When Wrong Assumptions are the Right Ingredients
Real Estate Investing is a very competitive market with low inventory and high demand. Sellers are able to ask healthy prices and investors are quickly buying up what is available.
So, I knew that for my latest property I needed to be willing to act quickly and go big, or at least as big as my financial models allowed. That is why I put in a quick offer on a duplex within hours of it coming on the market. It was a big purchase, my biggest one at the time, but my numbers looked good and I was ready to move up. The further I got into the deal period, however, the more I found my initial assumptions were more than a little off. Finding the silver lining in these wrong assumptions allowed me to stay focused on the end-game and not get caught up in the winding road.
Here are a few examples of how far off I was:
Interest Rate: This was the first 5/1 ARM loan I had done (my other properties are on 30-year fixed loans), but I felt that I knew what interest rate to use. Wrong interest rate assumptions on your purchase can impact your cash flow. Once the offer was accepted and I confirmed the rate with the lender, I found that my rate assumption was lower than the actual rate I would be paying.
Silver Lining: Fortunately, I build in a healthy margin requirement into my financial model and could absorb this difference while still forecasting positive cash flow each month.
Lesson Learned: Contact your lender and discuss the current market rate rather than relying on an online interest rate search. The rate I found online was for purchasing a primary residence, not for investment properties.
Open Kitchen Concept: The moment I saw this property, I knew that two walls in the kitchen must go. The open entertaining area that I envisioned was going to be a huge appeal to tenants. Reality took hold when I got a second opinion and learned that removing those two walls would use up most of my rehab budget.
Silver Lining: My kitchen renovation got cheaper because I now had lower material and nearly zero demo costs. This allowed me to spread my rehab budget to other projects in the property.
Lesson Learned: If you are thinking of removing walls or changing the layout of a room, consult an expert to understand the costs and scope.
Painting Estimate: This was the first time I had needed to estimate for exterior painting (my other properties already had fresh paint when I bought them). So I asked around and settled on an estimate. Fast forward to the closing date when I got an actual bid for painting the exterior and it is 25% more than my budget.
Silver Lining: I really liked working with the painting contractor. His price was fair, the company was great to work with, and I now have expanded my network of contractors.
Lesson Learned: Build relationships with subcontractors who you can quickly call on for ball-park estimates while you are pulling together your construction budget.
1. Do your homework, but trust your gut: Even though some of my assumptions were wrong, the project was still a success and it gave me many opportunities to learn new areas of the business. If I had used the right interest rate, known the kitchen would stay at 60 square feet, or used the higher painting estimate in my budget, I may have never moved forward with the project.
2. Don’t overreact if your assumptions are wrong: When new information reshapes your assumption, update your financial model and rehab budget to see what the actual impact to your cash flow is. Also, build in healthy margin requirements in your financial model so you have some breathing room to maintain a positive cash flow when the unexpected happens. I use 10% margin as my minimum, but try to get closer to 12-14%.
3. Trust that you’ll make up for it in other places: Knowing that my painting expenses were $900 more than budgeted motivated me to find savings in other areas of the project. With that mindset, I was able to more than make up that difference after a few days of planning. I finished the project under budget and on schedule.