5 Invaluable Lessons From My Worst Real Estate Deal Disaster

Last week I told a happy-go lucky, sunshine-and-puppies story about real estate success in multifamily investing. Unfortunately, not all such stories have happy endings. So this week we will embark down the foreboding path of real estate horror, as I recount our most painful venture here in Kansas City.

And it just happened to be our first in KC to boot.

We are originally from Eugene, Oregon, where my father purchased some 300 units of mostly campus housing around the University of Oregon. After the market for campus housing got too expensive, my dad started flipping houses. This is when I joined. Eventually we got tired of that and decided to join a friend of ours on a trip to Kansas City. He had been investing in several other markets and had settled on KC as the best of them.

Immediately the prices shocked us. Eugene is no San Francisco, but the prices are still much higher than the Midwest. We went around with a real estate agent and looked at a dozen or so apartments—jaws dropped the whole time. Most of them were beautiful old, brick buildings with marble floors in the entryway and elaborate decorations over the front doors.

Along with our friend, we made a handful of offers and eventually found one 29-unit building under contract (technically a 14 and 15-unit building a block away from each other) that we decided to partner on. The neighborhood was very close to downtown and didn’t look bad (famous last words, right?). In fact, one apartment was right across the street from a mansion!

Our purchase price seemed incredible. Only $450,000 for 29 units, or $15,517/unit. It wasn’t performing at the time, but it still had 22 occupied units—which meant it was only a minor re-position, right? (Famous last… yeah, you know.) Then we met a property manager, had lunch with them, and decided to use them.

Indeed, for several months after purchasing the property, things seemed to be OK. Yes, there was more rehab to do than expected. For example, the plumbing in one unit wasn’t hooked up underneath and lead to massive amounts of human fecal matter lying underneath the floor. Good times.

Still, things seemed to be progressing. But then month after month went by, and the occupancy didn’t improve. Every month we had as many move outs as move ins and lots of new turnovers to pay for. The utilities were also out of control. The property simply would not cash flow. No, check that, the property couldn’t even get a positive operating income, let alone pay for the debt service. For example, here was the net operating income for January through April of 2011 (not including debt service or taxes):

January: -732.50

February: -520.19

March: -1,302.78

April: -1,358.47

And so on. It didn’t take us long to figure out this neighborhood was not what we had anticipated. I’ll just put it this way: It’s what our partner calls a “rent optional area.”

It took a little longer to figure our property manager wasn’t up to snuff either. So about a year after we bought it, we kicked them out and decided to manage ourselves. This was a difficult thing to do at the time because we were still very small in Kansas City and didn’t have much of an infrastructure to build on. But we absolutely had to make a change.

Things started improving until the building was just about on the edge of cash flowing. Anxious anticipation abounded. Then one month about six tenants decided to exercise their option to not pay rent. And down again this apartment sank into the abyss of real estate transactions gone awry.

At this point we tried to sell it. No luck.

So back to the drawing board we went. Eventually we found a program in Kansas City similar to Section 8, but through a non-profit organization focusing on single individuals. We developed a great relationship with them and finally began to consistently fill the apartments. We also got a lot stricter regarding our screening, and the delinquency finally became manageable.

By doing these things, we finally got the apartments to consistently perform. Albeit, it’s worth noting that this was more than three years after we originally purchased them!

So what are the lessons from this unpleasant affair? Well, here are the five most important that I hope will help you avoid what we went through.

5 Invaluable Lessons I Learned From a Real Estate Deal Disaster

1. Be Very Careful Investing Out-of-State

I’ve written about this before, but you must be very careful when investing out-of-state. If you’re from San Francisco and are used to condos starting at a million dollars, then $15,000/unit seems to good to be true. Well, you know what they say about such things, right? We bought the property about four months before I moved to Kansas City and unfortunately took a lot of assumptions from Oregon with us. (Not explicitly, of course; we’re not quite that stupid.)

If you do take the plunge and invest out-of-state, make sure to do a lot of research on the area you’re looking at. Thoroughly vet any agent, manager, and contractor you use, and make sure to ask for references. Furthermore, you should visit fairly often to make sure everything is above board.

2. Don’t Buy in a Warzone

There are investors who can make a lot of money in bad areas, but they need to specialize in it. As many on BiggerPockets have warned before, newbies (and most others) should stay away from cheap properties in bad areas. A new roof costs the same in a Class A and Class D area. So the property may be cheap, but it is unlikely to actually cash flow. In addition, tenants in these areas are much more likely to not pay their rent.

It’s also important to note that some areas can be deceptive. This area didn’t actually look that bad, primarily because of the beautiful, old buildings (and the mansion). But those were built 80 years ago, and the area has changed a lot since then. A closer inspection on our part would have shown that this property was in a bad area. Indeed, had we simply gone onto CLRSearch and looked up the per capita income in that zip code, we would have found it was only $13,244/year.

In other words, pass on this one.

3. Due Diligence, Due Diligence, and Then a Little More Due Diligence

Never ever skip or skimp on due diligence. We ordered an inspection and reviewed it, but we only walked a few units. Had we walked them all, we would have found more damage (we went way over budget and ended up putting around $150,000 into it), but we would have also probably determined the tenant base was not very strong. Indeed, almost half of the people on the rent roll weren’t paying or stopped shortly after we acquired the property.

4. Property Management is the Lifeblood of Your Business

We should have gotten rid of our property manager much earlier. We asked for them to show us their Craigslist ad repeatedly, but they just said it was up and that nobody in that area used Craigslist anyways. (Pro tip: The majority of our leads for those apartments now come from Craigslist, so if any manager ever tells you this, fire them.)

Or we’d go into vacant units with them on inspections and the heat would be at 80 degrees in the middle of the winter. One time, they charged us $125 for a maintenance order that read “showed tenant how to use the thermostat.” Hell, after we replaced them, they even charged us to take down their own banner after I asked if they wanted it because we were going to put up one of our own. At least they refunded us for that.

Whether you decide to manage yourself or hire a manager, management is the cornerstone of your business. You can get away with a bad deal or rehab here or there, but you cannot get away with bad property management. It has to be a priority!

5. Don’t Give Up Because of One Bad Deal

If real estate were easy, everyone would be doing it. Sometimes deals go sideways. Even some deals that weren’t actually poorly thought out in the first place (unlike this one) go badly. Bad deals don’t just suck up your money, they suck up your time, energy and self esteem. It’s like running to stand still. The best case scenario is that you’ll just do less badly, so why try at all?

That’s the wrong mindset, though. Grind it out and fix the problem. The good one’s will make up for the bad one’s many times over. Fixing the bad one’s is just part of the job. The best thing you can do is simply learn from your mistakes (or preferably, in your case, from my mistakes) and do it better next time. Real estate is still a great investment.

Indeed, even this property is no longer a problem for us. Last year it had a net operating income of $70,000 and was appraised for $680,000.

Now it’s your turn: What terrible, horrible, very bad, no good deals have you had the pleasure of buying?

Let’s talk in the comments section below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.