\n<\/p>\n
Your real estate investment\u2019s returns could be ruined by a few hidden costs<\/strong> that you don\u2019t know about. For the rookie real estate investor, it seems like every investment has the same type of expenses; mortgage, taxes, insurance, repairs, and property management. And while these surface-level expenses are almost always present in a real estate deal, NUMEROUS extra expenses could sink your ship<\/strong> if you don\u2019t include them in your deal analysis. So, stick around, or you might get<\/strong> burnt on your next real estate deal<\/strong>!<\/p>\n To walk us through the different types of deals and the expenses that come with them, we\u2019ve got Henry Washington<\/strong>, James Dainard<\/strong>, and Kathy Fettke <\/strong>on the show. Henry, a buy and hold<\/strong><\/a> investor, knows that the \u201c<\/strong>cash flow<\/strong><\/a>\u201d new investors are calculating is far from reality<\/strong>. He highlights the exact expenses it takes to run a rental property portfolio and why those counting on self-management could be making a<\/strong> MASSIVE mistake<\/strong>. Next, James talks about the often over-glamorized world of flipping houses<\/strong> and the massive haircut investors take when they don\u2019t account for closing, construction, and tricky lending fees.<\/p>\n Finally, for our passive investor, Kathy goes into the world of real estate syndications<\/strong><\/a>, defining the numerous fees many \u201cmailbox money\u201d investors overlook. In fact, investors in these passive deals<\/strong> often don\u2019t know when (or how) they\u2019re getting paid. You DO NOT want to make this mistake!<\/strong> Stick around to hear it all, so you don\u2019t make these beginner blunders next time you get a deal done!<\/p>\n Dave: Kathy: Dave: Kathy: Dave: Henry: Kathy: James: Dave: Henry: Dave: Henry: Dave: Henry: Dave: Kathy: Dave: Kathy: Dave: Kathy: Dave: Kathy: Dave: Kathy: Dave: James: Dave: James: Dave: James: Dave: James: Dave: James: Dave: James: Dave: James: Dave: James: Dave: James: Kathy: James: Kathy: James: Kathy: James: Dave: James: Dave: James: Dave: James: Dave: James: Dave: Henry: Dave: Henry: Dave: Henry: Dave: Henry: Dave: Henry: Dave: James: Kathy: Dave: Kathy: Dave: Kathy: Dave: Kathy: Dave: Kathy: Dave: Kathy: Dave: Kathy: Dave: Kathy: Dave: Kathy: Dave: James: Dave: James: Kathy: Dave: James: Dave: James: Kathy: Dave: James: Dave: James: Henry: Dave: \u00a0<\/p>\n<\/div>\n Interested in learning more about today\u2019s sponsors or becoming a BiggerPockets partner yourself? Check out our <\/i>sponsor page<\/a><\/i>!<\/i><\/p>\n Note By BiggerPockets:<\/b> These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.<\/p>\n
Hello, everyone. Welcome to On the Market. I\u2019m your host, Dave Meyer, joined by three panelists today. We have Kathy Fettke. How are you, Kathy?<\/p>\n
I\u2019m good. I\u2019m alive. That\u2019s helpful.<\/p>\n
Are you referring to your heliskiing experience?<\/p>\n
I am. My anniversary gift from my husband to take me up on the peak of some random mountain for our 25th anniversary. I survived it, even though the pilot didn\u2019t want to go and the guide told us it was the most dangerous day they\u2019d ever seen. And then the helicopter sunk into the powder and he said, \u201cI don\u2019t want to spend the night out here.\u201d And I said, \u201cI don\u2019t either. This is not the anniversary gift I had in mind.\u201d Anyway, we made it back.<\/p>\n
What\u2019s up everyone? Welcome to On The Market. I\u2019m your host, Dave Meyer, joined today by Mr. James Dainard, Kathy Fettke, and Henry Washington. How is everyone?<\/p>\n
Fantastic.<\/p>\n
Good to see you guys again.<\/p>\n
I\u2019m good. I\u2019m back in warm California, so I\u2019m, I\u2019m happy.<\/p>\n
Are you still snowed in, Henry?<\/p>\n
There\u2019s still snow on the ground, but luckily the roads are navigatable. Is that a word?<\/p>\n
Close enough.<\/p>\n
Nava-<\/p>\n
Navigable?<\/p>\n
Navigable.<\/p>\n
There we go.<\/p>\n
Well, we had an earthquake.<\/p>\n
What?<\/p>\n
Kind of exciting. I wasn\u2019t there.<\/p>\n
In California? I didn\u2019t even see that.<\/p>\n
Right off of Malibu, about a few miles in, but I wasn\u2019t there, so hopefully the house is still there. We\u2019ll see. But if the earthquake didn\u2019t take it, it might be the Santa Ana winds we had all week, so.<\/p>\n
Oh boy.<\/p>\n
Glamorous California.<\/p>\n
I mean, it does\u2026 I know you\u2019re saying it\u2019s not, but it does seem pretty glamorous. I\u2019m pretty into it.<\/p>\n
In the summer.<\/p>\n
The weather at least seems really nice. I\u2019ve been staring at, it\u2019s like 4:00, 5:00, it\u2019s pitch black out here, so that sounds pretty nice. All right, well today we\u2019re going to get into a topic that we haven\u2019t touched on this before, but a lot of the show, we want to help people understand current market conditions, and honestly, a lot of that is how you underwrite your deals, and how you make estimates into some of the costs. Sometimes we talk about rent, and income, but today we\u2019re going to really focus on the cost side of your deals, and we\u2019re going to talk about hidden costs.
