Evaluation of a real estate opportunity comes in two forms:
- Use in search of a Site, or
- Site in search of a Use
In other words, a business produces something and needs a suitable location; conversely, a location is available for a suitable business. A parallel approach and methodology can be conceived to assist potential real estate entrepreneurs to evaluate if real estate is appropriate for them. This is the question often missed by most beginning investors.
This also may explain the high ratio of investor turnover; many new investors exit after only a few years in the business. The statistics are consistent and alarming: approximately 53 percent of small unit-count housing providers lose money according to IRS Schedule-E filing summaries, totaling $64 billion annually. Some may challenge that statistic with the concept of phantom losses due to depreciation, interest deductions, etc. Differing opinions aside, a more specific loss classification is telling. Nondeductible rental losses, which usually occur if there isn’t enough passive income to offset the total loss, over the last 10 years are roughly 1.6 million filings (approximately 2.7 million rentals) to the tune of $18 billion ($6,700 each rental) annually. Those losses are typically indicative of something gone extremely wrong and are difficult to dispute. In other words, 15 percent of small-unit-count rentals have losses in a big way. Interestingly, as an aside, that number closely correlates to national delinquency levels for low-cost housing.
Business by Design Is a Demand for Wisdom
Why do so many properties lose money? I have heard many stories, and even had a couple myself. Stories explain (or blame) circumstance. There will always be life circumstances. When we take responsibility, without explanation, something remarkable happens. We discover the real answer why! It reveals the error of our ways. The value of that wisdom is incalculable. And it’s eternal. When properly applied, the value compounds with time.
For me, I failed to design my business. I never asked myself the right questions first, before doing. I didn’t even know which questions to ask myself. Like many, I read a book, got excited, and jumped in. I bought one investment property in Baltimore, and after I got married and bought a new home, I’d converted my first primary residence into a rental. Rent was coming in and everything was going right, until everything went wrong.
Within 18 months, life circumstances changed dramatically. Without forewarning, my marriage was in jeopardy. And the real estate market had begun its downturn. The Great Recession impacted my renters, which I had to eventually evict. There was a period when I was carrying three mortgages; a divorce settlement forced the sale of one of the properties, and soon thereafter I found myself jobless weeks prior to the bubble bursting in late 2007.
We all live lives filled with stories, and I could easily explain why I lost money on those rentals. Yet I had learned the power of taking responsibility. After digging, I realized that I really didn’t know how to manage a rental, and I didn’t have a plan. Now jobless, I committed to learn how to properly manage a rental property. I started a management company, where I created processes and systems, and I truly began to understand risk management while I was getting my master’s degree in real estate.
Business by Design Is a Demand for Answers First
The management company provided opportunities to speak with many “accidental landlords” who had no choice but to rent their houses, requiring them to move because of circumstances. Most didn’t understand risk with financial consequence. And I had been successful in helping some people realize they did not want to rent their first residence, so selling would be a better option.
They realized they would not be successful on their own managing a rental and were unwilling to relinquish control to a third-party management company. It was better for them to realize it first than it would have been for me to onboard them as a client. It was worth the immediate opportunity cost, rather than the time it would have taken to manage for them. I provided them with a self-survey exercise to help them discover if they have the wherewithal to be a rental housing provider, and whether it also fit with their financial plan and capacity. So back to the question often missed by most beginning investors: Did you evaluate if this real estate opportunity is appropriate for you?
Business by Design Is a Demand for Clarity
Have you detailed or arranged your real estate business affairs to align with your personality, your goals, and your purpose for doing it? It may be a life purpose, or a variation such as a financial means to an end. For some, they might realize they don’t have a plan yet. Do you have defined investment goals? Investing is a plan; the type of investing is a strategy. If that distinction isn’t clear, then begin with that. (Answer the questions in the sidebar to get started.)
The questions are not complicated. I would caution one to be reflective when answering them, take time and give each appropriate consideration. It’s easy to answer favorably with the lure of opportunity. Consider not only the upside but the downside of each, and then answer.
Answering these questions helps your business design reveal itself. Design is how. A business plan is what. In this context, you have already determined “the what,” that you’d like to pursue real estate investing in some way. It should be put to the test to verify you have what it takes, by first asking how it will look.
The how helps you understand the systems and checklists that you will need, and you’ll experience how they work. If you are going to utilize your time and money for real estate investing, going through the exercise of asking how it will look will serve as an aid to inform the what. If your plan is to buy and hold one new rental each year, and you’ve determined people skills isn’t a strength of yours, you’ll have to match up how you can still achieve the goal — perhaps it will be an outside company to manage for you — then the budget must reflect that.
Business design of the how creates a standardized system to complete individual tasks so you achieve a desired outcome. Standards are the hallmark of consistency and the means to become efficient, repeatable, economical, and profitable. Checklists work even if people change. Business design is the creation of systems that lead to the path to scale. Start small. Standardize. Repeat.
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