Landlording Gotchas

Are you interested in investing in real estate? If so, the first thing that probably comes to mind is owning rental properties. This is certainly the most common and obvious approach to real estate investing. And indeed, it can be a great way to build wealth. You can purchase the rental property with a loan from someone else, and that loan gets paid off by the person renting the property. You pocket some extra money each month, and then years later you have a free and clear property that was largely paid for by someone else. Not bad.

Yes, owning rental properties can be an excellent means of generating long term wealth. But being a landlord is not for the unprepared or faint of heart. There are a lot of potential gotchas with renting out properties, and it pays to be aware of them before you become a landlord. I will identify a few things that you should consider below.

CashflowGotcha #1 – Cashflow

First, let’s talk about numbers. When you have a rental property, the goal is to make money, so you better know the numbers. When you’re calculating how much money you’re going to make each month, you just take the monthly rent and subtract off the mortgage payment and that gives you your monthly profit, or cashflow. Right? No, wait, we’re missing a couple of things. You also have property tax payments that have to be made. Maybe you don’t make these payments each month, but chances are the property tax payments will eat into your profit by no small amount. Oh, and you need insurance on the house, too. (And it needs to be landlord insurance, not your regular homeowner policy.) So that reduces the profit. Okay, so now we have rent minus the mortgage (principal and interest) minus tax minus insurance. So, that’s your profit per month. Profit = Rent – Mortgage – Taxes – Insurance. Right?

Well, not quite. It’s not really reasonable to assume that a property will be rented out in perpetuity, that is to say rented out for as long as you own it, with rent payments always coming in and with no vacancies. In fact, it’s not unreasonable to conservatively assume that you might have one month of vacancy each year due to tenants leaving the property. This would be one month with no rent coming in. Also, you may have a tenant that just stops paying. That obviously eats into your expected rent, too. And you may have to give incentives or concessions to get new renters. That reduces your expected rent income as well. Let’s just call all of these things Rent Loss. So, let’s treat this Rent Loss as a type of expense and subtract that off of our profit. Now our monthly profit formula becomes: Profit = Rent – Mortgage – Taxes – Insurance – Rent Loss. Okay, now we have our profit formula and can move on.

Wait a minute, not so fast. Let’s not forget that the house doesn’t just sit there in perfect condition year after year. It needs maintenance and repairs over time. We better estimate those costs and average them out over time so they don’t shock us when they come up. A new roof or AC unit can really take a bite out of your wallet. So, now we’ve got: Profit = Rent – Mortgage – Taxes – Insurance – Rent Loss – Repairs. That profit expectation is starting to shrink, isn’t it?

But we’re not done yet. There are other expenses, too, like legal fees, bookkeeping and accounting costs, eviction costs, lawn maintenance, etc. Well, that stuff shouldn’t be too bad, should it? Hmm. It certainly shouldn’t be overlooked. So now we have: Profit = Rent – Mortgage – Taxes – Insurance – Rent Loss – Repairs – Other.

Okay, so how much are these costs really? Well, a great quantity of research has shown that over a long-term holding time, the expenses on rental properties (not counting the mortgage) average out to be about 50% of the market rate monthly rent. This is referred to as the 50% rule. Sounds high, right? Yeah, it is. And it may be less in some cases, but may be more in others. You really need to calculate all of your expenses and make sure you have a buffer for big ticket repairs when they come up. The 50% rule is a quick way to estimate all the expenses. And as you have no doubt realized, these expenses greatly affect the monthly profit. Our Profit formula now becomes: Profit = Rent – Mortgage – 50%Rent. Ouch. This means if your rent is not at least twice the amount of your monthly mortgage, you’re very likely going to lose money over time. So, if you think it’s great that you’re renting a house out for $1000 and you’re mortgage payment is only $700, you are likely going to be in for a very painful lesson down the road.

The bottom line with evaluating your monthly profit (or cashflow) for a rental is you better make sure you know your numbers before becoming a landlord. You don’t want to have to rely on the price of your property going up in order to make any money.

RepairsGotcha #2 – Maintenance and Repairs

I mentioned above that you should expect that you will be dealing with repairs to the property over time. The more time passes, the more repairs and updates you’ll have to do. When a tenant moves out, you may find that you have to paint and install new carpet. Or repair small holes in the wall. Or replace the cabinets that are now disgusting. Or replace the faucet that the tenant broke. Or the door that was knocked off its hinges.

