Some of the best real estate investment stories are the cautionary tales. If it happens to you, your main goal is to figure out how to fix it or get out of it with the minimum amount of damage. And the second goal is to figure out what the lesson in it is for you.
If it happens to someone else, and you can learn from it, so much the better. You get the lesson without the pain.
But, boy, you have to feel for the person who is now facing the consequences of a bad investment decision.
Here’s what happened to a client of mine.
Dr. O had some money to invest and he had a big dream. He currently made approximately $25,000 per month, before taxes, and he wanted to replace that income as soon as possible with passive real estate.
He just didn’t see how that was going to work with single family houses that give him a return of maybe $250 per month. That would be 100 houses!
So he bought an apartment building.
He’d never owned real estate, other than his own luxury house. He’d never known anyone who had successfully managed real estate as an investor. He found plenty of people happy to take his money on “great deals.” But he had no way of knowing what to do next and unfortunately, the only people he asked for advice were the guys who wanted to sell him the property. That was the only way they were going to collect the commission.
You don’t need a crystal ball to see where this is heading. He COULD have been extraordinarily lucky and bought a winner by mistake, but he didn’t.
As I tried to unwind what went wrong as he was looking at repossession of his sports car and a quick sale of his house, at a loss, to avoid foreclosure, the whole story came out.
The cash flow looked great, when he was the projections. The problem was just that. They were “projections” and were based on what the seller said the rent SHOULD be. When I hear that, I am always extremely skeptical. If the seller is telling me the rent is too low, my first question is “Why doesn’t he or she raise it then?”
He never saw actual numbers for what the income on the property was. I always require both financial statements and then at some point in the due diligence process, I want to see a tax return and see what they reported. It’s possible they simply lied on the tax return. (In which case, I have learned they have no compunction lying to a government agency with possible criminal charges hanging in the balance.) What would stop them from lying to me now?
Usually, I do hear some concern from the owner because they take deductions for indirect expenses such as a computer, vehicle mileage, cell phone, home office and the like. No problem. Expensing indirect expenses like that, those not directly tied to the operation of the property are expected.
My issue is when the gross rent received is dramatically different than what they said it was. That means the rents aren’t at the level you expected and/or they have a lot more issue with vacancy than you expect.
In the case of Dr. O, we had to figure out what to do with this property. Was there a way to turn it around so that he would at least break even? And for his house and cars, the goal I had was to save his credit at all costs. If that meant taking a loss on some things, try to make the losses deductible against your income.
Strategy: Walk before you run. If you want to jump in quickly, make sure you have trusted, independent advisors who can help you with the due diligence. I can’t stress the “independence” part of this enough. If you rely on a sales person who is paid a commission or a seller who wants a sale to help you decide, they are biased right from the start. Of course, there are plenty of good people with ethics, but you just need a couple of need a sale more than a good conscience to put you in the poor house fast.
If we can help, give us a call. Richard is at 888-592-4769. We are a full service CPA tax firm, focused primarily on helping business owners and real estate investors understand their numbers and put legal tax strategies in place. Make more money, build wealth and pay less tax. That’s how to prepare for your future.