Backing Out of A Deal
“The good news is... you came a long way
The bad news is...you went the wrong way”
Last week, I backed out of a contract on an 8-unit multifamily property that I really wanted. This deal would have accomplished a lot of 2023 acquisitions goal of 4+ doors and our acquisitions goal of 10 total units for this particular market. Unfortunately, during our due diligence period, a few items came up that made the project not worth it. On this post, I’ll explore why due diligence is important, the sunken-cost fallacy and how to avoid it, and one of my favorite metrics: "return-on-hassle” which is just a simple term for risk-adjusted returns.
Why Due Diligence is your best friend.
Due diligence the steps you take to fully understand an investment prior to purchasing. Your due diligence period is the time in a contract that you have to complete these steps. The due diligence period and the inspection period are synonymous but an inspection is just one activity you can do during your due diligence period. Your lender will require certain due diligence items but here is a basic list of things you should expect:
Insurability Verification
Various walkthroughs (Property manager, contractor, etc.)
Zoning and Land Use Review
Environmental Assessment
Appraisal
Title Search
Property Inspection
Survey
Financial review, including rent roll verification
Interior walkthrough of the property.
Prior to going under contract, I get a “soft estimate” from my contractor. I really value my contractor’s time and getting a full bid normally takes more time than you have when trying to get a property under contract. So their “soft estimate” is supposed to be in the ballpark and we both understand that the number will change as we iron out the details. My contractor’s soft estimate for this gut rehab was $150,000, which I then rounded up to $200,000. With that number, I finished my underwriting and submitted a very strong offer which was accepted!
Get Your Team Involved
Interior walkthrough of the property.
Now that we were under contract, the team started rolling. My contractor started refining his numbers, my lender started looking into the property, and my agent started coordinating the other due diligence tasks. A week later, my contractor returned with his revised estimate…$262,000! Again, his previous value was a rough estimate, but an extra $100,000 was a lot, and due to overages, I now had to underwrite for a $300,000 renovation. This new rehab budget brought my ROI from 23% to 12%.
Simultaneously, my lender brought up multiple issues with how the contract was written. This was not a significant issue but added to the growing headache.
Return on Hassle
Interior walkthrough of the property.
Return on Hassle is the idea that you factor in time and work into your financial ROI. This idea is closely connected with risk-adjusted return, which factors the degree of risk into your financial ROI. The basic principle behind both ideas is that the more risk and hassle an investment, the greater the financial return.
This project was going to be a gut rehab and conversion of an 8-unit property into a 6-unit property. The buildings were vacant for years, requiring new roofs, extensive exterior updating, and exterior landscaping to beat back years of overgrowth. Overall, it would be a demanding project and not worth a 12% return. For comparison, we are getting 10% returns for simple single-family renovated properties.
Lose Money To Save Money (Sunk-Cost Fallacy)
Interior walkthrough of the property.
Backing out of a deal is challenging, but it’s better to make a tough decision than go the easier route and lose money. Due diligence inspections costs, and you could be tempted to stay in the deal so you don’t lose the money you’ve already committed. Don’t get caught in this trap! If a deal doesn’t make sense on paper, it won’t get better in real life. A bad deal can also drain your reserves and reduce your ability to do other deals in the future. A deal like this could also strain relationships with your team as you try to recoup losses by making cuts in other vital areas.
Here are the key takeaways from this post:
The due diligence period is your time to confirm that the investment makes sense before it is too late.
You should come out of the due diligence period with a clear view of how the investment will perform. Your team’s refined estimates are how you refine the overall investment costs.
Tough deals should have returns that make the ordeal worth it.
If a deal doesn’t make financial sense, back out before it is too late.