So, what are some of the traps that investors miss when they\u2019re underwriting their deals, or don\u2019t know how to calculate? And I don\u2019t know about you guys, but this is probably one of the more common questions I get. It\u2019s like, I get the math, how to underwrite a rental property, but how do I figure out the assumptions for a rehab, or how do I figure out the assumption for holding costs for a flip? Those types of questions, I think, really trip up the investors, and they change a lot based on market conditions. So, that is what we\u2019re going to talk about today, but first we\u2019re going to take a quick break.
All right, so let\u2019s get into it today, and we\u2019re actually going to break this down into different strategies. So, as usual, James is going to represent the fix and flipping crew for us. Henry\u2019s going to take the buy and hold position, and Kathy is going to look at syndications. James, let\u2019s start with you, and just talk about fix and flip. Just generally speaking, at the highest level, what are the big categories of expenses that you think investors really need to know about when they\u2019re underwriting their deals, and which ones do you think are the hardest to understand, and to underwrite correctly?<\/p>\n
Yeah, fix and flip is one of those businesses, because it\u2019s a high return deal, there\u2019s a lot of fees that can be associated with it. It\u2019s also a high risk transaction, as well, because you are buying\u2026 There\u2019s so many little things that can come up.
But the four main costs that I usually am watching when I\u2019m buying any kind of fix and flip deal, or a short term investment, where we\u2019ve got to close really quick, is closing costs and assignment fees. What\u2019s your total acquisition? The lending, because a lot of times you got to take down these properties with construction lenders, which have a lot of fees that can be associated with that loan, as far as doc prepping, what kind of interest are you being\u2026 How they\u2019re structuring their interest payments, and then construction, what are you missing outside the general scope of work?
And then lastly, it\u2019s always seller concessions, because those things can be big effects at the bottom line in the ROI, when you\u2019ve got to contribute to closing costs. So those are the four big things, and as an investor, you really got to dig into each one to make sure that you\u2019re not getting feed to death, because those fees can really, really jeopardize your return.<\/p>\n
All right, great. I know nothing about any of this, so let\u2019s get into that. You said the first thing here is closing costs, and assignment fees. So, what are some of the big costs associated with just acquisition there?<\/p>\n
Well, one of the biggest fees, hidden costs that I see happen all the time is in wholesaling. And because a lot of times when a wholesaler\u2026 When you\u2019re buying an assignment deal, or you\u2019re buying any deal, you have your own closing costs, which are typically going to be your title, and your escrow fees. And if you\u2019re an investor, a lot of times you can negotiate a better rate, because you\u2019re doing numerous transactions. So that\u2019s the first fee I\u2019m always going after is how do I reduce my transaction fees, escrow, title, I work with one title company, they give me a way better rate, they reduce my cost when I\u2019m doing the same transaction.
The other thing I have to watch out for is when you\u2019re buying an off market wholesale deal, you are buying the terms that the wholesaler structured with the seller as a negotiation. And part of that negotiation, sometimes, even when we\u2019re wholesaling or working with a seller, a seller just sometimes wants to know what their net number is. Like, \u201cI\u2019m walking away with $10,000 or $20,000,\u201d or whatever it is.
That usually means that the contract\u2019s structured with the buyer paying all the seller\u2019s closing costs. And so, there\u2019s a huge fee that can creep in at the end. I\u2019ve been see\u2026 Especially the last two years, it wasn\u2019t as big of a deal until these last two years, is you would go to buy a deal from a wholesaler and they say, \u201cHey, it\u2019s $200,000.\u201d \u201cPerfect, wholesaler. I\u2019ll take that deal.\u201d
I\u2019m calculating, as a buyer, that I got my standard escrow, and title piece. But then, when they\u2019re saying 200,000, or they\u2019re saying, \u201cHey, I locked this property up for 180, I want to make 20 as my assignment fee, you\u2019re buying it for 200.\u201d But then if they structure that you\u2019re paying the buyer\u2019s closing costs, that can get rolled into the deal, and that can be anywhere between three, four, $5,000 that can get added onto the property.
And if that\u2019s not specified in that assignment agreement, you could get stuck paying those costs, because if you\u2019re signing an assignment and saying, \u201cHey, I\u2019m just assuming this guy\u2019s contract,\u201d it\u2019s up to the investor to verify what\u2019s inside that contract. And so you can get stuck with those fees if you\u2019re not watching that.
