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Minimize Your Risk

SteveO

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It was Russ that suggested this thread. Hopefully others can chime in on how they have experienced this topic and what they have done.

Most people are probably here for the same basic reason... to get a lambo... :driving: ...Kidding...

The primary goal is to create passive income or make enough large chunks of dough that a regular job is no longer needed. Advice from others (including spouses and other loved ones) is frequently laced with the word "RISK". Risking bankruptcy and or losing your house and lifestyle is not what us investors want. We have worked hard in our lives to get our credit in order and build a household. The thought of risking that will keep many from moving forward.

I am going to add my input based on what I know. Apartments.

Some of the risks that might be involved.
  • gross income begins dropping

    Perhaps the macro economy has fallen into a recession, people are losing jobs and moving back in with parents or finding roomates. The areas vacancy rate starts to grow. The new owner may not be able to run the property as effectively as the seller.
  • income lower than projected after purchase

    Seller may have exaggerated the income.
  • expenses higher than expected

    Seller may have understated the expenses which is very common.
  • expenses rise unexpectedly

    Perhaps insurance or property taxes just took a major jump. Wages, security issues, or needs to begin a large marketing campaign may boost your costs.
  • major repairs come due

    Poor planning on major repairs with parking lots, roofs, painting, etc... or deferring maintenance out into the future that finally catches up.

It is inevitable that unexpected issues will arise. The key point is to make sure that you don't get caught offguard with the expected ones. It is also important that you have more than one game plan for increased income.

The biggest problem as an inexperienced buyer is seeing everything through rose colored glasses. It is easy to justify and modify figures on paper to fit what you want to see. Another problem is that the seller is trying to get as much as possible on the sale. They may be hiding some of the expenses or overstating the income. A comprehensive due diligence plan is important. The buyer must understand what they are getting and must take all emotion out of the transaction. There are many books and online resources for due diligence processes.

Be prepared to lose some deals in the discovery period of a purchase. The sellers may wish to move on and sell to someone that wont find the hidden issues.

Minimizing risk in this field also has some to do with maximizing potential gains. My goal is to look for the largest income gains that I can get. If I have done my job, the gains should hedge most of the bets well into my favor.

The economy works on a macro cycle nationally. It is something to pay attention to but the micro cycles are more important to me. If an area has favorable conditions coming up in the future and I can nail these down in advance, I have minimized some of the risk of the macro economy.

Under performing properties can sometimes be purchased below their potential value. Gains in income will lead to higher cashflow and greater value. Sometimes the gains are through expense reduction although these are more difficult to recognize. Ability to find mismanaged properties is the key here.

Understanding how to find the right location and underperforming properties are a major hedge against unforseen issues that may arise. This will hopefully provide some protection against losses in income or expenses that have increased higher that planned.
 

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andviv

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The biggest problem as an inexperienced buyer is seeing everything through rose colored glasses. It is easy to justify and modify figures on paper to fit what you want to see. Another problem is that the seller is trying to get as much as possible on the sale. They may be hiding some of the expenses or overstating the income. A comprehensive due diligence plan is important. The buyer must understand what they are getting and must take all emotion out of the transaction. There are many books and online resources for due diligence processes.

Be prepared to lose some deals in the discovery period of a purchase. The sellers may wish to move on and sell to someone that wont find the hidden issues.
...
Those two combined are the most difficult thing to overcome, in my opinion. An eager buyer PLUS an eager seller usually mean a higher price for the property.

Also, losing several deals is part of the myth that says that apartment buildings and commercial real estate is harder to do than SFHs. It is easy to lose motivation after saying fake income/expenses in the listings everywhere. It seems it is a common practice, even accepted by industry standards.

Great post. Rep++
 
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SteveO

SteveO

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Also, losing several deals is part of the myth that says that apartment buildings and commercial real estate is harder to do than SFHs. It is easy to lose motivation after saying fake income/expenses in the listings everywhere. It seems it is a common practice, even accepted by industry standards.
After the experience of running properties and having evaluated hundreds of them. Some of the information becomes programmed into your head. It get a lot easier to determine wich ones make sense from a glance. I don't lose too many in contract now because I try to lay out all the issues and expectations in my early discussions. Both as a buyer and seller.

