How My Due Diligence Saved Me From A Very Costly Investing Mistake

Well folks...adding a 5th rental property to my portfolio was not to be.  If you read My First Seller-Financed Deal, I was on the verge of what I thought to be a profitable investing decision at the time.  I'd analyzed my potential Cash-On-Cash (COC) return based on preliminary numbers, specifically, taking the sellers word for the value of the property (at the time).

What saved me from making a huge investing mistake?

The smartest thing I did during the process of attempting to procure this property was hiring a realtor-investor from the area.  I mentioned having hired a Keller-Williams agent who was local and also happened to invest herself in rental properties.  This was key.  First, she had plenty of connections in town (Little Rock, Arkansas), and she knew the market well.  After both parties signed the purchasing contract, she set us up with Stewart Title.  I made sure to have her add clauses in the contract that would allow me to back out of the deal.  Newbie RE investors...always have an inspection and appraisal clause in your purchasing agreements!  Most realtors do this anyway, but if you're not using a realtor, and are grabbing template purchasing contracts from the Internet, these clauses may not be included.

As my representative, part of my realtor's job was to be present at the inspection (buyer pays for this usually...cost me $250).  I gave her specific instructions: Size this property up for market value using your realtor and investor lens.  A day after the inspection, she offered me her market analysis and it was NO GOOD!  She stated to me that she believed the property to be worth about $60K, and that I could rent it for about $700.  Mind you, the purchasing contract was for a sales price of $75K.  So my realtor was telling me that I was overpaying by $15K!  It was not, however, because the house was in poor or run-down condition.  On the contrary, she found it to have "good bones" and be already in renting shape.  

Normally, realtors renegotiate price for you.  But, because I was the one to have reached out to the seller, and having been the one to establish rapport with him, I decided to email him with a new offer.  I explained to him via email that my realtor had "comped" the property and assessed it to be around $60K.  Of course this made the seller mad.  He'd put in way too much to renovate it, and was trying to recoup his original investment.  I offered him $65K.  He came back with $73K.  I told him I thought his price, based on my realtor's market analysis, was too high, and offered to have the property appraised on my dime.  To my luck, he agreed.  He obviously didn't trust my realtor's home value assessment.  Had he taken my $65K, I would've been underwater on this deal even before closing on it.

My realtor found me a company who appraises properties in the Little Rock area.  The cost to me was $500.  In retrospect, this is perhaps the best $500 I've ever spent.  The appraiser sent the results to my realtor about 6 days later, and the appraised price for the home was shocking: $50K!  I had my realtor share a copy of the entire appraisal report with the seller.  I let him stew on the shock of the results for a day, figuring he would be overly reactive if I gave him a new offer that same day.  The following day I sent him a well-crafted email.

To summarize it, I explained to him that the appraisal was independent, and unbiased.  That the market price of the home was begotten at the peak of our national real estate market, and that I believed a downturn would make it very difficult for the property to appreciate to the point of his current asking price ($73K).  (No way the home would gain $23K in price in 5 year's time, representing the length of our seller-financed term).

I offered him $55K, and claimed that I believed $5K to be a fair premium to pay above market price for a seller-financed deal.  I kept all the other terms the same, namely, $15K down payment, 7.5% rate for years 1-3, and 8.5% for years 4-5, amortized as a 30-year mortgage with balloon payment at the end of year 5.  He came back with a counter offer of $70K and added a new stove to sweeten the deal.  I was like...no way dude.  I explained to him I could not give him $20K above market, and like all proud sellers he disputed the appraisal too!  He believed all of his upgrades to the home were not being rightly considered by the appraiser.

People, let me clue you in on something.  You doing some home improvements doesn't mean you're going to add a dollar spent for dollar appreciation to your home's value.  In fact, your ROI (return on investment) on a kitchen upgrade may be between 60-80% of what you paid.  The average ROI on a bathroom remodel is nationally about 62% of what you paid.  Unfortunately, the seller of this property believed his home was undervalued because his renovations were being underestimated, but that is not how appraisals work.

Sure, appraisers take into consideration how the home looks at the time of the appraisal, but they also look at similar properties that have sold in your area and the price paid for these other comparable homes.  This comparable homes factor is much more important to the appraisal than your kitchen or bathroom upgrades.

The seller and I didn't come to terms so I terminated the deal.  The seller could've asked for all of the EMD (Earnest Money Deposit), namely, $750, but out of courtesy for me giving him a free inspection and appraisal report on his home, he only asked for half of the EMD, $375.  If I were him I would've asked for all of the EMD!

Cost of Doing Business

As a real-estate investor, there will always be costs for doing business.  For this particular NO-DEAL, I spent:

$250 (Home Inspection)

$500 (Home Appraisal)

$375 (EMD to seller)

$300 (Realtor Fee for services rendered)

$75 (Title Company Fee for processing and termination)

Total: $1500

All of it is tax deductible so I'm not trippin'!

Lessons Learned

Next time I communicate with a seller willing to carry, I will make sure it is clear that I will give him/her full asking price if the property appraises at that price.  I will let the seller know that in the event of the property having serious issues (after an inspection) AND also not appraising at sales price, I may decide to either terminate the deal or send him/her another offer for consideration.  I will of course also let the seller know this will be included as a clause in the purchasing contract.

I made the mistake of not letting this seller know I'd reconsider the price after the inspection, and since he was a newbie at seller-financing, he didn't know to expect this.  He didn't have a realtor representing him so he was at a disadvantage doing it alone.  It's a good thing I was tactful and considerate at all time so as not to have a bitter end.

Well, back to the drawing board.  I hope these lessons have helped you on your real estate investing journey!  Until next time.