Speaking of tenants causing damage, you better get a good security deposit up front. And additionally a pet deposit for that dog the tenant is moving in.

But even if the tenant takes good care of your place, stuff just gets old and breaks down over time. Toilets seem to always have issues. Water heaters only last about 10 years. Roofs take a beating from the sun and weather. Air conditioners are good for around 20 years if you’re lucky, and need maintenance over time. Fixtures and faucets get worn out. Door knobs break, appliances fail, garage door motors die. And stuff just gets old, ugly, and less desirable, making your property less attractive to renters. You can’t expect that your rental property will not need significant work over the time you own it.

Also, as a property owner, you have to be prepared to deal with emergency issues at a moment’s notice. Be ready for a call at 4 in the morning about a plumbing leak. And not all renters will be friendly in bringing up issues. Speaking of tenants…

TenantGotcha #3 – Tenants

While I’m sure you would love to hope that tenants in your properties will be trustworthy, upstanding, wonderful individuals with no problems that will affect you, that’s not living in reality. Some tenants will be great and some won’t. You should at least be mentally prepared for some of the headaches that tenants can cause you, especially if you live in a state where the laws are not friendly to landlords.

Some tenant problems are probably obvious, like causing damage to your property. This is one of the reasons for getting a security deposit from the tenant upon move-in and for having a landlord insurance policy on the property. And tenants sometimes pay late, so you need to determine your method for handling that. For example, you have to enforce late fees, but how much latitude do you give, and when do you ask the tenant to leave or file an eviction. But there are also innumerable other things you may have to deal with because of tenants.

Ever hear of a professional tenant? This is someone who is well-versed in tenant laws in your state. In other words, they know almost every way to screw the landlord and live in the property rent-free for as long as possible, causing you not only a loss in rent income, but also a pile of legal fees and headaches, in addition to possible damage to your property.

Here is one story of a professional tenant: http://blog.nj.com/njv_barry_carter/2011/05/carter_newark_man_acts_as_his.html

Here is an example of a nightmare tenant that was inherited with the purchase of a property: http://www.biggerpockets.com/forums/67/topics/64944-the-occupants-from-hell-

Anyway, the examples go on and on. The point is to be careful who you let rent your properties. This leads to another thing you have to deal with when landlording, …

Screening tenantsGotcha #4 – Screening Tenants

You wouldn’t just let anyone rent a property from you, right? So, what are your guidelines? How do you screen people? Who do you rent to, and who do you say no to? Well, it’s up to you. But you better know the laws and you better come up with a good consistent screening process that you stick to.

Regarding the laws, there are some protected classes, which means you can’t rule out applicants just because they are a member of that class. For example, you can’t turn away someone because of the person’s race. So, you need to make sure you’re in compliance with the law.

But what other criteria will you use to screen applicants? Will you do a criminal background check? Will you do a credit check? Do you consider previous financial issues, like foreclosures or bankruptcies? What about previous evictions? Do you check references? If so, how many? Do you look at where they live now? Do you consider things like tattoos? The smell of the person?

Again, it’s up to you to determine what your screening criteria will be, but it’s part of your job as the landlord, and it’s a process you have to go through for each applicant. Or maybe you could hire a Property Manager to both deal with tenant issues and tenant screening. Which brings us to the next thing to be prepared for…

Managers gnawing at profitsGotcha #5 – Property Managers

A Property Manager seems like a great solution to dealing with a lot of things that cause you headaches as a landlord. The Property Manager will deal with advertising that your property is available to lease, managing the tenant screening process, collecting rents, managing tenant issues, handling repairs that come up, and helping evict tenants. Great, so all you have to do is get a Property Manager, right? Maybe, but you have to really interview your Property Manager and also check up on them.

Some Property Managers add additional costs beyond the expected fee. They’ll charge extra for placing tenants, for example. Maybe that incentivizes them to turn over the property more, which is not a good thing. Or maybe they add hidden fees when dealing with repairs. Maybe that repair only cost $50 but you got charged $100. Or maybe they got a friend of theirs to do the work in exchange for some kind of kickback. Or maybe there wasn’t a repair done at all and you just got billed for one.