If a buyer comes to me and asks for credit based on financials that I had initially shown to them or wants a credit for parking lot repairs that we had referenced in conversation, I will not budge. If they find a roof leak that I didn't know about, I will talk to them in a fashion aimed at resolving the problem with a credit or repair.

As a buyer, I like to see everything out in the open. Discussions along this line goes a long way with the agents and sellers.
 
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SteveO

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Does anyone else have ideas on minimizing risk?
 

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I'll throw my two cents in here. For me I have to look at a deal from the perspective of what could go wrong. I am not expecting things to go wrong but I have to deal with the what ifs. I also try to work the deal so my margins aren't so close so I do have room for error. If I get in a hurry or desperate for a deal, that is when I am going to make a major mistake. I also have good communication with sevral RE agents in the area and a social network to let me know about trends in the local neighborhoods. You cannot have too much knowledge or friends. You never who knows who. Good luck to all.:cheers:

Greg
 
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SteveO

SteveO

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I am not expecting things to go wrong but I have to deal with the what ifs. I also try to work the deal so my margins aren't so close so I do have room for error. If I get in a hurry or desperate for a deal, that is when I am going to make a major mistake.
Very important to understand the downside as well as the upside opportunity. Also, chasing a deal just to get one is a mistake as well.

I have heard the term analysis paralysis so many times over the years and have seen people talk about doing something without taking the steps.

I thought there would be more interest in this post. Perhaps there are not a lot of risk adverse people on this forum.
 

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Putting together my Real Estate plan recently made me think a lot about managing risk, especially as I'd like to jump right into apartment investing without much (actually any) previous real estate experience. I had to ask myself, "how I can jump into large investments with no experience without exposing myself to more risk than I can handle."

My answer is to very clearly define my minimum entry criteria for any RE investment, and without exception, stick to it. Additionally, I made sure that my minimum entry criteria was very conservative (at least it seems very conservative now, who knows), which will hopefully keep me away from marginal opportunities where the smallest miscalculation could mean trouble.

I'm hoping that in the worst-case, any investment that I jump on that appears to be high-margin, low risk turns out to be marginally profitable at worst. Things may be much worse than I anticipate based on my inexperience, but hopefully my high-bar for entry at least keeps the opportunity a positive value one.

Specifically, I'm looking to invest in apartments, and have set very conservative entry requirements for the following:

- Cash ROI
- Total ROI
- DSCR
- Total Cashflow
- Clear opportunities to add value (below market rents, cosmetic improvements, etc)
- Favorable financing terms
- Deal review by another knowledgeable investor, as well as my team (lawyer, accountant, broker/agent)

The last one I believe is probably the most important. Having someone I trust who has previous experience and expertise give the green-light on a deal I'm considering will likely go a long way towards ensuring I don't get myself into a bad situation that I might have avoided.

The nice thing about this approach is that I can modify it as my experience increases and my instincts improve. I can become more lenient in some entry criteria (like financing terms), when I'm more comfortable that my view of other entry criteria (like ROI and upside potential) is likely very accurate.
 

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I thought there would be more interest in this post. Perhaps there are not a lot of risk adverse people on this forum.
I'm not sure SteveO. The deal, for me, is that all of this is investing is still a new way of thinking for me. I come from the steady employment and save money mentality for over 40 years. Then I read RD and several other books and have achieved a turn around in my direction over the last 2 years. The word risk used to hold such power over me. Fear and risk were synonymous. Now I see risk as just another piece of the investment puzzle. Not something to fear but to strive to control intelligently.

So here are the steps I take to analyze my RE deals. Feel free to help me out if I'm missing something:

1. I see a potential deal(MLS, Craigslist, FSBO, driving down the street)
2. I consider the location, neighborhood, proximity to needed services...
3. I begin accumulating numbers(comps, insurance, taxes, age of property, size of property,...)
4. I contact my RE agents for any information I may not be aware of .
5. I run the numbers on my spreadsheets.
6. I arrange a visit if it looks worthwhile.
7. I have a talk with my spouse to verify my thinking(maybe to ask permission:))
8. Decide what my maximum bid for the property will be and figure what my starting bid will be.
9. Have my RE agent make my bid usually subject to my inspector going through the property.

All of this can take a few hours, a day, or a week. It depends on the deal and how good the deal may be.