So, how I like to always structure my off market deals is instead of a purchase price, I do total investor acquisition. So, that means when I\u2019m buying it from the wholesaler, I\u2019m going, \u201cHey, I\u2019m buying this for 200,000,\u201d but that uncovers all the costs in there, and then that way if there is additional costs, that comes out of the assignment, not my pocket.<\/p>\n
So you\u2019re saying that there is a chance, using your example where it\u2019s, the house is at 180, the wholesaler wants 20 grand for an assignment fee. You\u2019re saying that there are scenarios where you as the investor could buy it for 200, and then you would have additional costs on top of that, that could be unexpected?<\/p>\n
Yeah, because when you\u2019re buying a wholesale deal, you\u2019re not actually buying a property. You are, on the next transaction, you\u2019re buying the rights to the contract on that property. And so however that contract\u2019s structured, if it\u2019s not clarified on if that\u2019s being deducted from the fee, yes, you are going to be responsible for any buyer\u2019s closing costs, because you\u2019re now assuming that contract, right?<\/p>\n
Okay, that makes sense. Okay, that\u2019s a very good tip. Yeah, I never would\u2019ve thought about that. And so, is that something that wholesalers\u2026 What you were suggesting, the total acquisition fee, using that as the number for your negotiation, it sounds like, is that something wholesalers are familiar with, in your experience, and they\u2019re comfortable reconsidering the way they structure their deals, or their presentations to you, around your preferred metric?<\/p>\n
Yeah, a lot of times I\u2019ll have a little bit of issues when I\u2019m working with maybe a newer wholesaler, just because they just also didn\u2019t think about it either. So if they call me and say, \u201cHey, this price is 200 grand,\u201d the price is really 205 if I\u2019m paying all the closing costs. And so, I just have to educate people a little bit, like, \u201cOh, next time will you let me know it\u2019s 200, and I\u2019m paying all sellers close\u2026 So I can calculate it correctly.\u201d
The clarification question I always ask is, \u201cIs there any other cost outside of it?\u201d And then, \u201cIs this my total acquisition fee?\u201d And if I do that, it can kind of narrow the price down, if they say yes, and then the contract states later, they\u2019re responsible to cover the difference at that point.<\/p>\n
Okay, cool. Thank you, that\u2019s super helpful. So, the second thing you said where there\u2019s some hidden costs that you might want to make sure you\u2019re calculating, is with lending and hard money. There are some well-known fees and costs associated with getting a loan, but what particularly about flipping, and hard money do you think people need to keep an eye out for?<\/p>\n
Especially nowadays, so the lending hard money space has changed. It has the been one of the biggest industries that\u2019s changed over the last 24 to 36 months. Hard money, when I was buying as a new investor, was just like it\u2026 I mean, it was really hard money. We would go to a lender and say, \u201cHey, we got this property. They want us to put a certain amount down.\u201d They\u2019d verify the loan to value, and I could have my cash in 24 to 48 hours. And it was a very simple process at that point.
And then, you kind of knew what your fees were, which typically with a lender, when you\u2019re using a construction or hard money loan, which most of the times you need to do with a fix and flip, you got to add value to these properties. They\u2019re going to be higher rate and points. So the first things you always want to look for is what\u2019s the points on the loan? And what points are, is it\u2019s the origination fee, with the balance of that property, which is going to be the purchase price, and the construction component.
The next thing you want to know is, what is the interest rate? Which is going to be, typically with hard money right now, it\u2019s going to be 10 to 12%. And based on that rate, you want to make sure that\u2026 There\u2019s a couple things that you want to watch out on the interest, and the rate. The thing that I\u2019m always looking out for, is if I\u2019m doing a construction loan, are they charging me interest on the full balance of the loan, or only the drawn amount?
That can really make a big difference on a long project, because some lenders do finance, because they say, \u201cHey, I\u2019m reserving you the cash, and so, if we\u2019re reserving the cash, we\u2019re charging you for the interest.\u201d Now some lenders don\u2019t do that.
And so, those are really important things to do, because again, it can be thousands of dollars on your interest when you\u2019re reading your loan sheet. In addition, too, you want to know if there\u2019s any kind of prepayment penalties, right? Because like what I was saying earlier was when we had hard money, it was like cash guys giving us money. Now there\u2019s banks in the space, and banks come with different types of terms.
They\u2019re used to prepays, they want to keep their money out on the street, because if you are a short term investor, and you\u2019re getting a 12 month hard money loan, and you\u2019re selling that deal in eight months, and there\u2019s a prepay, that\u2019s going to affect your deal, and return down. So, sometimes there can be a one to two point prepay.
Other times there can be motivation, where, like we have a hard money company called interest funding. We actually incentivize our borrowers to pay us off quickly, because we like to get in and out of loans. It\u2019s safer for us. And so, you want to be also asking what the benefits are. And then the biggest thing you got to check out for in your lending is just those hidden little doc fees, because they just rack up.<\/p>\n
But can you negotiate out of those? It\u2019s like, they always keep it at a level where it\u2019s annoying, but it\u2019s not worth actually arguing about. Do you actually go after your lenders for those things?<\/p>\n
I will, because there\u2019s also the cat and mouse game all these lenders play, and it\u2019s like, \u201cOh, I only charge one point, and I\u2019m this rate.\u201d But then you look at their doc schedules and their fees, and it\u2019s almost the same as a two point lender that may have a lot more reduced fees. So, you do have to look through them all, because when you\u2019re paying $350 to $500 per fee, and there\u2019s four to five of them in that deal, that can turn into two to three points.<\/p>\n
Yeah.<\/p>\n
And if you\u2019re doing that on 10 deals, that\u2019s going to add up dramatically over a year. And so, just always be watching. There\u2019s always the construction doc fee, the underwriting fee, then there\u2019s a construction draw fee that could be like $500 per draw that you have. Then there could be a\u2026 What\u2019d I get? I got one recently, I\u2019m like, they charged me a $100 to generate a payoff. I was like, \u201cYou got to be kidding, I\u2019m paying you off, and you\u2019re going to charge me $100?\u201d<\/p>\n
