By Dr. James M. Dahle, WCI Founder
In 2016, we finally shed a bad investment that had plagued us for years. That was the year we finally sold our investment property. We lost a ton on this property, although the exact amount was difficult to calculate for various reasons. This was in spite of the fact that the rent was much higher than the mortgage payment, which seems to be the first criterion that rookie investors look at when evaluating rental properties. In this post, I'm going to revisit our mistakes in the hopes that someone else will learn from them.
But first, some general calculations to show how bad the carnage was.
- Purchase price: $138,000
- Sale price: $114,500
OK, that's a 17% loss. That's bad enough, right? But wait, there's more. The IRS lets you add to the basis for various improvements and other costs. As I recall, I got the basis up to about $145,000. Now, we're at a 22% loss. Also, in this price range, to get anyone to buy it, you had to throw in 3% of closing costs, and 3% of $114,500 is $3,400. Now, we're up to a 25% loss. We also had to spruce it up significantly to get it sold—between repairs we did to get an offer and the ones demanded by the inspection, you can add in another $6,000 or so. We're at 29%. Also, you have to pay a realtor, and 6% of $114,500 is another $7,000. That's a 34% loss.
Now, let's talk about the cash flow over the years as a rental. I think we were cash flow negative—sometimes severely cash flow negative—every year. In fact, for the first 18 months after we moved out, we didn't have a renter in there at all because we were desperately trying to sell it. After 14 months of failure, we then tried to find a renter for the next four months.
All in, we lived in it for four years, and it sat empty for 1.5 years; we had a renter paying rent for 3.5 years, and then we sold it for a huge loss. We walked away with $18,000 in cash but had thrown lots extra at the mortgage over the years. We also had pulled cash out previously to purchase another home. (Thankfully, we more than made up for our losses with appreciation of our big fancy doctor home bought in the depths of the housing crash.)
But you can see how it is hard to give a definite figure on just how bad our losses were. When you consider the leverage, it was at least a 100% loss, maybe 200%. It was bad. It was an investment disaster by any measurement except for the fact that we could afford to lose the money.
Here were the biggest reasons we lost so much money on this house.
#1 Bought at the Peak
We bought the property in 2006 at the peak of the housing bubble. Most people who bought any kind of property in 2006 did not enjoy very good returns. In fact, if I had been in Las Vegas, it would have been much worse. In 2006, the average property in Las Vegas was $299,000. It bottomed out in 2012 at $109,000 before gradually climbing back up to its 2023 status of about $390,000. Despite nine years of holding, the average 2016 home buyer in Las Vegas was still looking at a 36% loss. I did a little better than that in Virginia, getting out with a 17% loss (if you only look at the purchase prices). Despite the general rule that you only have to hold a property for 3-5 years for your appreciation to make up for the transaction costs, it's easy to see there are times when that time period can be much, much longer. In this situation, we clearly should have rented.
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#2 Paid Too Much for It
Looking back, I think we could have bought the property for about $130,000 if I had been a better negotiator. I applied the lessons learned when we bought the big doctor's house, but in real estate, you make your money when you buy.
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#3 Did Not Pay Enough Attention to Resale Issues
This home was in a diverse neighborhood just off a military base. The schools get poor ratings. We didn't really care about all that. Only one of our kids was going to be in school—and that was just kindergarten—while we lived in that house. We thought it would be easy to resell the property given its proximity to a military base. We were wrong, and it cost us a lot of money.
#4 Did Not Buy as an Investment Property
Like many others who bought homes anywhere near the peak of the bubble and then wanted to get out of them within 3-5 years, we became accidental landlords. We never bought this property intending for it to be an investment. Don't get me wrong, we did all the right things. We put 20% down, got a decent rate on a mortgage (6% was pretty good at the time), negotiated, and made sure it was a place that was very affordable for us. In fact, we used this property to save up for our dream home, such that it was nearly paid off by the time we moved out of it four years later.
At that time, we were having a little trouble selling it, so when we bought a place in Utah six months later, we got a 20-year home equity loan as a bridge loan. The rate wasn't great (although still lower than the 6% we had), but the fees were very low, which was the most important thing since we were only going to have it for a few months. Well, months turned into years, and we still had that 5.35% loan. To make matters worse, we tried and tried to sell it, reducing the price by about 20% from its peak value. At that value, it made for a reasonably attractive rental (cap rate 6.7%), although it still took a few months to get a renter in there. But between trying to sell and waiting to get a renter in, we paid that mortgage without any rent coming in to offset it for a full 18 months after moving out. It was a good thing it was VERY affordable for us. Most importantly, while it certainly met our needs for a home to live in at the price we paid, it was not a good price to pay for a rental property. It only had a cap rate of 4.7% at that price.
Bottom line: we learned a lot about real estate investing over the nine-plus years we owned the property, and knowing what we know now, we would never buy it as an investment; would never use the loan we used; and, of course, would never wait that long to get a renter into it.
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#5 Absentee Landlord
This “investment property” is located precisely 2,218 miles away from my current home in Utah. I only returned to the area one time in those five years for a WCI speaking engagement. It's one thing to do syndicated real estate deals in another state. It's entirely different to do direct rental when you're the only owner and you have to trust a property manager to do a good job. Our property manager did a reasonably good job finding a good tenant, but they did a terrible job of keeping her happy. After a while, we fired the manager. That boosted our return a bit, but it also made us the primary property manager. Luckily, I had a good friend I trusted who is a general contractor. He did a great job doing maintenance and upgrades for us, but a lot of it was stuff we could have done for far cheaper and easier if we had lived nearby. And forget trying to find another tenant. That's why we put it on the market when this tenant decided to move out.
We also discovered that we dislike being landlords and we're not that good at it. We even argued about who was supposed to cash the rent checks, and that's the easiest part of the whole thing!
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#6 Ignorance of the Importance of the Little Extras
This property is in a flood zone, so we had to buy flood insurance. It also had an HOA fee. While low, it added up. Those two extras—especially combined with taxes, insurance, management fees, and maintenance costs—made sure that we were cash flow negative every year we owned it (although we had a slightly positive overall return several of the years.) The general “55% rule” says that your net income is 55% of your gross rent. For us, it was more like 50%, and that doesn't include that 18-month vacancy.
Despite these six mistakes, this whole episode didn't have a huge financial impact on our life. We had very affordable housing for four years, saved up enough for a down payment on our dream house, and did not have to bring money to the table to close. But from the time we moved out until the time the house was sold, we probably had a cumulative loss of close to $60,000 on a $138,000 property. That's the total of the transaction costs, loss in value of the property, and the total of the negative cash flows.
Many people who purchased in 2006 and wanted to sell in 2010 did far worse (I had one colleague with a similar military doc salary who bought a $750,000 house at the same time), so we'll count our blessings. And we more than made up for our losses by being able to buy our big fancy house in 2010. We certainly learned a lot that goes in to every investment we now consider, especially real estate investments. Like with entrepreneurship, you want to fail early in real estate and with as little money involved as possible. If you are interested in learning more about real estate and minimizing mistakes like mine, check out our No Hype Real Estate Investing course.
Although we made mistakes while becoming accidental landlords, there are plenty of ways to make money in real estate investing, active or passive. If you're interested in pursuing real estate investing and working with some of the WCI-vetted partners that I invest with, here are some of the best companies in the business.
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What do you think? Were you ever an accidental landlord? How did you make out? What's your worst real estate investment? Comment below!
[This updated post was originally published in 2016.]