You also have a layer now between you and the tenant. Often this is a good thing, but sometimes it can lead to issues. Do you really know what the tenant is telling the landlord, or what the landlord is telling the tenant? For that matter, do you even know what rent the Property Manager is collecting. Maybe they are charging more for rent than they are giving to you. Maybe there are severe issues brewing with a tenant that the Manager is not telling you about. Maybe they are neglecting maintenance on the property, creating health or safety hazards and thus exposing you to a potential lawsuit.

Maybe they completely lied to you when you interviewed them. Perhaps that comprehensive tenant screening process they sold you on never actually gets used, and you end up with one bad tenant after another. Their claim that they regularly do physical inspections both inside and outside the property – are you confident that they’re really doing those?

Not all Property Managers are unscrupulous, but I’m sure you’ve been around long enough to realize that some will be, and that you need to be on your guard. And even for the honest ones, it’s not likely that anybody is going to care about your property as much as you, the owner, so you have to expect that you will never be perfectly happy with a Property Manager, and that you will still have to follow up on things. That takes me to Gotcha number 6…

House Burning MoneyGotcha #6 – Umm.

I’m too tired from typing to come up with a sixth, but hopefully you get the point. Landlording can be a profitable venture and a good means for acquiring wealth, but it’s not without its share of potential issues. You need to make sure you do the math before you buy a property to rent out (or decide to turn your residence into a rental). You need to understand that you’re going to have frequent maintenance and repair issues. You’re always going to have to deal with tenant issues, from the screening process through their eventual departure. And even hiring a Property Manager does not free you from paying attention to what’s going on with your property.

In our business, we rehab homes, also known as fix-and-flip. We hear from a lot of landlords who are tired of dealing with their rentals. Often we get contacted through our website http://WeLikeHomes.com from people who want to sell rentals they have. Many times the properties need massive repairs, or they just haven’t been maintained, or the owner is sick of managing tenants or messing with other issues with the house. So just consider these potential gotchas to landlording before diving in. It can be simple to get into landlording, but it’s not always as easy to get out.

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BiggerPockets

Using BiggerPockets

I haven’t done a blog post in ages.  My last one was about the BiggerPockets conference that took place earlier this year in Denver.  There were a lot of great speakers there who were very generous in sharing their time and knowledge.  Many of the attendees were equally outstanding – everyone I met there was friendly and willing to discuss their work and experience in real estate.  Joshua Dorkin, the founder of BiggerPockets did a great job setting up the event and hosting it.

Even though my last post was over a year ago, I’ll follow up with a similar topic, which is the actual BiggerPockets site itself.  What is BiggerPockets, you ask?  It is a social networking site for real estate investors.  In my opinion, the definitive site for real estate investors.  I think anyone involved with or interested in real estate investing must check out the site, and hopefully participate.  Why?  I’ll give a few reasons below.

Knowledge

There is a vast amount of knowledge available on BiggerPockets.  A treasure trove of data, information, reference documents, and advice is sitting there for anyone interested in any topic related to real estate investing.  The many years of forum discussions alone are worth searching through.  A fantastic blog section has innumerable posts from very experienced investors.  The information posted freely on BiggerPockets can save massive amounts of time and headache.  The people who post on BiggerPockets run the gamut of positions in the investing business: there are lawyers, financial advisors, wholesalers, rehabbers, landlords, commercial investors, note investors, mobile home investors, developers, and so on.  Chances are if you are interested in doing something in real estate and you have a question, someone on BiggerPockets can help and is willing to help.

Networking

BiggerPockets is not just a repository of information and resource files.  What makes it work are the people who are involved on the site regularly.  And there are a lot of them.  With a lot of experience and connections.  And you can interact with all of them.  Just get in on the forums, or follow blogs on the site, and become online colleagues.  Post questions, post suggestions, and post responses.  Talk with people, and meet with other local investors off-line.  Maybe even do business with fellow BP members.  It happens all the time.  There is no reason it can’t work for you also.

Helping Others

Part of the networking process and part of the joy of BiggerPockets is to help out other people.  Hop onto the forums and see how your unique insights may help someone out.  Even if you are inexperienced, don’t be afraid to post.  Everyone’s constructive and well-meaning input is welcome.  Sometimes just the right positive encouragement may make the difference to a fellow investor.  So jump on in and contribute.

