Don’t be Fooled by Paper Profits
Paper profits are profits that show up on paper that “look good” but are they? I was having a conversation the other day with a fellow real estate investor. We were perplexed about all the properties being purchased because of the large profits that appear to be generated based on what shows on paper or “paper profits”. Paper profits can be extremely misleading: because let’s face it: on paper things are always designed to look good. I see all too often that people buy property based on a piece of paper that shows a large return on investment. Yes this tends to be the largest share of their diligence. It is extremely important to do proper diligence on a property over and above what someone puts on paper for income and expenses. The more people buy based on this type of diligence the more sellers embellish the information. Buying real estate should be about sustainable profits over time.
Large myth conception is, a cheap property will generate larger returns.
• Truth: Cheap properties tend to be found in higher crime areas, more transient or less desirable areas. Good tenants that rent for an extended period of time like to rent homes that are in good neighborhoods they feel safe in. Tenant turnover is a huge expense that distracts from sustainable returns. When you have tenant turnover the profits illustrated on paper are rapidly absorbed in tenant turnover expenses. One tenant turnover per year can result in a new placement fee for a new tenant. Screening costs, vacancy time while property is being cleaned,painted and or repaired. The paper profits may be reduced by 50,60,70 percent or more.
• Truth: cheap properties are typically older in age and require much maintenance. These maintenance issues can reduce and possibly totally deplete all profits.
• Truth: Cheap properties tend to be in areas that are dominated by rentals. The only exit strategy in a rental dominated area is to sell to another investor. Investors are looking for cash flow and good deals and will not pay top dollar for these properties which reduce your exit strategy down to low profitability.
• Truth: while profits look to be great returns, the actual dollars generated (even when everything goes fine) are small dollar amounts. A double digit return looks great and the double digit returns in a years’ time still add up to small dollars generated. A 15% return (as an example) looks good on paper but to create a significant amount of cash return requires multiple properties to create a sizable dollar return. These multiple properties that are required create a large amount of risk.
When proper diligence is performed and the cheapo properties are evaluated against a more expensive but newer and more desirable property with safety and sustainability the returns over time will always perform better on a higher priced sustainable property than on a cheap property that is unpredictable.