 unit), we also had another valuable lesson reinforced. We priced this property aggressively at $475,000 and actually had seven bids come in. The most important thing to us was to get the property closed by mid-December so we could ensure the 1031 into the 32 unit property. Two of the bids were close, so we asked each lender to write us a letter in order to reassure us that they could close by mid-December. Both lenders wrote us letters explaining why their client was the best option for us. One lender just touted his bank’s history and didn’t address the rapid close, the other lender laid out a clear timeline of when the different steps would happen for a close date of December 16th. Which one did we end up choosing? Of course the lender who committed to closing by mid-December! So, this lender actually got their client the property. I feel bad for the other buyer because their lender wrote such a poor letter!
Learning Pearls: Always know your numbers and don’t gamble on appreciation! Consider doing repairs yourself after negotiating down the price. Your choice of lender can play a huge role in whether you get a deal, so choose wisely! Be sure to think of them as an integral member of your team because they can sometimes be the difference between getting a great deal and losing a deal.
32 Unit in Tacoma, WA
Facts: Soon to close at $3,080,000
This property was presented to us off-market by one of our commercial agents here in Washington. A wholesaler brought him the deal, who I actually had a chance to spend some time with at our inspection last month and who reinforced the first learning pearl. Understanding the seller’s psychology is integral to making a deal work (for a wholesaler, agent, and the buyer).
What we learned
In this case, the seller is in his 80s and drives 4+ hours (8+ hours roundtrip!) to visit his property, which is a huge effort at his age. The wholesaler actually cold-called the seller and was able to form a connection with him by empathizing with him about the effort it took. He was eventually able to convince the seller to sell. He did this so well that I actually heard the seller say versions of “I deserve some time off” and “I can’t keep working so hard” while we were touring the property! This is all to reinforce that understanding what the other side wants can create a win-win situation for both sides.
The second point I want to make here is that both our agent and the wholesaler are getting paid handsomely for bringing this deal to us. And I celebrate this. I understand that this means we’re paying more for the deal, but that’s okay. I want my vendors and agents to do well. Because if they do well, they’re motivated to continue working hard and bring me more great deals in the future. If the numbers work, the numbers work. It doesn’t matter how much the agent or wholesaler is making. And the numbers on this deal really work, especially when you take into account the tax savings and the forced appreciation.
First let’s talk about the tax savings. This property will create a massive paper loss with bonus depreciation. We’re in process of getting the quotes from cost segregation companies regarding how much of a tax write-off we’re going to be able take in 2019 on this property but we estimate we’ll create a $750,000 depreciation loss (which will shelter both our income and the tax from liquidating our 401(k)).
In addition to the tax savings, you also have the forced appreciation. Once we rehab all of the units over the next year and increase rents, we estimate that the property will be worth $4.5 million and we’ll be able to refinance and pull all of our money out in 18 months. How are we going to afford renovating 32 units (soon to be 33 since we’ll be converting a storage room into an additional unit)? Well, one of the great things our agent has done is to find a bank willing to roll the rehab costs into the loan – so we actually get a loan with that money available for the rehab. See, he’s earning his commission!
Hopefully it’s now clear to you why we’re selling all our small properties to buy new, larger properties this year.
Learning Pearls: Understanding seller psychology is an important skill. Pay your team well, because there’s enough for all of you to do well together. Forced appreciation and tax savings are where the real step up in wealth is made (not as much cashflow).
What about your other real-estate activities?
In addition to the moves I’ve covered here, we were involved in one other purchase of a 16 plex in Yakima, WA which we ended up backing out of, a bidding war on a 33 unit in Dallas, TX where we were in best and final… twice, and we had two sales fall through in November: one on a duplex north of Seattle and the other on a single-family home we own in Everett. Both of these will likely be re-listed early next year so they can be used in our next 1031 exchange to purchase a larger complex.
And that’s not even counting the deals we evaluated and decided not to pursue by putting in an offer.
A busy year by any stretch of the imagination!
What does your real estate portfolio year in review look like? Any big learning pearls? Share them in the comments!
Also, don’t forget that registration for our course Zero to Freedom Through Cashflowing Rentals is open until December 15th. If you’re ready to fast-track your journey to financial freedom, follow this link to learn more and register!