Branching Out

Maybe you are already in a niche of real estate investing, or you are interested in a certain niche.  That’s great.  But when you start checking out BiggerPockets, don’t be surprised when you become curious about other forms of real estate investing.  Soon you’ll find yourself wondering about lease-options, or land contracts, or master leases, or land improvement, or note flipping, or rehabbing, or commercial properties.  The list goes on.  You’ll see when you check out the site.  On any given page of the forums, you will likely find at least 5 to 10 different topics being discussed.  You’ll discover your interests will broaden quickly.  Just make sure not to get too distracted.

BiggerPockets is Alive

The founder of BiggerPockets is Joshua Dorkin.  The site is his baby, and this is his full-time job.  He doesn’t do this on the side and he didn’t just set it up and let it sit.  He is on the site all the time.  He posts on the boards and responds to inquiries.  He is constantly working on improving BiggerPockets and making it more useful to real estate investors.  His work in setting up the first BiggerPockets Summit in early 2012 just shows how dedicated he is to making BiggerPockets THE site to be involved with if you are a real estate investor.  So what are you doing still reading this?  Go check out BiggerPockets now!

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BiggerPockets REI Summit

BiggerPockets is hosting a Real Estate Investment convention next year! If you are a real estate investor and don’t know about BiggerPockets, you should! It is a great site for investors and has all kinds of excellent information about every area of real estate investing. The forums there are terrific, because investors of all levels contribute valuable information daily. They also have articles, blogs, and even a file section where you can download sample documents for free.

I am expecting the BiggerPockets REI Summit 2012 to be a great place to learn and meet fellow investors from all over the country.  If you want to know what’s going on in real estate throughout the nation and network with other successful real estate investors, this Summit is going to be worth the trip.  Plus, it will be in Colorado in late March, a perfect time for hitting the slopes for skiing, doing some hiking, or just enjoying the mountains (or even the city).  I’m there!

If you want to go to, or just see what’s going on, head out to the page on BiggerPockets here or just go directly to the official site for the Summit here.  Happy Investing!

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Housing Market Recovery?

Hmm.  Think the housing market is going to “recover” soon?  Maybe in a year or two, we’ll see prices start to climb?  I don’t think so, at least not out here in California.  I think we’re in for a long, slow drag…  There are just way too many foreclosures in the pipeline.  Now, it’s time to take advantage of the market we’re in and flip some houses!

Check out this sobering information:  Unloading REO inventory

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Short Sales!

Short Sale SignLike a lot of investors these days, most of our offers at this point are on REO properties and Short Sales.  For anyone who is not aware, an REO is a bank owned property, and a short sale is when a homeowner is selling the house for a price that is below what is owed on the mortgage.  For short sales, the bank must agree to the sale, because they will not be getting back the principal that was loaned out.  Also, the bank does an appraisal on the property and comes up with the minimum amount that they will accept.

We offer regularly on short sale properties.  These are usually fire and forget.  We submit the offer, and then move on, assuming that we won’t hear back from the seller because we almost always offer lower than the asking price.  And if we do hear back, it will sometimes be months later.

Currently, we have 3 accepted offers on short sale houses.  Cool!  Does this mean we are going to get 3 properties to renovate?  Maybe.  Maybe not.  So how many do I think we’ll get?  No idea.  Possibly none of them, possibly all of them.

There are still too many unknowns, and the biggest one is the bank.  Will the bank approve the sale at the contracted price?  There is no way to know.   How long will it take to get an answer from the bank?  Again, who knows!  Supposedly, some banks are moving faster on short sale decisions these days, but we’ve heard timelines up towards a year to get an answer from some banks.

Okay, but let’s say the bank approves the sale.  Then we have to decide if we still want the house, and at the price we originally offered (or at the bank’s minimum price).  If we’re getting our original price, of course we want the house, right?  Well, maybe.  It depends on the latest condition of the house, which may have deteriorated more during the time we were waiting, thus necessitating more repairs and costing us more money to renovate, thereby eating into our estimated profit.  Also, what will the market value of the house be when we hear back from the bank?  If we waited 6 months to get an “okay” from the bank, the remodeled value of the home may have dropped significantly during that time, especially here in Los Angeles.  When we offered on the house, our renovated value for the home might have been $400k.  And 6 months later it might be $360k.  That could very likely mean that buying the place no longer makes sense.

