ARE YOU PREPARED FOR WHAT LIES AHEAD?
Every investment starts with a plan.
But, many investments don’t go exactly as planned. There are hiccups. Such as a house flip that goes over budget, or a property sits on the market a long time. It could be holding costs accruing while a property sits vacant. The pandemic has slowed or stalled many government functions such as permitting and evictions.
How can you be prepared when things don’t go as planned?
Dwight D. Eisenhower is quoted as saying, “Plans are worthless, but planning is everything.”
It is through planning that we anticipate what could happen, then explore contingencies and options.
There is a significant difference between anticipating surprises and worrying about what will happen next. One will help you be prepared for what lies ahead, while the latter will hinder any success.
There are many surprises that we may face as real estate investors.
Some surprises become strategic challenges. For example, if a house that you bought to fix and flip does not sell, what are your options if you decide to keep it? Can you turn it into a rental? Are the local rents high enough to support it as a long-term rental? Is it feasible to hold it as a short-term rental?
What if a bank will not refinance a property due to changing lender or government requirements? Have you ever known an appraisal to come in low?
What if a local government will not let you convert a property’s use, such as from a hotel to apartments? This could be in the form of direct opposition or onerous regulations.
We can also ask what could happen that would decrease the value of my investment?
How could the market change? What would cause it to change? Rising interest rates? Could credit become harder to obtain? What about population decreases? The pandemic has created significant changes in the market, including population shifts from state to state.
What about local zoning restrictions such as a prohibition against short term rentals?
What if a major employer in an area lays off thousands of employees? It is estimated that 10 people are affected for every person laid off. How diverse is the local economy?
Could there be shifts or reductions in government spending? Who remembers the military base closings that started in the 1990s? Many military bases were closed. This shifted jobs away from those communities. It also opened the door for new opportunities. For example, a former air base could be repurposed as a general aviation airport.
Natural disasters such as storms and hurricanes can also disrupt markets.
Other surprises can become operational emergencies.
What do you do when your property manager quits? Or your maintenance person?
How do you handle a sewer line break? Or a sewer backup caused by tenants putting junk down the drain?
How do you respond to a kitchen fire caused by a tenant? What if the fire damaged the unit above the fire?
Any of these surprises can create emergency situations that demand time and resources. How do you mitigate that risk? How much time should be spent planning for such possibilities?
One of the lessons from Warren Buffet is to seek protection of principal first, then seek greater returns.
We can ask what are the greatest and most likely potential threats to our investment? And what can we do about them?
One way that we protect our investment is to define multiple exit strategies for every property before purchasing it.
In the multi-family housing market this can include selling at a future date for cash, refinancing the property and getting our initial investment back, or selling the property with carry-back financing. If vacant land is included there may be the possibility of subdividing and selling a portion of it.
When purchasing a property we use the inspection period to perform due diligence and evaluate any items that could cause the property to produce less net operating income than expected. This is not limited to a physical inspection of the property. It also includes inspecting the financials and looking for discrepancies and opportunities to generate additional revenue or reduce expenses.
What are some other ways we can protect our investment?
When we purchase a property we use attorneys to review the purchase and sale agreement, set up our legal structure and ensure compliance with the Securities and Exchange Commission. There are different attorneys for different functions. We want to seek out the right attorney to have on our team for each function that calls for legal counsel.
One of the most common ways we can protect our investment is through insurance.
There are many types of insurance and coverages. Title insurance is obtained when we purchase a property. Liability, fire, flood, wind and named storm coverage can be obtained to reduce our risks. The list goes on and the deductible can be high for commercial properties.
How can we shift some of the cost of insurance to someone else?
Renter’s insurance is one way. Consider what happens when a resident has a kitchen fire. Repairs from a small fire may cost $2,000 to $5,000 or more even if it is contained within the kitchen. Most residents don’t have enough cash set aside to pay for something like this. And as a landlord you don’t want to risk increasing your premiums with a “small” claim. How do you shift the risk? Require renter’s insurance. Then the resident will have the means to cover the damages.
Maintaining sufficient reserves for repairs and capital improvements is another part of being prepared. Repairs will be needed. Air conditioners will stop working in the summer. Roofs will have to be replaced. Parking lots will have to be resurfaced. Cash reserves enable you to maintain the property in a condition that attracts the best residents.
CAPITALIZE ON THE CHANGES
It would be great if we could not only be prepared to survive market or operational changes, but also thrive in them. How can we take advantage of a situation?
During the pandemic many people were forced to stay home. Some were able to work from home. Zoom became a common tool as people needed to meet but could not do so in person. Zoom grew as a company as many other businesses used it to increase their own efficiencies. These companies turned a tool used for survival into a tool for increasing profits.
Surprises can create opportunity.
Many properties lost significant value between 2006 and 2008. There were many foreclosures and short sales. Some people were able to take advantage of this market and purchased properties at significant discounts.
Not long ago I was invested in a mobile home park where additional lots were being added. Every two lots we added required additional septic tanks along with water and electricity. The additional lot rent increased the value of the park. Over time the market value of all mobile home parks in the area went up. We asked ourselves whether we should continue adding lots as planned or sell the property early, taking advantage of the higher prices in the market and leaving more meat on the bone for the next investor.
Planning is essential for surviving and thriving. We will have “unexpected” market and operational changes. With proper planning these can be anticipated and prepared for so that they do not create emergencies. This is how we can be prepared for lies ahead.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.