I believe that I cover my bases on my risks on step 3 and 4. Sometimes I have had to make visits to city hall (for zoning) or to banks(hidden 2nd liens) to uncover more info. With my last property(an REO) I had to call the city because I found out there would be a lien for lawn mowing. I had to make sure that the bank would be paying it before I would purchase the property.

Now SteveO, I have done 3 fairly small deals so far but I am really contemplating making the big jump to apartment complexes. Been reading your stuff about that lately. Good stuff. Thanks and good luck to all.:cheers:

Greg
 
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SteveO

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Greg,

How have the deals gone so far. Did your homework pay off?
 

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I have had my first deal and it wasn't my best but it cashflows. Then the city it is in now has a budget shortfall and is seeking a .31 cent bump in taxes. Obviously unseen risk. Of course that means I have to bump up the rents and risk losing some tenants. So far all has been smooth but this is all unfolding real time. I can afford to absorb the increase I just don't want to.

My second deal was a better buy is doing great. It is a low maint. SFH and I have a real steady tenant in it.

My third and current deal is a REO that was sold as 3 units but it really has 4 units. I bought it cash for about 40% of FMV. It needs some repairs but I believe I can cash out for more than I have to spend. That will be real cool. Have to watch my pennies on the repairs though to keep it a great deal. Already have a list of potential renters. We close on it this Friday!

All of this was accomplished before my first year in RE was complete. My first year anniversary of my new life is Oct. 2. I plan to have a party!:cheers:
 
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SteveO

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Greg,

You minimized your risk by starting with single family houses to gain experience?

Congrats, btw...
 

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Runum

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Thanks SteveO. Actually my first property was 3 houses on one lot. I wouldn't buy them unless they were fully rented by reliable renters. I was scared to death and pumped at the same time. Right before the purchase my inspector found drugs in the A/C vent of one of the houses. I demanded that the tenant be replaced or the deal was off. They had a new tenant the next week and I got to approve of them before they got their lease.

My second purchase was the SFH and it was vacant. My wife was scared we would never find a renter. It needed some sprucing up but I put out a FOR RENT sign the day after closing and started getting calls 30 minutes later. The next day was a Saturday and I was trying to work in the house. I couldn't get any work done because of all the people that wanted to see the house. It looked like a parade in the house. I had it leased 2 weeks before we had all the work done on it.

One thing I had not thought of until just now. All of my rentals are on busy residential streets and all of them are on corner lots. That helps with exposure. Lowers advertising costs. Also, my SFH is right across the street from a day care center. That increases my exposure to potential renters even more. I guess that minimizes some risk.:thumbsup:

I guess I started out with small deals for comfort and to get acclimated to managing my business. I am closing on the 4 units REO Friday and already have a line on 3 more quads priced at 70% below taxable value. I am just trying to learn this stuff one challenge at a time. I don't want to grow too fast and make it unsustainable. That is another way I minimize my risk, I grow at a predictable but challenging rate for me.:thumbsup:
 

AroundTheWorld

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I was thinking about this yesterday. The comment applies to real estate...

A deal often times presents itself in the form of a property with a problem. Solve the problem - and you have your deal.

Minimize risk by solving the problem before you are committed to the property.
 

Russ H

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A deal often times presents itself in the form of a property with a problem. Solve the problem - and you have your deal.

Minimize risk by solving the problem before you are committed to the property.
That's one of Kiyosaki's key points in making "win win" deals.

He says, if he can find a deal where he sees an opportunity-- something that others did not see, he's *happy* to pay asking price. The seller gets what they want-- and he gets something that he can increase the value of.

This has been the model for each of our current projects (except the house we live in).

We buy at market value, change the use (or radically improve what it does), and reap the benefits.

*******

Example #1: Buy a 10 rm B&B and improve it.

We bought in Nov 2003. Occupancy was ~ 45% (OK) and gross revenues were ~$400/yr

This year, we will have close to 85% occupancy (almost double), and gross will be about $750K.

*****

Example 2: Buy an old building and upgrade its use

We bought this in 05. A rickety old apt building, built in the 1880s.

Fixing it up to be a B&B.

Purchase price: $1.5M w/a separate lot.

Value when we finish: $200-300K for the lot (we're subdividing and adding value to other properties), plus $4.5M for the finished B&B.

******

Example 3: Buy a monthly rental, convert it to a vacation rental.