Yep, short sales can be frustrating.  But on the good side, at least the opportunities exist.  We continue to offer on them, because there are good deals to be had, and there are a bunch of homes with a lot of potential that need some “refreshing”.  And we do have 3 accepted offers!

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Highest and Best

If you are a real estate investor in today’s market, I am sure you have submitted offers to banks on what they call REO properties.  REO stands for Real Estate Owned, which refers to the properties that the bank actually owns, usually as a result of foreclosure.  But you probably already know this.

And I’m sure you’ve also been in the situation where the bank gets multiple offers and the listing agent says to each party that submitted an offer to now submit their “highest and best” offer.  They are asking for the highest price you will offer for the property, with the best terms (no inspections, no contingencies, highest earnest money deposit, and so on).  You are now in a bidding war against other buyers, probably against other investors.  What do you do?

For us, most of the offers we’ve had accepted on REO properties actually resulted from this “highest and best” situation.  So for the offers we got accepted, what did we do?  How much did we jack up our offer?  5%?  10%?  $10,000?  Nope.  So what did we do?  We resubmitted the exact same offer we submitted initially.  When we submit our offers, we almost always submit an offer well below asking price.  But at the same time, we submit based on the numbers we think will work and yield a decent profit based on the costs of the rehab.  Notice that I said a decent profit.  I didn’t say an exorbitant profit.  We go in with an offer we think is reasonable for the property.  So when the bank says “highest and best”, we almost always resubmit the same offer.  We just can’t risk anything more.  We ran the numbers, and we stick with them.  “Highest and best” doesn’t scare us into bidding more; we don’t NEED to have the property.  We stick with the numbers.  If we don’t get the property, that’s fine, we’ll move on to the next one.

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Marketing Begins

Up until now, we’ve gotten our properties from the MLS or wholesalers.  We’d like to start buying directly from homeowners, though, so we’ve recently started marketing.  It’s a small step, but it’s something.  We just mailed out our first batch of letters.  These were sent to owners of houses that seemed like they might be vacant or in need of repair.  And we also put out some signs to try to attract attention from owners needing to sell.

So far we have received only a couple of responses that have not yielded anything productive, but I realize we’ve really just dipped our toes in the water.  We plan to ramp up our marketing more throughout the year.  We feel like we need at least one more avenue of marketing, and we’re trying to decide which path to take next.  We’re thinking of pursuing one or more of the following:

• Mail to absentee owners
• Probate – Mail to inheritors
• Mail to owners of expired listings
• Mail to owners of homes with code violations
• Post “We buy houses” style craigslist ads (Post where? The “real estate services” section?)

If you are an investor, have you tried any of these techniques? Which have worked well for you?

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Lessons from our Second Condo Rehab

This post will be a quick one about the second condominium we rehabbed – the Willis Ave property.  We saw this 2 bedroom 2 bath bank-owned property listed for about $60k.  It seemed like we could make money at that price, so that’s what we offered.  They got back with us in a couple of days saying that they had multiple offers and that we should submit our highest and best offer.  So we resubmitted with… the exact same offer.  And they selected ours.  Lesson: Don’t get into a bidding war, stick with the numbers that make sense.

We estimated about $15k in rehab costs and that we could sell for about $100k.  Having just completed a similar project, we were confident in our rehab estimate, and we figured even if we sold for only $90k (a fairly safe bet because we had recent comps of the same model), we’d still come out slightly positive.

Most of the rehab went smoothly – remove the old crap and put in nice new stuff.  We updated the carpets, kitchen, bathrooms, lights, outlets and switches, etc.  The one small snag we hit was the ceiling.  There had been a leak in the roof that stained the ceiling and ruined some of the popcorn in a couple of areas.  We decided to just patch these spots and then paint the entire ceiling.  The result was great…  If you had a neck injury and were unable to look up at the ceiling.  Trying to patch a popcorn ceiling – not such a good idea.
So then we had the contractor remove the popcorn off the main living areas, smooth it out, and repaint.  Luckily, it all still ended up within our budget of $15k.  Lesson:  Don’t try to patch fix a popcorn ceiling.  They look crappy to start with, why spend money making them worse!

