My friends Jarrrett and Raja are magicians. They live in Las Vegas and they’ve had a magic show at the Stratosphere Hotel. They’ve been semi-finalists on America’s Got Talent. They’ve been featured frequently on the TV Show Masters of Illusion. They’ve even appeared on the TV Show Shark Tank. I’m sorry to disappoint you that when the canvas booth goes up in flames and the girl disappears from the booth and appears seconds later across the room floating in a water tank that’s inside a Grand piano, it’s not magic. It’s an illusion.
Well folks, magic doesn’t happen in real estate either.
I get so many questions from listeners that follow the same theme. I see real estate listings from brokers that assume magic happens. When I say magic, I truly mean magic.
Let’s imagine that you were running a retail store. Customers come into the store. They buy your product at the retail price and you purchased the inventory at a wholesale price. Your profit quite simply is the retail price, minus the wholesale price, right?
No, of course not. You have to pay rent on the space for the store, and you have to hire cashiers to take payment, and inventory managers to manage the inventory levels and purchasing of new inventory. You have to spend on marketing and advertising. All of that costs real money. If you don’t account for the actual management of the business in your business plan, then you’re relying on work getting done by magic.
I really want to banish the term passive income from the dictionary because it doesn’t exist. All of these businesses are active businesses.
There was a question from Joe who is evaluating a 20 unit mobile home park. The mobile home park is at 80% occupancy and has $59,000 in gross income. After expenses, the park nets about $37,000 a year in net income. The 20 unit park is on an 8 acre property. At a purchase price of $375,000, Joe is wondering if this is a good deal.
The problem with this deal is that it assumes that magic is happening. If you don’t have a person dedicated to managing the business, then nobody is managing the business. A 20 unit park is not large enough to hire a dedicated manager. So that means hiring a part-time manager, and a part time maintenance person. That’s a problem.
If you finance $300,000 of the purchase at 5% interest, you’re looking at an additional $24,000 in debt service. So the cash flow is now $13,000. That assumes that nothing goes wrong, that you don’t lose another tenant, that the septic system doesn’t need repairs, or that the water well doesn’t face contamination from an agricultural source.
So often, I see these financial projections put together based on a snapshot of recent performance. But the problem is that these snapshots are incomplete. There are categories of work that attract real expense. The projection of $37,000 in profit and a 10% cap rate is a pure fantasy. There is no money allocated in the expenses for cutting the grass on 8 acres. That amount of landscaping will cost nearly $1,000 a month if the grass is cut weekly.
The point here is not to dig into the weeds on this particular deal, but to frame the problem.
Last week, I visited a historic manor inn. The Inn is in a wonderful location. It’s a perfect venue for hosting weddings. It has been beautifully decorated and the rooms would attract a high nightly rate during peak season. It’s a perfect setting for corporate retreats. What’s the problem? It only has 11 guest rooms. It’s too small to be economically viable. Unless the operator lives onsite or nearby and acts as an owner/operator, the economics don’t work.
This is the problem with projects that are too small. They rely on real work happening that isn’t allocated in the operating budget. When something happens for free in a business, that’s magic. We all know that magic doesn’t really exist. It’s just an illusion. There is a sleight of hand happening.