Bought this in Dec 06. A 100+ yr old rental house w/terrible elec, plumbing, etc. Lots of deferred maintanance. Income before expenses per year: $18,000.00

Opened it as a vacation rental in Sept 07. Estimated income per year: $120,000.00 (we've already taken in close to $20,000 in bookings just since we opened, less than 3 weeks ago). That's more than it made in a YEAR before!

DISCLAIMER: These conversion expenses cost money (hundreds of thousands of dollars). Plus, our uses have MUCH higher pre-tax expenses than the previous owners, so you need to factor this in

(we hate all those pre-tax expenses, right Diane? :smxB: )
-Russ H.
 

tbsells

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I minimize risk by staying with what I know. I know single family residences, duplexes, tri's and quads in a certain geographic area. I know what they should sell for, what they will rent for, what type of tenant they tend to attract, what financing options are available to me, what the problems are likely to be, and more before I ever look at them. These are the type properties I tend to invest in.
I think of my self as risk adverse. But, I have developed a $1.5M subdivsion which is considered very risky by most people. It didn't seem too risky to me or I wouldn't have done it. I did my due diligence as far as determining cost and I knew what the market would be for the lots when completed. It didn't seem risky. What is an acceptable level of risk to one investor may seem crazy to the next depending on his experience, financial strength, and knowledge.
To me risk management is all about knowledge. Specific knowledge about the asset class in which you are investing. If you don't know more than the next guy you are very likely to become his "greater fool." With knowledge and experience comes the realization that you can take some risks because you can afford the downside if it comes.

With all of that being said I now realize that I have a problem. My adversion to risk and desire to manage it has become a LIMITING BELIEF. It has kept me from thinking bigger. I just bought the book SteveO recommends by Volluci about buying apartments. I'm financially ready, but maybe not mentally because my perception is that the risk is greater. I'm working on changing that. For me, I need alot more knowledge on the subject before I'll pull the trigger. This forum and discussions of this type have helped me to realize whats holding me back. Its time to move forward and grow.
 

AroundTheWorld

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I minimize risk by staying with what I know. I know single family residences, duplexes, tri's and quads in a certain geographic area.
As I read that...

I was thinking this...

With all of that being said I now realize that I have a problem. My adversion to risk and desire to manage it has become a LIMITING BELIEF. It has kept me from thinking bigger.
It is a great point... You do want to stick with your competency - but you also want to expand your compentency.... and expand your thinking. It is imperative to grow in your knowledge and in your belief system.

I still remember the day my hubby and I looked at eachother and said, "OHHH.. It is time for a 'big' deal." On that day, we decided to move from building spec houses (SFR) to getting into apartment buildings or something similar.

It was an amazing day! True "Ah - Ha" moment.
 
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SteveO

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I have always looked at subdivisions as being very risky. While I have not ever looked into them it just seems like there could be a lot of complications and risks with sales.

What seems risky to you seems rather low risk to me. As you stated though, it is because of what we know.

Knowledge and experience are certainly a way of minimizing risk.
 
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SteveO

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I still remember the day my hubby and I looked at eachother and said, "OHHH.. It is time for a "big" deal." One that day, we decided to move from building spec houses (SFR) to getting into apartment buildings or something similar.
So, you had taken some risk and it worked out. Now you were ready to take more risk as a result?
 

randallg99

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Does anyone else have ideas on minimizing risk?

When buying buildings or businesses, I have stressed that tax returns must be available and I have no problem asking for them in the initial discussions to get a feel for the sellers.... red flags :smash: are raised if there is any hesitation or refusal. Schedule E and all associated corporation papers are required.

Exceptions to this rule are the single family homes where I am familiar with the area and market.

There are great ideas on this board and this thread regarding minimizing risk and I learned something today...
 

AroundTheWorld

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So, you had taken some risk and it worked out. Now you were ready to take more risk as a result?
Great Question... I had not really thought about the steps of risk... but ya - I think that is basically how it went...

Our first "risk" was to build a spec house. It went very well.
We did it a few more times.

The next "risk" - which was a biggie - is that my hubby left his job.

After doing that - and a handful of real estate deals... moving on to the big deal didn't actually feel all that risky. It was done is stages too, though...

The "big deal" we ended up with was self storage. But we developed it in stages. Built some units. Leased them up. Then built more.