Another hiccup in the rehab – we needed to turn off the water supply.  I guess we didn’t fully learn the lesson from our first condo renovation.  Again, there was only one water shutoff valve for the whole complex.  Luckily, this complex had fewer units and no ancient boilers that had to be dealt with, so we were able to just quickly shut off the water, do the work, and turn it back on again.  Lesson: Beware the water supply for condos!

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Lessons from our First Condo Rehab

Okay, after the first silly post, here is a real post.  This one will be about what we learned from one of the first full rehabs we did on our own, the International Ave property.

This was a condominium that we purchased wholesale from another investor who bought it at a trustee sale.  When we bought this one, we had only seen photos taken during a walkthrough.  The other investor said it would be about $3,500 to rehab the property – just paint, carpet, and cleaning.  We really couldn’t tell much from the photos – the property looked okay, but I was doubtful that it would only be $3.5k to fix it.  Also, there was a non-owner tenant living in the property, so we’d have to give him cash to move out, or evict.

The investor was asking $86,000, and he said it could be sold for $115,000.  Here are the numbers he presented to us:

  • Purchase price:         $86,000
  • Eviction:                     $550
  • Repairs:                      $3,500
  • Closing costs:             $1,725
  • Commission:              $5,468
  • Sale Price:                  $115,000
  • Est. profit:                  $17,757

This seemed like a reasonable deal – put in about $90k, net about $18k, which ends up being around 20% return on the cash put in.  Experienced investors will immediately see that he neglected to include holding costs.  Also, I didn’t trust his rehab estimate, but even with increasing the rehab costs to $6k, and adding in another $1k or so for holding costs, we figured we’d still do okay.

We agreed to the purchase price and bought the property, and the investor agreed to help us with the eviction/cash-for-keys process.  It turns out the occupant was willing to leave and the investor came to an agreement of $1,200 for the tenant to move out within 3 weeks.  Okay, so that $550 to evict quickly turned into $1,200.  Lesson learned: estimate that cash-for-keys or eviction will cost at least 1 month’s rent.

When we met the tenant on his move-out day and did our first walk-through of the property, it immediately became clear that it was going to be significantly more than $3,500 to fix the property.  Just paint and new carpet wasn’t going to cut it.  In addition to carpet and paint, the place needed new kitchen cabinets and countertops, new appliances, a new vanity, new bathroom mirror and lights, a new tub, a new tub surround, new faucets, three new closet doors, new doorknobs, new outlets and switches, a new window, new smoke detectors, new ceiling tiles, new ceiling lights, new vent covers, and probably a few other things I’m forgetting.  It was looking to be at least $10,000.  Lessons learned: Don’t trust photos.  And don’t trust a wholesaler’s estimate for repairs.

Then we started work on the place.  A few days in, the contractor asked us if we knew how to turn off the water to the unit.  No, we did not.  I called the HOA and the person told us that there was one central water shutoff for the whole complex (roughly 250 units).  She said to turn off the water was a big deal because they had to give all the occupants at least three days notice that the water would be off for the specified period of time.  Also, they had to have a specially certified plumber come out when the water was turned back on because there were old boilers and old pipes, so they had to make sure everything was operating correctly and no leaks turned up.  Okay, I asked her when they planned on turning the water off again and she said nobody needed it currently and they usually only do it once 3 or 4 people request it, and I would be the first on the list.  I put my name on the list.  A few days later she called me and said there was an emergency and they needed to shut the water off, so any work we needed to do, we should do it now.  I called the contractor and he did the work quickly.  We were lucky we didn’t have to wait a month or two to change out a couple of sinks!  Lesson learned: Beware of condos and the water supply.

When we finished the rehab, we listed the property at $119k.  My partner spoke with the

investor who sold us the property, and he told her that we’d be lucky to get $110k.  What?!?  When he sold it to us, he presented the retail value as $115k, and that was with only updating carpet and paint!  Lesson learned: Don’t trust someone else’s numbers for anything.

Fortunately, we received a number of offers on the property and we sold it quickly for $122k, so it still worked out for us.

Here is a recap of some of the lessons we learned on this flip:

  • Estimate at least one month’s rent to get an occupant to move out.
  • Don’t trust photos of the property.  Visit it yourself.
  • Beware of condo issues like water supply.
  • Don’t trust someone else’s estimates.  Do your own analysis!
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