Finding Diamonds -or- Why Do Those Idiots Buy These Bad Deals?

Seriously, how come I evaluate a bunch of deals like I’m supposed to and never find one that even remotely works, but then I see it get bought up later at some price way higher than I would be able to pay? Are there that many idiots around here?

Of course there are that many idiots, but you are not one of them, and those guys buying those properties are probably not, either. They are just investing differently from you. And probably are at a different time in their investment career. It’s frustrating.

When you are starting out you have this terrible need to just buy something coupled with this equally terrible lack of finances. You see big buildings going up all around you in this high flying real estate market and want to be part of it. You might even have a glimpse of the 6 figure profits that these people are making on their deals. Even one of those would set you up for a year! How are they finding those deals? Seriously.

Keep in mind that you are just starting out. Even though you are a high performer, you have a large cash flow but you have a small capital problem. Meaning you don’t have a lot of cash money. It may be tied up in that big house, land, horses, boats, cars, or whatever. Airplanes? Maybe those too if you are crazy. I know a physician who has a long term lease on a hangar at the local airport. He has built an aircraft from parts. Parts. I envy him for his singular focus, but not for his spending habits.

You need to turn that cash flow into capitol, and you are doing it with real estate. You won’t have a lot of cash to put into a deal, so you have to start small. You will look at purchasing that tiny house to flip or rent out. Your profit margin will be paper thin and you will wonder why you are putting so much time into a deal. You might even calculate your hourly wage from doing the deal and think about how much you would have made in your day job. That kind of thinking is what keeps people working for their bosses until they retire.

No. You are better than that. You evaluate many deals a week searching for that diamond. But a diamond to you might be a tiny rough speck that Mr. DeBeers or whoever would just throw that away, because it would cost him more to get it polished. That guy putting up the high rise would lose a big amount of money trying to flip the house you are eyeballing because that is not what he does. You need to start at that smaller property, find your niche, then find the economy of scale when you start to do many more deals. That is how you profit, not by waiting for the Hope Diamond.

But they take all the good deals!

Of course, like Garry Keller says “All the good deals are taken.” Think about it. You need to be the one taking them. But, a good deal for one is a bad deal for another. Let’s say you find a house for sale at $100,000. You are certain that you can rent out the place for $1,000 a month. You estimate that expenses are $500 a month. Let’s say you have been evaluating deals for a long time and have a great mentor so you are 100% certain your numbers are correct. Is it a good deal?

At 5% interest rate, 80% LTV (you need to put 20% down), amortized over 20 years you will have to pay the bank $527.96 a month. That means your total monthly income is -$27.96! Awful. Only a fool would buy it. Next week you hear from your agent that the place sold for $100,000. Asking price!

What gives?

Well, the gal who bought it may just be one of those idiots you talked about earlier. Keep in mind that there are not many deals in this market worth even looking at, so people are going to bite at things that may not be the best deal. On the other hand, this buyer may just be at a different place in his real estate career.

Think about the investor who has made a lot of money in other projects. Maybe he had a thriving business that just sold. Maybe he got an inheritance. He is looking for places to invest that money and keep the IRS’s hands away from it as much as possible. He knows that real estate is a good investment vehicle. Let’s say he does the exact same math you do. But he comes to a very different conclusion.

How Can He Possibly Buy That Clunker?

This idiot, as you say, puts down 60% of the sale price to buy the house, effectively 40%LTV in the bank’s terms. Now, he is paying $263.98 a month. Plus expenses, that nets him $236.02 a month in profit. What a difference!

This gal’s cash on cash return goes way down but it is better than yours. Yours was negative. You have read this blog so you know that the less money you put in a deal, the more cash on cash return you get. So you try to minimize your own money in the deal. What they don’t tell you is that a lot of time you need to put more money in it. Keep in mind that there is a tipping point, of sorts, when you decrease your money invested so much that cash on cash return suddenly goes negative.

Or the buyer did a seller financed deal, or worked out some other arrangement with the bank. There are any number of ways that another person might purchase that property and find a benefit. You need to focus on yourself and how the deal might work for you.

Figure out how much you have to put into a deal. When you are starting out if you put that much money in as ‘the idiot’ did, you would have profit, but tying up all that money into the deal would stunt your real estate growth. So, when starting out, you need to be a lot more selective on your deals. The diamonds are out there, on the outside they just look like rocks. Give it time and real estate will become your diamond mine.

Dr. Equity

2 thoughts on “Finding Diamonds -or- Why Do Those Idiots Buy These Bad Deals?”

  1. Well said Benjamin! Just because you see the sale price does not mean you know anything about the investor or what they are making on the deal. Maybe an investor is great at raising capital and has a large cash reserve, maybe an investor has in-house property management and can decrease expenses and increase rents more effectively than most, and just maybe they are in way over their head and will lose the property in a fire sale a few months down the road. The point is, make offers based on your own underwriting. Do not get caught up in hubris!

    1. Hi Rob, thanks for your insightful comment. Every investor is different. If it doesn’t work for you, move on and don’t look back.

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