It would have been more "risky" had we built ALL the units before we actually started leasing up. While we had done our research on demand in the area - the proof is in the pudding and there are always that nervous time period where you wait to see if you were right.
 

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tbsells

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This is a great thread. It has really caused me to think.

The key to successful investing is maximizing the risk/return tradeoff. Anyone can minimize risk by doing nothing.....or "investing" in CD's. But we all know that will get you no where. The real question is "What level of return do I expect for a given level of risk." Risk is somewhat subjective, as we have already discussed it depends upon a persons knowledge and experience.

For me, I will require a greater return to invest in apartments than I do to invest in SFR's, duplexes, tri's, and quads. I think that is only reasonable. I'm sure its also available in the marketplace.

My next step is to start reading Volluci's book and start looking for the bigger deals.

Thanks to all for the input!
 

AroundTheWorld

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I was thinking about this yesterday. The comment applies to real estate...

A deal often times presents itself in the form of a property with a problem. Solve the problem - and you have your deal.

Minimize risk by solving the problem before you are committed to the property.
I have a story that illustrates this point. I will lay out the situation now ... and wait for a bit before I post the conclusion of the story... I want to hear your opinions and ideas about what you would do to minimize risk in this situation.

It is a real-life story.

A piece of property bordering forest service on one side and private property on three sides. No easement through the forest service and no access to the property in any other way.

Solve the problem of no easement (no access) and you have a property that is worth $1,000,000. You can pick it up for $400,000.

Hmm... sounds risky. What if you can not get the easement from the forest service? It is only worth what you are paying for it... $400,000 and who knows how long it will take you to sell.

There is more to the story. You also have in your hands a letter from the forest service. In this letter, the forest service says that they will give you access if you can prove that you can not obtain access through any of the other properties.

And... you have a letter from each neighboring property owner stating that they will not give or sell you an easement.

Now do you buy? Is the risk gone?
 

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Solve the problem of no easement (no access) and you have a property that is worth $1,000,000. You can pick it up for $400,000.

Hmm... sounds risky. What if you can not get the easement from the forest service? It is only worth what you are paying for it... $400,000 and who knows how long it will take you to sell.

There is more to the story. You also have in your hands a letter from the forest service. In this letter, the forest service says that they will give you access if you can prove that you can not obtain access through any of the other properties.

And... you have a letter from each neighboring property owner stating that they will not give or sell you an easement.

Now do you buy? Is the risk gone?

I'm no expert, but I'll take a stab at how I'd think about this... (remember, I'm a former professional poker player, so I'm going to approach this as a gamble, which it is)...

The risk certainly isn't gone. Until the Forest Service actually grants you the easement, there will be risk. But, I imagine you can reasonably assign a probably to the risk. In addition, you can reasonably assign a value to the property based on whether you get the easement or not.

Here's the info we'd need (along with my guesses for the values)***:

1) Chance that we get the Forest Service easement: ~70%
2) Value of the property if we get the easement: ~$1M
3) Value of the property if we don't get the easement: ~$300k (after carrying costs)

Using this information, I would derive an Expected Value equation to determine the expected value on the property given the above probabilities and values:

EV = (.7) x ($1M) + (.3) x ($300k) = $790k

Subtract the $400k you invested originally, and your overall EV is +$390K

So, your EV if you take this "gamble" is +$390k. Not bad!

Of course, that's not the whole picture. You also have to consider your worst-case downside, which would be losing $100k and a bunch of time/effort.

Can you afford that worst-case outcome? Would it bankrupt you? Cause you financial hardship? Or would it just be a bump in the road?

If it were me, I'd take that risk (assuming those numbers were accurate)...


*** Keep in mind that I'm making up numbers here. Perhaps the likelihood of getting the easement is actually closer to 50%? Or closer to 90%? I don't know. But you could likely get better estimates, and you should. Plug them into the equation to get a better sense of what you stand to gain or lose.
 

8 SNAKE

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I would want to know how large the parcels of land are that adjoin the property in question. I'm not very familiar with MT real estate (in MO I don't think that you can sell land-locked property), so I'm just using logic on my approach.