Money collection fee.<\/p>\n
Yeah, money collection. Yeah, I\u2019m paying\u2026 Yeah, they\u2019re trying to make it sure I\u2019m not paying them off.<\/p>\n
You\u2019re paying them to take your money.<\/p>\n
Exactly. That one I felt really good about. But all these fees add up, and you really got to watch for them. And a lot of investors will\u2026 That\u2019s their first thing, is, \u201cWhat\u2019s your rate and points?\u201d And they get fixated on this, but you want to look at the whole big picture. What is the total cost of all of these? How they\u2019re structuring their interest payments, what kind of doc and prep fees, and then really compare apples to apples at that point.<\/p>\n
Sounds like it would be a good idea to be a lender, then.<\/p>\n
Being a lender is one of the best businesses there are.<\/p>\n
Clearly.<\/p>\n
Being a hard money lender, it is the best business to operate. I will say that. Because you don\u2019t have to do all the hard work. The investors are doing the hard work. You just got to make sure you verify the asset, and you\u2019re good.<\/p>\n
And just charge a bunch of fees.<\/p>\n
Reasonable fees. If it\u2019s [inaudible 00:13:07] .<\/p>\n
Okay. James, so far we\u2019ve talked about closing and costs, and lending, construction. I feel like this is obviously a big one. There\u2019s probably so many things to it, but what\u2019s your top tip here, for helping people avoid any hidden fees, or costs with construction on a flip?<\/p>\n
The biggest one that I always say is, is the bid fixed, or is it time immaterial, or just an estimate? Those are going to be the big variances on those hidden fees, because I have had clients, and it\u2019s happened to me too, where you get submitted a bid, and you have to read that fine print. Are these allowances that are being listed on your estimate, or is it fixed? And if there\u2019s verbiage about there being an allowance, or it\u2019s an estimate only, that contractor can raise their price at any time, at least in Washington state. So, that\u2019s the big one with construction, to make sure you\u2019re narrowing that scope, that it can\u2019t be increased just because costs go up.<\/p>\n
What structure do you prefer, James, for your contractors? Is it fixing the bid?<\/p>\n
Oh, we fixed bid everything. I want to know price per square foot, or fixed bid, and if they can\u2019t do that, it makes me a little uncomfortable.<\/p>\n
Okay, cool. And then last thing you said was seller concessions. Very popular topic these days. So, what are you doing to make sure you\u2019re accounting for seller concessions right now?<\/p>\n
As the market cools down, you want to look at what demographic you\u2019re selling to. If it\u2019s a first time home buyer right now, we might pack in an additional 2% to 3% in closing costs, because that buyer might be asking for that on every deal. In 2008, \u201909, and \u201910, there was limited financing, limited buyer pools, and it was a lot of motivation for first time home buyers. And so, it was almost always on those deals we were going to have to pay 2% to 3% in closing costs.
And so you want to make sure you know who you\u2019re selling to, or what product you\u2019re selling. Like if you\u2019re a new construction builder, and the rates are high, you might be buying down the rates. So these are all\u2026 If you\u2019re paying three points on a $300,000 flip that you\u2019re selling later, that\u2019s $9,000, which can be anywhere\u2026 A lot of times, 25% to 50% of our profit on the smaller deal.
And so, watch out for those closing costs. So, how we kind of protect ourselves on that, when we\u2019re running our analysis and our underwriting, we\u2019re calling every broker, and then we\u2019re reading through the MLS to see if there was concessions costs given when they sold it. Because if the comparables are all saying they had to support those closing costs, we have to factor in our pro forma.<\/p>\n
You have a good rule of thumb, James, for how much people should set aside when they\u2019re underwriting a deal right now, for seller concessions?<\/p>\n
What I\u2019ve been doing, because roughly is, we have 6% broker fees, and then we usually have about 2.5% in closing costs, to 3%. So, I add an additional 1% minimum to each deal. So typically when I\u2019m selling a property, I knock 10% right off the top. If I\u2019m selling it for a million bucks, I\u2019m going off a net of 900, because that\u2019s going to be all my closing costs right off the bat, plus a little bit of wiggle room. So, that\u2019s how I underwrite things really quickly in my brain.<\/p>\n
All right. Well, there are some good tips for underwriting right now, in the fix and flip space. Henry, let\u2019s move on to you, and talk about buy and hold. So, what do you see as the big buckets of expenses that need to be accounted for, and what are some of the major areas that you find investors underestimating, or miscalculating, when they do their underwriting?<\/p>\n
Yeah, man, so buy and hold. I think most people understand the high level buckets. So we\u2019re talking about maintenance. Everybody knows stuff breaks. So, you need to be budgeting for maintenance out of your properties. Everybody understands that there is going to be property management of some sort, so there\u2019s a budget for that. There\u2019s capital expenses, there\u2019s vacancies, and then everybody else knows there\u2019s your debt service, and your principal, your interest, and your insurance.
So, those are the main buckets that people are typically aware of. But what I found is that people like to skimp on some of these. They\u2019re like, \u201cAh, it won\u2019t happen too often. I\u2019ll just leave that out of my underwriting. Vacancies are really low here. Stuff rents so fast, so we\u2019re not going to budget for vacancy.\u201d Or, \u201cI\u2019m going self manage, so we\u2019re not going to budget for property management.\u201d So, I think people leave a lot of that stuff out.
But even within some of these expenses, there are hidden costs in the hidden expenses. So when you think about vacancy, everybody understands vacancy. Yeah, people will move out, and then when they move out, I have to re-rent it, and so I need to budget for that time that somebody is not living in my property.
But when you really break down vacancy, there\u2019s a lot in there that people don\u2019t account for. Yes, vacancy means when somebody moves out, you need to pay the mortgage. But what people don\u2019t think about is, what about vacancy when tenants don\u2019t pay rent, right? Because maybe a tenant doesn\u2019t move out, but they\u2019re just not paying you rent for whatever reason, and you\u2019re going through this series of back and forth with a tenant. You\u2019re still having to cover the mortgage for that timeframe, and they still live there.
