Your First Deal
Getting Started in Real Estate 4/5
You can write dozens of offers, go under contract multiple times, yet never close on a deal. Why? Is it just bad luck that there is always some deal breaking issue? Possibly. But you might want to reflect and ask if you are unconsciously sabotaging yourself. Rather than talking about the process of closing on a property, I want to talk about the investing mindset and pushing deals through to the finish line.
The investor mindset
The mindset you approach each and every deal with is crucial to your success. How much do you trust your numbers? How much do you trust your team? How good are you at navigating a deal when things go belly up?
Almost no deal lines up perfectly with your pro forma after completion. There are plenty of places where things can and will go wrong. Even before you close, your numbers can quickly start falling apart. Your inspection can turn up unexpected costs or the general contractor you've been talking to is unavailable and you need to find someone more expensive. Maybe your property manager thinks the scope of work needs additional items to hit the expected rents. What is the right mindset to adapt and successfully close?
If Kat and I had an investing phrase, it would be "if the numbers work." On the surface, it sounds like a no brainer. When you find your returns slipping and the deal failing your criteria in some way, how do you make the "go" or "no go" decision?
When I was getting started, I was afraid of buying a bad deal. I ran the deal numbers very conservatively and was not willing to explore adjusting the numbers to reflect a higher risk tolerance. If the deal no longer hit my rigid numbers, it wasn't a deal for me. I provide an example with numbers below of a deal I passed on. With experience, I can reflect and say that my problem was not understanding my numbers and the amount of risk (or lack thereof) that I had built into the deal.
Understand how your numbers work
I don't mean understand what cash-on-cash means or ROI or how much money you're spending. Understanding your numbers does not mean necessarily understand your criteria. It means knowing how each number affects the "go" and "no go" decision and what is "deal critical" versus "nice to have."
I imagine running my numbers akin to turning various knobs. Pushing the rents up $50 can boost the cash flow just enough to hit the minimum of what we're looking for. Is that $50 increase realistic looking at comps? Perhaps. On the other hand, what numbers are unrealistic to try to control? There's no point stressing over the rate or the exact amount to set aside for maintenance and capex (There's some discussion to be had over what to set aside but most people find a value and stick with it). In addition to all this, adjusting one number can in turn cause your other numbers to change. A classic example would be doing flip vs rental grade finishes. This changes your ARV, rents, and a whole host of other numbers.
Here's a good exercise. For each number that you can adjust, take the time to do the following steps
- Would adjusting this number change your decision to buy or not buy? To what degree is the deal more or less appealing?
- How much control do you have over this number?
- You probably don't have great control over the average vacancy or current trending mortgage rates but you can control rents and rehab scopes.
- How are you determining this number?
- For example, some budget the maintenance and capex at 5% rent a piece. Does this number make sense?
- How does adjusting this number impact your other numbers?
- For example, larger rehabs can mean more things are replaced. This can translate to reduced maintenance overhead and capex reserves for the first few years. Additionally, a recent rehab can improve rentability.
- What numbers and adjustments are "no fly" zones? What should you never adjust past a certain point?
- This is important, make sure that you clearly define your "no gos" and don't compromise on them. These "no gos" should be based on rational decisions and research.
- At what point will adjusting the numbers be taking on too much additional risk?
The goal of this exercise is to start thinking about your criteria and numbers as a series of knobs that can be adjusted in various directions to achieve the same result - getting the numbers to work and closing the deal. At the same time, the more you fiddle with the numbers, the closer you get to the line that separates a deal and a disaster. If you understand your numbers, you'll not only run deals faster but also be more creative and capable of closing them.
How risk-averse are you
Your risk tolerance will play a big role in determining your cut-off point that separates an ok deal from a "no go". This varies from person to person and will change with experience. By adjusting your numbers to make the deal work, you're trimming fat off the deal and adding potential risks. Unfortunately, this is often necessary to get a deal to the closing table.
When we were starting, we adjusted our numbers less and therefore ended up building larger returns into those deals. These deals had less risk but were also much more difficult to acquire. In doing so, we passed on dozens of solid deals that would have worked. As we've gotten more experienced, we are more confident in our process and numbers and are willing to take on more risk. This is our current investing mindset but find something that works for yourself.
My "first" deal (but not really)
My first deal we got under contract would be a great example of hindsight being twenty twenty and what happens when you're too conservative with your numbers. 2428 Sickle Rd, I still think occassionally about this one.