I'm going to assume worst-case scenario that you can't get access from the Forest Service. If the adjoining parcels wouldn't be harmed too much by an easement, I would draft an offer to all three property owners offering $100,000 to the first one that allows the easement. Send it to all three and let it be known that the first to sign gets the cash. Odds seem quite high that you'd get at least one taker and double your money ($400k for land plus $100k for easement nets you $1,000k).
 

Diane Kennedy

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I'm no expert, but I'll take a stab at how I'd think about this... (remember, I'm a former professional poker player, so I'm going to approach this as a gamble, which it is)...

The risk certainly isn't gone. Until the Forest Service actually grants you the easement, there will be risk. But, I imagine you can reasonably assign a probably to the risk. In addition, you can reasonably assign a value to the property based on whether you get the easement or not.

Here's the info we'd need (along with my guesses for the values)***:

1) Chance that we get the Forest Service easement: ~70%
2) Value of the property if we get the easement: ~$1M
3) Value of the property if we don't get the easement: ~$300k (after carrying costs)

Using this information, I would derive an Expected Value equation to determine the expected value on the property given the above probabilities and values:

EV = (.7) x ($1M) + (.3) x ($300k) = $790k

Subtract the $400k you invested originally, and your overall EV is +$390K

So, your EV if you take this "gamble" is +$390k. Not bad!

Of course, that's not the whole picture. You also have to consider your worst-case downside, which would be losing $100k and a bunch of time/effort.

Can you afford that worst-case outcome? Would it bankrupt you? Cause you financial hardship? Or would it just be a bump in the road?

If it were me, I'd take that risk (assuming those numbers were accurate)...


*** Keep in mind that I'm making up numbers here. Perhaps the likelihood of getting the easement is actually closer to 50%? Or closer to 90%? I don't know. But you could likely get better estimates, and you should. Plug them into the equation to get a better sense of what you stand to gain or lose.
JScott, I'm giving you Rep++ for this. Two main reasons:

(1) I think we forget that we can (and should) quantify risk. If you can take the emotion out of it, and just look at the numbers (and whether you can afford the downside) decisions become easy. My husband (by education an engineer) and I (by education an accountant) use the formula you've got here ALL the time for decisions. Of course, for some people the decision might be so emotional that you couldn't sleep at night, then you've got to give room for that emotion.

(2) I'm originally a Reno girl. We cut our teeth on probability, how to double down and how to properly order a drink. I can't believe anyone could even consider themselves educated without knowing those things... :smxB:
 

andviv

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I'd make an offer for 400K with a contingency on me getting the easement. I'd ask for a period of 3 months (or whatever time I'd need) to get this done so now I reduce the risk (won't buy if can't get the easement) and would put as little earnest deposit money as I possible could (how does $0 sound for you?). If I can't get the easement then there is no deal and I can walk off this with nothing else lost than the time used and a great knowledge (learned a lot from this process).
 

nomadjanet

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It has been a long time since I have felt that we really had much at risk. As I mentioned in some other posts. We usualy do deals that are less than 500K and we have enough liquidity to make this not much or a risk at all.
We are getting reay to do our first large deal we are looking at borrowing more than 2million dollars to get started. I am exicted and a little scared but this is a project I have wanted to do for 10 years, the right property has finally been presented to us and I am seeing the possibilities more than the risk. Luckily my optimistic nature is held in check by my DH the realist who sees more problems than solutions. You may think this is a bad thing but it is not, if he sees the problems, I have the opportunity to solve them before we lose our investment.
Janet
 

8 SNAKE

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I'd make an offer for 400K with a contingency on me getting the easement.
That's a safe plan, but is it realistic? If I'm the seller and the reason that I'm offering this property at $400k is because it lacks an easement, why would I accept an offer contingent on getting the easement that doubles my property's value while keeping it off the market for a set period of time?

I'm not saying that you're wrong, I'm just pointing this out for the sake of discussion.
 

andviv

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8, valid point... however, if they are motivated to sell they will accept my contract if nothing else shows up. I am presenting my offer based on what could work for me. If it works for the seller then we have a ratified contract, otherwise we don't. I try not to second-guess the intentions/motivations that the other party could have. I start the negotiation and see where we go from there. If there is a win-win then great, otherwise, thanks for your time and call me if my offer looks good for you down the road.

By the way, I think your solution is very creative and may also work. At what point do you make the offer to the seller and to the other three owners? who do you make the offer first? do you make the offer to the other owners AFTER buying the property or before that?
 

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