So, I think vacancy is much deeper than just, \u201cSomebody\u2019s moving out, and I\u2019m re-renting it.\u201d Also, what about eviction costs, right? You\u2019re a landlord, at some point you\u2019re going to do an eviction, or two, or three, or four. It depends on how good you are at tenant selection. But no one budgets for evictions on the front side, and I think evictions are part of vacancy.<\/p>\n
And expensive.<\/p>\n
And expensive, and it\u2019s going to vary from state to state. So you should do your due diligence, know what an eviction costs you, and budget part of that into your monthly expenses for your property. You also have utility costs during vacancies. So, if your property is empty, and you\u2019re having to renovate it, right? Well, you\u2019re not only covering the mortgage, but you\u2019re covering the utilities, and those utility expenses aren\u2019t things that people think about as part of what you pay for as a landlord. They say, \u201cOh, well, my tenants are going to pay for the utilities.\u201d Yeah, they will when they live there. But what happens when you\u2019re doing a 60-day renovation on a property? That utility expense goes back to you. So, you\u2019re carrying utilities.
And so, it\u2019s not just tenants moving, it\u2019s much more than that, because you\u2019ve got tenants moving, you\u2019ve got renovations, and a lot of times people who are going to do this buy and hold method, or especially the BRRRR method, they\u2019re not considering all of these holding costs on the front side. You\u2019re buying a property that needs a renovation. So, all of these expenses start hitting you from day one, before you\u2019re ever making any money. And so you want to underwrite that into what you\u2019re offering for a property, and be able to budget for it on the front side.<\/p>\n
So, how do you do that practically, Henry? Because a lot\u2026 If you use the Bigger Pockets calculators, or a spreadsheet, usually there\u2019s a line item for vacancy, and it\u2019s usually a percentage of rent is what most people do. Is that what you do, or do you recommend adding sort of another lineup? Do you jack up the vacancy number?<\/p>\n
I don\u2019t think that it matters, as long as you add it in there. So, if you just want to increase your vacancy percentage, right? So some people, as a rule of thumb, just use the vacancy percentage of a market, so you can find your market, and understand, \u201cHey, in Northwest Arkansas, we have 5% vacancy, so I\u2019ll budget 5%.\u201d
Well, 5% typically probably isn\u2019t even one month\u2019s rent. And so, I prefer to do it more on, how long do you envision a property to be vacant when you have to turn it over, and then add a little padding for these other things that we talked about. So, in my opinion, it needs to be at least one month\u2019s rent, plus these additional things. And so, just use your best judgment, based on what these things cost, and add a little bit to that. Or you can have separate line items if you\u2019re super detail-oriented.
Another thing to think about is a lot of people do not budget for property management. They say, \u201cWell, I\u2019m going to self-manage.\u201d And I know that sounds great, and I think most people should self-manage where it makes sense, but you have to understand what your goals are as a real estate investor.
If your goal is to buy one property a year for five years, and then at the end of your journey you\u2019re going to have five properties, okay, self-managing might be something that\u2019s reasonable for you. But if you\u2019re planning to scale this business, if you want to get to your financial freedom by generating enough cash flow from your rental properties, it\u2019s probably going to mean you\u2019re going to do more than five properties. And yes, right now managing your properties seems like a good thing to do, because you want to learn, because it saves you the money. But at some point, you are not going to want to do that if you\u2019re growing, and scaling, and you want to be able to still cash flow your properties when that happens.
And so, if you\u2019re not underwriting your deals with 10% property management in there, I think that you\u2019re hurting yourself, because if you\u2019re buying something that doesn\u2019t work, if you add that 10%, well you\u2019re buying a really slim deal, and then you\u2019re going to lose your cash flow, if and when you decide you don\u2019t want to do that. Also, you don\u2019t know what life brings, right? You don\u2019t know what opportunities are around the corner for you. Maybe you get a different job, maybe you have to move. There\u2019s all these things that could unexpectedly require you to hire property management, and you haven\u2019t prepared to do that, and I think that\u2019s a big one that people miss that\u2019s easily added to your underwriting.<\/p>\n
I think that\u2019s such a good point. I mean, this is an oversimplification, but in a lot of ways, the only way to really lose money in rental property investing, is forced selling, like if you have to sell at a bad time. The housing market generally goes up. So, if you can hold on through bad times, you\u2019re going to do well.
And I think property management is one of those sort of traps where you can get sucked into forced selling. Like you said, if your life changes, if something happens, and it doesn\u2019t pencil out with you not managing, you could sell what might be a great deal, because you just\u2026 Like long term, because it just doesn\u2019t work with your lifestyle anymore, or you can\u2019t find a property manager to do it effectively. So, I think that\u2019s a really good risk management strategy, is to make sure, even if you\u2019re self-managing and intend to do it forever, to continue to underwrite with those. Very good tip. Any other ones, you think?<\/p>\n
Yeah, one final one to think about, that I think a lot of investors don\u2019t think about it, because they don\u2019t really consider it at an expense, but it kind of turns into one. So, a lot of landlords don\u2019t\u2026 they\u2019re not diligent about rent raises. I buy properties all the time from landlords, and their market rents are so low, and you\u2019re essentially leaving money on the table by not keeping up with market rents.
I\u2019m not saying you need to be at the market number every single time, but if you\u2019re not increasing your rents with what the rent rates are in your area, essentially you\u2019re charging yourself an expense every month, because you\u2019re leaving money on the table from the rents that you could be getting, especially if you rented it to another tenant.