This was a 3/1 tri-level with potential to turn it into a 4/2. On paper, it looked like an amazing deal. It was in a great rental neighborhood, minimal crime, and more importantly a perfect BRRRR. The only downside was the relatively poor cash flow due to having a suboptimal rent to price.
| Initial Pro Forma | Amount | Final | |
|---|---|---|---|
| Purchase | $55k | Cash flow | $72/mo |
| Rehab | $25k | Left in deal | +$2k in pocket |
| ARV | $115k | Cash on cash | inf. |
| Rent | $1050 |
Given this was our first deal, we had three contractors bid on the price. None of the numbers were close to $25k. We got two $33k bids and one $55k. The first hurdle, this was not a concern as the deal still hit our 12% minimum cash-on-cash.
| Post SOW | Amount | Final | |
|---|---|---|---|
| Purchase | $55k | Cash flow | $72/mo |
| Rehab | $33k | Left in deal | ($6k) |
| ARV | $115k | Cash on cash | 15% |
| Rent | $1050 |
Here's where things started to get fuzzy. Our sewer scope report came back with a huge hole in the line. The cheapest quote to replace the line was $10k. This made our return look significantly worse because we were leaving more money in the deal and the property didn't have great cash flow.
| Post Sewer Scope | Amount | Final | |
|---|---|---|---|
| Purchase | $55k | Cash flow | $72/mo |
| Rehab | $43k | Left in deal | ($16k) |
| ARV | $115k | Cash on cash | 5.5% |
| Rent | $1050 |
We did the standard back and forth with the seller, asking them to cover the $10k unexpected cost of the sewer line repair. They offered to meet us halfway at $5k concessions which put the deal as follows.
| Closing Table | Amount | Final | |
|---|---|---|---|
| Purchase | $55k | Cash flow | $72/mo |
| Rehab | $38k | Left in deal | ($11k) |
| ARV | $115k | Cash on cash | 8% |
| Rent | $1050 |
If you put this deal in front of me today, it's a done deal. There are so many places to push the return that I was too risk-averse to consider. Here are a few of my options:
- Adjust the rent: Pushed the rent to $1100 for a 12% return or $1150 for a 15% return. Even if the rent could not be pushed this year, we would have the opportunity to increase it down the line.
- Adjust the taxes: Marion County taxes non owner occupied homes at 2% tax assessed value. Because of this, we were running our tax amount at 2% of $115k because we were concerned about the worst case. The assessed value was $80k. Realistically even with a 10% increase, we would be nowhere near the $115k taxable amount. Using 2% of a more modest $90k assessed value would have yielded 13% returns.
- Adjust the ARV: This one is somewhat out of your hands but still a valid case to consider. When you're doing such a large rehab, you can afford to be more aggressive with your comps. The home will show better and the newer finishes will be reflected on the appraisal report. While increasing the ARV to $120k actually lowers the return slightly (7.7%), does it really matter when you are only leaving $7k in the deal? You've gained the 25% forced equity, equivalent to $30k.
Starting out, I was afraid of buying a bad deal. I was constantly looking for a home run and making mountains out of molehills as a result. I scrutinized every problem and did not understand my risk tolerance or how to adjust the numbers. In reality, pushing the rents or adjusting the taxes would not add a significant amount of risk. Rather, I had built far too much safety into the deal, even for someone who is very risk-averse. I didn't truly understand how recent rehabs may influence rents or vacancy. Instead of having the mindset of making the numbers work, I had the mindset of not buying a bad deal. As they say, hindsight is 20/20.
The importance of the first deal
Not every deal needs to be a home run and the majority of your deals won't be. It's a huge milestone to close on your first deal and get to first base. This is especially crucial when it's your first deal because it signals to your team that you are serious about investing in that market. Not only that, it opens up the path to testing the rest of your team and processes. Up until then, the only truly tested member of your team will be your agent.
Conclusion
Get into the mindset of doing what needs to be done to close on your first deal. Understand your numbers and learn what knobs you can and can't turn. When you do walk away, reflect on what made you walk away. Be aware of when something is a deal breaker because you can't take on more risk versus when you're looking for reasons the deal won't work. If you're approaching deals with the mindset of making them work and you understand your numbers, you'll be more creative and find that the "mediocre" deals look a lot more attractive.
Homework
For every deal we closed on, we wrote offers for a dozen and analyzed countless more. When the opportunity does come around, make sure you are prepared to act quickly. Understand your numbers and what makes a deal "go" or "no go."
- Review your numbers. See the section "Understand how your numbers work" above.
- Run deals every day. Set up Redfin and Zillow alerts. Have your agent put you on an MLS search. Get familiar with the neighborhoods and make running numbers a habit.
- Start writing offers. If you're not writing offers, there's no chance you're making it to the closing table.
A word about turnkeys -- Despite the negative associations investors have with turnkey companies we personally know investors who got started buying a turnkey property. In a way, it makes a lot of sense. Getting started, there are so many variables to consider that it can get overwhelming. Turnkey properties allow you to reduce that and focus on building a solid relationship with two key members of your core team, your agent and property manager. They serve as a halfway point where you can stabilize and better understand the market before fully diving in.
As always, if you have comments, questions or want to chat, reach out using the links in the footer. If you enjoyed this content and want to get notified when we publish a new post, use the mail list form below to subscribe.