The Most Important Concept you Forget - Sunk Costs!
Updated: Jun 3, 2020
What's quite possibly the most important word to understand when conducting due diligence on a deal?
Sunk Cost
"A cost that has already been incurred and that cannot be recovered" is the way it was defined by a Britannica article. This is a cost that cannot be changed and should have no bearing on your decisions moving forward.
In a property acquisition, this includes your due diligence deposit (in North Carolina), inspection, appraisal, and any fees that are paid throughout your due diligence period. During this time you may identify something that negatively impacts your deal, and if you can't get the seller to acquiesce you have a tough decision:
Do I bite the bullet and move forward or do I back out of the deal?
The sunk cost fallacy may tell you that you need to move forward because of the money you've already invested, which is why it's considered a fallacy! The true answer to that question depends on whether or not the deal is still good, REGARDLESS of the money spent so far.
It is with that in mind that I share with you two examples of properties where despite spending $2,000 in due diligence, I chose to walk away from the deals.
MOORESVILLE DUPLEX - GAS GAS GAS!
This nice looking duplex was just sitting there on the MLS waiting for me...beautiful exterior, decent interior condition, and an extra plot of land to boot!
The asking price was $179,000 and we had negotiated it down to a purchase price of $160,000. The deal was under way, the financing had been initiated, the appraisal was complete, and the inspector was enroute.
So far the news was great and I was feeling good! I was under contract for $19k below asking price, and the appraisal came in at $165k. It was at that point I get a call from my agent while walking through the Atlanta airport that there was a major issue identified by the inspector. The gas packs (heating and cooling units) looked to be leaking into the house when the heat was turned on and both would need to be replaced.
Let me back up for a second. I was excited about the deal but ultimately it was risky. I was going to be spreading my funds pretty thin, recouping my cash by selling off the vacant land parcel but that would be slow and take a lot of time. So the only way it made it worth the risk and opportunity cost was if my money was providing a very good return. With only minor repairs required to this point it fit the bill, but now replacing both gas packs changed that.
The two units would be an added capital expenditure of $10,000. It may not seem like much in the grand scheme of things, but given the situation I just described it was a very important number. So we went to the seller and told them the deal. I like the property and want to close on it, but the only way I can do it is if they replace both gas packs or provide a credit of $10,000 (not reduce the price, but provide a credit).
They were willing to work with me, but only up to $5,000. I appreciated the show of good will and effort to work together, but here's the most important thing:
I knew what worked for me
That didn't work. It was as simple as that. I had invested $500 into a non-refundable deposit, $550 into the inspection, and $600 into the appraisal. These were all sunk costs that I would never get back (except for the deposit that would have been applied at closing), so they were irrelevant in my decision.
We walked away, never looked back, and it was a fantastic decision that I'm extremely grateful to have learned!
KERNERSVILLE FOURPLEX - NOT WORTH THE RISK
Fast forward 2 months and we're at the new year - I had just closed on a different duplex and found an off-market fourplex that looked great on paper.
The deal came through a wholesaler and I was taking it down with a like-minded partner. This fourplex was an old farmhouse that had been converted and sat on a pretty sizable plot of land. We were under contract for $140,000, with the seller set to carry $120,000 of financing for a year.
Luckily the wholesaler didn't require a non-refundable deposit on this one, and we were smarter about our sequencing. We wanted to get a subject-to appraisal to determine the value once the rehab was complete, but we waited to do so until after the inspection was complete (see, I learn from my mistakes).
My partner and I were already a little wary of the deal after seeing the property. The conversion to a fourplex was shoddily done, the units needed a good amount of work, the tenants were difficult, and this wouldn't be an easy deal. The numbers looked good but we were cautious.
Enter the inspection. First, he was unable to get into one unit because the tenant refused and he didn't enter another because the tenant was sick (this was at the onset of Covid-19). As he continued working his way through the rest of the property he identified a number of potential issues with plumbing, the roof, and the attic insulation, but the biggest concern was electrical. He gave me a call afterwards and told me that before anything else happened we needed to get an inspector out to review the electrical system.
At this point we estimated the total value to repair everything he identified to be around $30,000, and that was before the actual rehab. While the seller was willing to negotiate on the price, he wasn't willing to do any of the work or pay for it directly. As a result, we would still be putting money down for the purchase, paying $30k cash for the repairs, and another $20k for the rehab.
Even if he dropped the price the full $30k, the cash outlays were still significant and not something my partner and I were interested in on a risky deal. The only other option would be if we had a rehab loan we could use to bridge the gap until the property was rehabbed, and due to the onset of Covid many hard money lenders had paused on lending.
At this point we made the decision to back out. We called the seller and ended everything very amicably, explaining the situation and that it just didn't make sense to us. Luckily on this property the only cash we had spent was on an inspection, and due to the fact that he couldn't do a complete inspection and write a report that only cost $275. A hell of a price to save us from a rough deal!
At the end of the day, due diligence has its purpose and understanding a sunk cost is hugely important! On either deal I could've continued moving forward because of the time, money, and effort invested to that point. If I did, I would've ended up with 2 different very risky deals that didn't meet my criteria simply because of the sunk cost fallacy.
Don't be afraid to back out! Make sure you know your financial situation, and make sure you know your criteria for what's a good and bad deal before you go into it. If the deal doesn't make sense, take a step back! There will be more, and you'll be more successful in the long run if you stick to your guns and do what you know is right rather than acting because of sunk costs!