Now, I\u2019m not saying be irresponsible, and raise rents on people without considering who your tenants are, what situations are out there, but you need to have some sort of systematic process in place to ensure that you\u2019re keeping your rents up with the market, and with inflation. Because if you\u2019re not doing that, then you\u2019re paying an inflation expense, and you\u2019re paying a rent expense by not charging those things.<\/p>\n
Opportunity costs are costs. I mean, if you are losing out on an opportunity, that costs you something, that is an inefficiency in your business that you need to take advantage of. So yeah, I mean, that\u2019s hard to underwrite for though, right? You\u2019re just like, you can\u2019t be like, \u201cOh, I\u2019m going to be bad at running my business, so I need to add this [inaudible 00:25:18].\u201d<\/p>\n
And a lack of business acumen.<\/p>\n
I guess if you\u2019re just really self-aware you could do that, but I\u2019m not that self aware. You learn those ones the hard way.<\/p>\n
And that\u2019s why we hire ho property management, right? If you don\u2019t have the heart to raise rent on people, factor for the property management expense, let them do it. So, just put one of those in there. Either rent raises, or property management cost.<\/p>\n
Absolutely. Couldn\u2019t agree more.<\/p>\n
All right, well, any other last thoughts? I think we\u2019ve covered now buy and hold, and fix and flip. Kathy, I have you going last because I know you have to go to the airport, so if our listeners just hear Kathy run out the door, it\u2019s because she has to make a flight, but she\u2019s here with us for now. So, let\u2019s ask her about syndications, and what the big costs\u2026 I assume we\u2019re, we\u2019re going to do this as a LP, as someone who invests, a limited partner in a syndication. What are some of the, as a passive investor, some of the costs that we should be thinking about?<\/p>\n
Yeah, and just to explain to some people who maybe don\u2019t know what a syndication is, somebody, an investor finds a deal, and needs more money, doesn\u2019t want to go to the bank, so they bring in passive investors, other investors who don\u2019t want to do the work, just want to invest. So, the person who found the deal is generally called the sponsor, and they\u2019re the GP the general partner, and then the investor is the LP, the limited partner.
So, I can really speak to both sides, because I\u2019ve been on both sides, and there\u2019s hidden fees on both sides, because it\u2019s a partnership, and it\u2019s flexible, meaning if the deal goes really well, then everybody generally makes money. If it doesn\u2019t, that\u2019s when people get upset, right? Because there\u2019s not enough money to trickle down to everybody.
So, as an investor, it\u2019s really important, first and foremost, to look at the fees, because the sponsor may say, \u201cHey, we\u2019re going to split this 50\/50.\u201d Now, the investor generally gets like 80% of the profit, but it\u2019s 70, 80% depending on the deal, and the sponsor gets 20 or 30%. But I\u2019ve seen people flip it. I mean, there\u2019s all kinds of ways these are structured.
But let\u2019s say it\u2019s 80% of the profit, and you\u2019re like, \u201cWhoa, this is great. I\u2019m going to get 80% of the profit and do none of the work.\u201d Well, what if within the documents, there\u2019s all kinds of fees that you didn\u2019t account for, and those fees eat up all the profit during the process of the deal, such that there\u2019s no profit left, and you get nothing? So, this is really important to understand.
On the flip side, if you\u2019re the sponsor, if you\u2019re the syndicator, and you don\u2019t charge any fees, which I\u2019ve done, when I first started syndicating 12 years ago, I didn\u2019t want to charge fees to the investors. I just wanted it to be fair, and even, and I\u2019ll just do the work, and we\u2019ll just split it all at the end. But I also gave an enormously high preferred return.
So, that\u2019s the next thing, is the preferred return is who gets paid first, who gets preference? And it\u2019ll outline that in the documents. Some documents don\u2019t have any preferred return, everybody just gets their money pro rata. It\u2019s better for the investor to have preference, to get paid first, before anybody else. That\u2019s a preferred return. So, in the beginning, I was giving my investors a 15% preferred return per year.<\/p>\n
Whoa, I want to go back in time and invest in this.<\/p>\n
Man.<\/p>\n
Because no fees, 15% pref, that sounds great.<\/p>\n
It was crazy. But this was 2010. I mean, we were getting stuff for 10 cents on the dollar. There was so much in it that everybody made money, except if things go longer. So if you project you\u2019re going to get through this deal in two years, but it goes three, or four, due to things that are really maybe out of your control completely, well, the investors are still getting that pref, they\u2019re getting paid first. They\u2019re getting that 15% before I get anything.
So, in some of those deals, I didn\u2019t charge any fees, I gave an enormous preferred return, and by the end, I didn\u2019t get anything. So I did all the work, didn\u2019t get the profit, but the investors did great. So in a syndication, it needs to be equal. Everybody needs to make money.<\/p>\n
Absolutely. Yeah. I think that this concept of the capital stack, basically the order of which people are getting paid, is really important. And that\u2019s not just for syndications too. Sometimes this happens in partnerships on smaller deals, as well. If someone\u2026 You really need to model out in your underwriting, the order of which people get paid.<\/p>\n
Yes.<\/p>\n
Because if there\u2019s a lot of money, it might look like a huge pot of money, but if someone gets a guaranteed 10% return before you get a dollar, maybe that big pot of money doesn\u2019t go so far, and it\u2019s really worthwhile to even draw this out, and just visually understand who\u2019s getting paid what, before you get into any sort of partnership, including a syndication.<\/p>\n
And syndications are regulated by the Securities Exchange Commission, the SEC, so you are supposed to have all of that explained in the operating agreement. It\u2019s usually in an LLC, and a private placement memorandum, where all of that is spelled out. But most people don\u2019t read them. They\u2019re boring, they\u2019re legal. But if you\u2019re investing in a syndication, just spend the money to have an attorney review it for you, or just make sure you really understand it.
