If you have ever been around a testing lab or observed a stress test on TV or in a video, then you may be familiar with the term “forcing it to fail”. It is pretty simple actually. The technician, for example, sets up with a piece of metal that is pulled from both ends until it breaks. This type of stress test can be applied to other applications as well. It is a basic truism that innovation comes from a relentless drive to keep trying, and then trying again, learning each time what works well, and what doesn’t.
The same type of thinking that goes into lab stress tests can prove useful with Real Estate Investment (REI) deals as well. The philosophy behind all of this is that it is wise to determine as early as possible if a transaction you are thinking about investing in is doable, or not. If not, then common sense dictates that you want it to fail as fast as possible, before investing money and time in a deal not worth the effort.
The first place to start is to gather together all the information that is relevant to whatever deal you (or your investor client) are contemplating: terms, conditions, price, etc. Some of the “stress test” questions to ask, right off the bat, may include: Is the price you are paying to the seller for the property going to allow you a decent profit when you go to sell it? Have you already lined up exit strategy money (cash buyer or hard money loan)? Are you certain that the cash buyer is fully qualified, i.e. he actually has the money in the bank right now to complete the deal? If you are going to borrow the money, have you already been approved for said funds, i.e. they have provided you with a Letter of Commitment (LOC)? Are you dealing with investor-friendly real estate professionals such as a Realtor, escrow professional and title company?
Let’s assume for the sake of discussion that you are able to convince an owner to sell you his property at a steep discount (off of current Fair Market Value—FMV); the distressed homeowner is both flexible and highly motivated to sell. Both you and the seller sign a LOI (Letter of Intent) or a MOU (Memo of Understanding).
So, with a deal like this, is it better to co-wholesale or to fix/flip? That of course depends: You need to consider factors such as the velocity of money with a wholesale flip vs. higher profits if you rehab and then sell. Wholesaling carries lower risk, happens quicker but with possibly lower potential profits. A fix/flip offers the chance for more overall profit but with higher risks and usually takes much longer to complete. Best advice: Run the numbers on both scenarios and see which one is best for you.
Next, carefully study the assumptions you came up with to see if they hold up under scrutiny. Create a budget. Contact potential cash buyers. Reach out to hard money lenders, potential sellers, real estate facilitators. Then reverse engineer the deal from what you see as your eventual selling price, backwards, through all the perceived costs, to finally arrive at how much you can justify paying for the property in the first place.
If the numbers make sense, then it is time to confirm your preliminary assumptions by introducing real world potential problems to the equation. Have you factored in the cyclical nature of RE? How about seasonal variations in weather? You may want to “reverse wholesale” the deal to be sure you have a ready-to-go cash buyer lined up for a wholesale property flip.
Assuming your math looks good, and it appears all the players are on board, the last step is to stress test each one to make sure they are for real. ARE the buyers ready to commit? If so, put it in writing by getting them under contract. Or, is the hard money guy ready to provide you with a LOC? If all the obvious factors look positive, it is time to tie up the property by putting it under contract with the seller.
Analysis: If any of the above players show any resistance at all to what you are trying to achieve, BEWARE. That is the time you need to either push the deal to fruition or force it into failure. The truth is, the REI landscape is replete with large numbers of previous deals that were doomed to failure, from the get go, but the investors ignored the obvious signs and clues that were right in front their noses, and plowed ahead anyway because they were hot to make a deal happen. Bad choice.
Bottom Line: The key to success in this business is making sure you have all your ducks lined up before committing nickel one to any deal. Never be afraid to walk away from a deal that does not pencil out just the way you need it to turn out. Don’t be afraid to turn up the heat on any of the players detailed above, because if the deal is going to fail, you need to know that as early as you possibly can. If you force a deal, and it fails, that isn’t bad news, actually the opposite is probably true; in all likelihood, it means the deal wasn’t worth doing in first place. With deals that cannot pass the stress test, better to let them fail, and fail early. Then move onto to greener pastures.
What We Do: Quickly provide short-term, first position, private capital funding, to real estate wholesalers, among others. Contact info: Tod Snodgrass, email@example.com, 310-408-7015