And Dave, what you said about understanding that waterfall is the most important thing. Who\u2019s getting the profit when that profit hits? And who\u2019s getting fees? Now, I\u2019ve learned since that a syndicator should be charging fees, because you\u2019re doing the work, and there might not be profit. It\u2019s an investment, there\u2019s no guarantee. There could be another pandemic. Right?
So in the case of, and I\u2019ve talked about it before, but our Park City deal, we got shut down for two years because of COVID, but we\u2019re still paying that 15% preferred return when we\u2019re not making any money, and can\u2019t do any work, and you can\u2019t change the documents. Right? This is just\u2026 It didn\u2019t say, \u201cOh, if there\u2019s a pandemic, we\u2019re not paying this.\u201d
So, you\u2019ve really got to understand the fees being charged, and if that\u2019s going to take all the profit, and as a syndicator, or the investor in it, is it equal? Is it fair? So, typically, you would see a one to 2% just sort of asset management fee. We\u2019re just kind of watching this. If it\u2019s development, it\u2019s going to be a higher fee, because there\u2019s more to it, there\u2019s more work, so the fees might be higher.
There\u2019s generally going to be a fee for the person who does the financing, because they\u2019re doing all that it takes to get the financing, and sometimes they\u2019re taking a recourse loan. So, it\u2019s okay, expect that, but not an exorbitant fee. So again, maybe one to 2%.
There might be an acquisition fee. Now, this is where the people get paid to just find the property, and go through the process of acquiring it. There\u2019s still broker fees on top of that, and there might be a disposition fee, the time it takes to sell the property, even though a broker\u2019s really doing that. So, these are all fees. Some syndications will have them, some won\u2019t.
It\u2019s got to be good for everybody, and there has to be enough cushion that those fees can get paid, and there\u2019s still profit in the end. So with every syndication, make sure they have a very detailed pro forma showing you where all the money\u2019s going. Because if it\u2019s vague, and this is what I\u2019ve learned over the years, if anything\u2019s vague, then the syndicator, the sponsor, can say, \u201cWell, the documents allow this, because it didn\u2019t not allow it.\u201d And so everything needs to be spelled out.
And then another big\u2026 I noticed this was with a single family fund that wanted us to wanted partner with us, and they were kind of Wall Street guys. And as we looked at their pro forma, and their documents, they were charging $500,000 per person in salaries.<\/p>\n
Whoa.<\/p>\n
In salaries. And this is a fee that came on top of anybody, any of the investors getting their money. We\u2019re like, \u201cI mean, maybe you guys do that on Wall Street, but we don\u2019t do that on Main Street. That\u2019s not how it works.\u201d So really look for that. Who\u2019s getting paid? And what happens if they said this project\u2019s going to be done in two years, but it goes for five years, do they still get that salary? So again, there\u2019s a lot to look at. A lot of people just don\u2019t pay attention, and they just believe the marketing materials, and don\u2019t read actually the fine print. So, if you don\u2019t want to read it, have somebody else who understands it, read it for you.<\/p>\n
Read your contracts.<\/p>\n
Yes.<\/p>\n
God, yes. I mean that\u2019s basically, maybe that\u2019s just the theme of this episode. It\u2019s just hidden fees. It\u2019s like read your contracts, and you\u2019ll eliminate probably half the fees that you encounter as an investor, or just a human, in life.<\/p>\n
And then there\u2019s another thing that people really don\u2019t understand with syndications. We\u2019ve noticed this all the over the years, is they don\u2019t know their status\u2026 I don\u2019t know how to say this. They don\u2019t know their status, their position as the investor. So they don\u2019t know where they fall in that waterfall.
They don\u2019t know if they\u2019re an equity investor, so they don\u2019t even know what that means. They don\u2019t know if there\u2019s somebody ahead of them that has priority to them. Or they think maybe they\u2019re a lender, they\u2019re investing and they got a 6% preferred return, and they think that\u2019s a loan. They think that that\u2019s guaranteed. It\u2019s not. It only comes out of profit, the preferred return, generally, unless you\u2019re coming in as a lender.
If you\u2019re a lender, you know what? We talked about it earlier. The loan gets paid first. Always. The lender is in the best position, almost always, and there\u2019s usually a first and a second. Obviously the first lender has the first priority, and if there\u2019s no profit, you still got to pay it. You still\u2026 The sponsor, the investor takes the loss, the lender doesn\u2019t.
So, if you are investing as a lender, it\u2019s definitely the highest priority. If you\u2019re investing as an equity investor, you\u2019re at the bottom. You get paid after everybody else gets paid. And if there\u2019s huge profit, you can make a tremendous amount of money. If there\u2019s no profit, you get nothing. If there\u2019s losses, you lose your money.<\/p>\n
It\u2019s very good advice. Well, thank you all for all this. It\u2019s been super helpful. There are, actually, if you want to learn any more about the nuts and bolts of operating of these different types of businesses, there are actually great Bigger Pockets books for any of these.
Jay Scott did a really good house\u2026 He has two flipping books, one on estimating rehab costs, one and just being a flipper. Brandon wrote a great book about managing rental properties, and Brian Burke has a great book on investing in syndications. So, if you want to learn a little bit more about underwriting deals in a written format, you can check those out on biggerpockets.com\/store.
With that, we have one question from the Bigger Pockets forums that I want to ask you guys. It is about the general economy, and then we\u2019ll let Kathy make her flight. Emily Hazard went on the Bigger Pockets web forums and said there, \u201cMorgan Stanley sees something called the 4-4-4 happening in 2023.\u201d Have any of you heard of this?<\/p>\n
No, I have not.<\/p>\n
Me neither. I hadn\u2019t either. So, it\u2019s called, \u201cMorgan Stanley sees an environment in the future with 4% federal funds rate, which is a little bit below where it is now, 4% inflation, which is definitely below where it is now, and 4% unemployment, which is a bit higher. Do you think this is accurate? What are your thoughts?\u201d All right. Anyone want to take a first swing at this?
So just as a recap, it\u2019s Morgan Stanley forecasting that we might see a year in 2023 where the federal funds rate is 4%, inflation is 4%, and unemployment is 4%. That would be inflation and Feds coming\u2026 The Fed fund rate coming down a little bit, inflation coming down a pretty good amount, and for unemployment going up just a little bit. So, what do you guys think?<\/p>\n
It sounds balanced, and nice.<\/p>\n
I think it\u2019s hopeful.<\/p>\n
Yeah.<\/p>\n
I personally don\u2019t see that happening. I actually think the federal fund rate will be around 4%. I think, hopefully inflation gets to 4%, maybe by the end of the year, it might, probably a long shot. But the one thing is this unemployment numbers are just not moving.<\/p>\n
Yeah, it\u2019s wild.<\/p>\n
The labor market is getting no ease on that, and that\u2019s where I\u2019m like, \u201cAt some point, something\u2019s going to happen there,\u201d but it right now, it does not seem to be breaking.<\/p>\n
Yeah, I mean that\u2019s wishful thinking, and it would be wonderful. I guess the question is when? I mean, are they thinking it would be this year? Because the Fed has made it really clear going to keep raising rates, and shooting for 5% Fed fund rate, and yeah, they\u2019re really shooting to kill jobs, and they haven\u2019t done a great job at that yet, which I guess, depending on if you would like a job, or not, it\u2019s good news for the person with a job that they haven\u2019t killed the jobs the way that they wanted to. So, I highly doubt that. I think the Fed fund rate\u2019s going to be higher, and inflation probably higher too, at this point, unless there\u2019s a little tweaking with the data, which is possible.<\/p>\n
Really? I think inflation\u2019s going down. I think, we\u2019re already at 6.1%, if we stayed at the run rate we\u2019re at for the last six months, we will be at like 2.5% by June. So as long as inflation doesn\u2019t go up, we will be well under 4%, just from a mathematical perspective. It could go back up. I have no idea, but just based on the trajectory right now, I think it\u2019s going down.
But I totally agree on the Fed funds rate. I think they\u2019ve basically said there\u2019s no way they\u2019re cutting rates in 2023, and it\u2019s already above 4%. So, that seems like a long shot. Unemployment is just the big question, right? It\u2019s weird. You would think that it would be higher, but it does seem like there\u2019s kind of this bifurcation of the labor market, and there\u2019s this big\u2026 All this public discussion about layoffs, but those are just happening in the tech sector.
If you look at more traditionally blue collar jobs, the labor market is incredibly strong there. And I read something today in the Wall Street Journal that said that 78% of job openings right now are at \u201csmall businesses.\u201d So still, we hear about Amazon and Microsoft laying off businesses, but that\u2019s not\u2026 Or, laying off people, but that\u2019s what\u2019s driving the labor market. It\u2019s all these small businesses. And so, it\u2019ll be interesting. Personally, I think that\u2019s sort of the X factor for the economy this year is what happens with unemployment.<\/p>\n
And we are seeing, for like our job, because we\u2019re the small business in Seattle, all the tech guys just steal everybody. And the last 24 months we\u2019re really frustrating. You\u2019d be like, \u201cI need an accountant, and I can\u2019t get an\u2026 This is crazy.\u201d<\/p>\n
You can\u2019t pay 750 grand for an accountant, James?<\/p>\n
Oh, yeah. It\u2019s like, it\u2019d be an entry level marketing person, they\u2019d be like, \u201cI\u2019m going to get paid a $100,000 at Amazon.\u201d I\u2019m like, \u201cWell, I can\u2019t do that. It\u2019s just, that doesn\u2019t work.\u201d But it is easing up a little bit. There is some, like construction companies are starting to lay off some people. There is, some of that blue collar is lightening up, but at least you can get applications now.<\/p>\n
Typically the layoffs that I\u2019m seeing are in industries that had to staff up during the pandemic, or staff up during what happened as a result of the pandemic. So, the mortgage industry is doing some layoffs, but obviously, that\u2019s affected by the rates being what they are, and mortgage applications not being what they were. And then in tech, and then a lot of different customer service industries, where they had to staff up to handle the load of calls coming in from people who were just sitting at home.<\/p>\n
Totally. Yeah. So, it\u2019ll be interesting, but I hope they\u2019re right. That sounds like a great place to wind up. If we wound up with 4% unemployment, that would not represent a significant break in the labor market. It would be mean inflation still too high, but back in the stratosphere at least. And then, federal funds rate a little bit low below where they were? I mean, that would be wonderful. So let\u2019s all hope that we\u2019re right, but it does seem like there are some headwinds that might prevent this forecast from coming true.
All right. Well, Henry, James, Kathy, thank you so much for being here. For everyone listening, if you appreciate this show, appreciate the insights from the three panelists, please give us a five star review. We really do appreciate it. It really does help us. You can do that on Apple, or Spotify, so please go do that. Give us a five star review. We\u2019d really appreciate it. Thank you all for listening. We\u2019ll see you next time for On The Market.
On The Market is created by me, Dave Meyer and Kailyn Bennett, produced by Kailyn Bennett, editing by Joel Esparza, and Onyx Media, researched by Pooja Jindal, and a big thanks to the entire Bigger Pockets team. The content on the show On The Market are opinions only. All listeners should independently verify data points, opinions, and investment strategies.<\/p>\n